Microsoft and Yahoo!: Happily Ever After?

If the No. 2 and No. 3 Web search titans tie the knotvia Microsoft's multibillion-dollar bid for Yahoothey may only just keep up with No. 1, Google
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Having spent north of $10 billion buying and building a Web business, Microsoft (MSFT) finally acknowledged its best efforts have done nothing to stall Internet leader Google (GOOG). On Feb. 1, the software giant took its most audacious step yet, announcing an unsolicited $44.6 billion bid for online rival Yahoo! (YHOO).

The deal would combine the second- and third-largest players in Web search. For Microsoft, it may be something of a Hail Mary pass, a last best attempt to catch Google while it still can. "We have been making good progress," says Microsoft CEO Steven Ballmer. "We're in this game, and we're going to be in this game. But the market leader is getting stronger."

Microsoft offered a 62% premium on a share price that's been sliding for the better part of a year amid five consecutive quarters of profit declines. So the overture will be hard to resist and a rival bid is unlikely. Some analysts said the deal makes strategic and financial sense, especially for Yahoo. The company's stock surged 48% to $28.38.

Still, whether and how quickly a combined Microsoft and Yahoo can mount a meaningful counteroffensive against Google is by no means clear. The cost savings won't be easy to achieve in an economy veering toward recession, the companies will struggle to elegantly combine disparate operations, and Google can be expected to use the time to lengthen its lead in the quickly growing online ad market. Regulators will probably approve the deal, but not before a lengthy review that could involve imposing conditions aimed at ensuring competition.

Microsoft vs. Dominant Competitor

Microsoft believes it can eke out $1 billion a year in cost savings from the combined operations. Anant Sundaram, a professor at Dartmouth's Tuck School of Business who has studied mergers and acquisitions, says that may be ambitious. "With the economy looking increasingly wobbly, it is not clear that the revenue synergies will start to happen any time soon," Sundaram says.

Ballmer's keen awareness of that deterioration was evident in a Jan. 31 letter to Yahoo CEO Jerry Yang. Ballmer noted the two had discussed partnerships in late 2006 and early 2007 but that in light of Yahoo's worsening outlook, "the only alternative now is the combination of Microsoft and Yahoo! that we are proposing." Yang even rejected merger overtures in February, 2007, Ballmer wrote, hoping a new ad strategy and reorganization would brighten prospects. "A year has gone by, and the competitive situation has not improved," Ballmer wrote.

There's little doubt that Microsoft's interest in Yahoo has grown more fervent as Google's lead has increased. The battle to catch Google grows harder by the day. "I think Microsoft is desperate," says Forrester Research (FORR) analyst Charlene Li.

In Google, Microsoft sees a foe that is very much like the one it was in the early days of personal computing. Back in the 1980s and '90s, Microsoft created what's known as a network effect, whereby a service becomes more valuable as more people use it, with its Windows operating system. The more people used it, the more applications got written for it. That made Windows ever more appealing to computer users, ultimately helping the company garner more than 90% of the operating system business.

Benefit to Advertisers Unclear

In online search and advertising, Google is having a comparable impact. As more people search the Web using Google, its search results become more relevant. That in turn makes advertising through Google all the more appealing to marketers. Google not only sells ads to accompany search results, but it is also becoming an online ad network, serving as the go-between for advertisers and site publishers across the Web. Web publishers increasingly turn to Google's network to sell ad space because the company has the largest collection of advertisers interested in buying.

Microsoft hopes to diminish Google's advantage through the Yahoo acquisition. If Microsoft can smoothly mesh Yahoo into its MSN and Windows Live Internet businesses, it could create a network that approaches Google's size. Google accounted for 56.3% of all Web searches in December, compared with a combined 31.5% for Microsoft and Yahoo, according to Nielsen Online. A combined Microsoft and Yahoo would "bring together critical mass," Ballmer says, and "we'll build off that strength."

It's unclear, though, whether advertisers prefer a single strong rival to Google or two lesser companies fighting for their business. Increasingly, advertisers are looking at smaller sites to target their ads, says Jarvis Coffin, co-founder and CEO of Burst Media (BRST.L), an ad network that helps place ads for such brands as Alamo, Disney (DIS), and ESPN. Getting together won't make Microsoft and Yahoo "more responsive to what the market is looking for and what consumers are looking for online," Coffin says. "It isn't going to make it any more relevant and powerful for advertisers."

What's more, smoothly integrating operations will be difficult for two such large companies with disparate businesses and clashing cultures. Microsoft and Yahoo have been gobbling up online businesses, including online ad firms aQuantive, bought by Microsoft, and Right Media, acquired by Yahoo. "They've really bitten off quite a bit to digest," says Kevin Lee, executive chairman of Didit, a digital marketing firm. "It would be quite an undertaking to combine all those pieces."

Messy Overlap of Businesses

Then, Microsoft will also have to figure out how to meld the Yahoo brand into its own stable of online businesses. "There's no doubt that Yahoo, the brand, lives," Ballmer says. Microsoft has already stumbled trying to operate its two online brands—MSN and Windows Live. Now it will need to add a third brand that's arguably stronger.

And then there's the challenge of figuring out what to do with overlapping Web sites and services—from the companies' automotive buying pages to their portals to their Web-based e-mail programs to their instant messaging services. "It's a mess," says Forrester's Li. "Users are notoriously fickle. One change and they're gone."

And, of course, Google won't be sitting idly as Microsoft addresses those challenges. "They're going to be doing this in the face of a very aggressive competitor," Li says.

A merger between Microsoft and Yahoo made much more sense three years ago, before Microsoft built and bought its online empire, says editor Danny Sullivan. Now, there's so much overlap that the cost has grown exponentially. And Microsoft will have its hands full figuring out how to put the businesses together. "It probably still makes sense now, but it's a much more challenging process," Sullivan says.

The deal would eclipse Microsoft's largest acquisition—the August, 2007, purchase of online ad firm aQuantive—by sevenfold. And it would drain the $21.1 billion that Microsoft had in cash as of Dec. 31, since Microsoft plans to pay for half of the deal with cash and the remainder in stock. Microsoft generates more than $1 billion a month in free cash, so its coffers could be restored in short order.

While Microsoft shares dipped on the news, falling 6.6% to $30.45 on Feb. 1, Sanford C. Bernstein analyst Charles Di Bona believes shareholders will come around. Microsoft built assets like its adCenter online advertising platform to compete with Google. But it wasn't able to leverage those offerings with the relative smattering of users it had. "What they are admitting is that they can't monetize those assets without a sizable community," Di Bona says.

Regulatory and Cultural Hurdles

Yahoo executives still might balk at the deal. They have been cool to the idea of selling out because they believe they have the pieces in place, such as a base of 500 million monthly visitors, improved search-advertising technology with the year-old Panama project, and new display-ad targeting technology from last year's acquisitions of Right Media and BlueLithium, to return to some semblance of its former glory. But after a fourth quarter in which it announced a muted outlook for 2008, knocking its stock down 8.5% on Jan. 30, its leverage was fading. In a statement, Yahoo said it would "evaluate this proposal carefully and promptly in the context of Yahoo's strategic plans and pursue the best course of action to maximize long-term value for shareholders."

Assuming Yahoo agrees, Microsoft will still need to get the deal past regulators. The company believes the acquisition will stand up to the regulatory scrutiny. The House Judiciary Committee said on Feb. 1 it will hold a hearing to discuss the proposed merger on Feb. 8. While congressional leaders don't have the power to block planned acquisitions, their attention to such matters can influence the regulatory bodies that do.

In a statement, the antitrust division of the U.S. Justice Dept. said it is "interested in looking at the competitive effects of the proposed transaction." Given the DOJ and Federal Trade Commission's recent history of approving billion-dollar ad network deals, many believe the merger will ultimately be approved.

Maybe the biggest challenge Microsoft will face is cultural. Yahoo's 14,300 employees come largely from the Silicon Valley world that loves to hate Microsoft. "Yahoo has always considered itself a bit of an upstart," says a former Yahoo employee who asked to remain anonymous. "Most Yahoo employees will feel that, A., we lost, and B., there is no way in hell that I am going to work for Microsoft."

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