Microsoft Swoops In on Yahoo

The software king, with its $44.6 billion bid for the portal, wants to catch Google in the ballooning online ad market

Concluding that neither company can successfully take on Google by itself, Microsoft (MSFT) launched an unwelcome takeover bid for Yahoo (YHOO). Microsoft said Feb. 1 it will pay $44.6 billion, or $31 a share, for Yahoo. The offer represents a 62% premium over Yahoo's closing share price Jan. 31.

The deal would marry the world's largest software maker with the owner of the most used Internet portal, helping the resulting company better grapple with Google (GOOG) in a market for online advertising that's expected to balloon to $80 billion by 2010.

Though Google's name was scarcely mentioned during a Feb. 1 conference call discussing the deal, it was clearly the 800-pound motivation for Microsoft's overture. "This market continues to grow and the leader continues to consolidate position," Microsoft Chief Executive Officer Steven Ballmer said during the call. Ballmer said he called Yahoo CEO Jerry Yang the night before to make the offer and has been pursuing the deal for 18 months. "Our companies really do share a vision for online services and advertising," Ballmer said during the call before U.S. markets opened. "There is no better way to increase scale and capacity than this acquisition."

No Improvement After a Year

In late 2006 and early 2007, Microsoft and Yahoo discussed ways to work together, including through a merger, Ballmer noted in a letter to Yahoo's board Jan. 31. Yahoo spurned the overtures, pointing to the "potential upside" of various efforts to improve its performance, including an effort to wring more profit from online advertising, Ballmer wrote. "A year has gone by, and the competitive situation has not improved," Ballmer said.

By some estimates, 42% of all online advertising dollars go through Google. Microsoft, Yahoo, and Time Warner's (TWX) AOL, combined, grab roughly the same percentage of the market, according to Jeffrey Rayport, founder and chairman of Marketspace Advisory, a strategy consulting firm. Some analysts said the transaction would help Yahoo and Microsoft compete with Google.

"Yahoo is under enormous pressure to realize value, and such a deal would serve this purpose," Standard & Poor's analyst Scott Kessler, who covers Internet companies, wrote in a research note to clients Feb. 1. Jim Yin, who covers software for S&P, said the deal "would help Microsoft compete more effectively against Google in search-engine and online advertising," though he added, "The merger presents integration challenges." (Like, S&P is owned by The McGraw-Hill Cos. (MHP).)

Improving Economies of Scale

Google has steadily increased its share of online ad dollars during the past few years. That's due in large part to the sheer number of people reached every day by Google and the ads it shows. The company is the dominant place people go to look up information—it hosts more than 60% of Web searches—and partnerships with leading social networks such as News Corp.'s (NWS) MySpace have allowed it to extend its reach even further.

With Yahoo, Microsoft would greatly expand the number of people who visit its network and the sites on which it can serve ads, enabling it to counter Google's reach. "This is a business that has scale economics in the search and advertising industry," said Kevin Johnson, president of Microsoft's platforms and services division.

Microsoft also sees the deal as giving it the engineering power to fuel innovations on the Web. Both Microsoft and Yahoo have been criticized as innovation-stagnant compared to Google, which continually releases new products, and boasts of giving technical employees one day a week to work on new ideas. "By combining our engineering talent we are going to enable more innovation over a wider range," said Johnson.

Savings on Capital Expenditures

Online publishers want a strong competitor to Google and therefore support the combination, Microsoft general counsel Brad Smith said on the call. "They're encouraging us to make this kind of acquisition," he said.

Microsoft says it would be able to reduce costs by $1 billion a year through the combination. The enlarged entity would be able to cut back on some capital-intensive efforts, such as building massive data centers. Microsoft expects to see earnings per share of break-even or better by the second half of 2008.

Microsoft executives spoke little of the mass layoffs that would likely be demanded if the two companies combined. Microsoft executives said the new management teams would consist of key people from both companies. However, Yahoo's workforce of 14,300 would undoubtedly be reduced as Microsoft combined similar projects and departments that once competed with one another.

Corporate Cultural Differences

Yahoo began reducing its own staff, and combining redundant efforts, late last year, after founder Yang took over as CEO. It announced plans earlier this week to lay off 1,000 employees.

The integration of such a massive company will not be easy for Microsoft. Yahoo has a distinct culture, comparable in some respects to a media company, that many see as vastly different from the more buttoned-up Microsoft. But it's just that kind of culture that Microsoft may be trying to adopt as it focuses more on the Web, looking toward a future in which even desktop applications such as Microsoft Word are served over the Internet. "It's a transformation of our business," says Ballmer.

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