An Open Letter to Steve Ballmer

I know you want to make your mark on Microsoft, but you should stop trying to be all things to all people. Take a tip on focus from that other Steve

Dear Steve,

Let's talk over this Yahoo! (YHOO) thing before you move ahead. It's a profoundly bad idea.

Now that Bill Gates has completely stepped away from day-to-day operations at Microsoft (MSFT), I can understand you wanting to make a big move, shake things up, put the big Ballmer imprint on things. But as bold strokes go, as you probably know, big mergers practically never work.

Look at some of the big deals in high-tech history, most of them colossal failures. Going back a few years, there was IBM (IBM) and Rolm in 1984, and then AT&T (T) and NCR (NCR) in 1991. More recently, there was 1999's clunker between Lucent and Ascend (which helps explain last year's takeover of Lucent by Alcatel (ALU), itself a dubious-looking deal). And then there was Compaq and Digital Equipment in 1998, followed by Compaq and Hewlett-Packard (HPQ) in 2002. (O.K., that last one worked out in the end, but not before costing Carly Fiorina her job. Steve, are you listening?) Oh, and let's not forget the $164 billion failed marriage between Time Warner (TWX) and AOL, which Time Warner is now looking to cut loose (, 2/7/08).

Portents of Merger Misfortune

Nothing about Microsoft and Yahoo suggests to me that in combining them you'll be able to avoid any of the standard pitfalls that make big tech mergers fail: brain drain from departing employees, political turf wars amid clashing cultures, morale-depleting anxiety as the focus shifts from work to layoff jitters, customers eschewing uncertainty and going to less-distracted rivals like Google (GOOG).

Oh, I know—on paper the combination makes sense. Yahoo generated sales of about $7 billion last year. Combine that with Microsoft's online revenues, and you've got a $10 billion business. And Yahoo's profits, $660 million last year, almost offset Microsoft's online red ink. Add in the operational savings you'd expect from combining the businesses, and the Microhoo online operation could make $1 billion a year in profit down the road. But is it really worth blowing what's worth $41.5 billion in cash and stock now for uncertain profits a few years from now? The fact that investors have wiped $3 billion off the value of that offer in a week should tell you something.

After all, who knows what will happen to the Internet while you're busy splicing these companies together. Name one truly important Internet innovation that has come internally from either Microsoft or Yahoo. I can't either. All the best new stuff at Yahoo has come by way of acquisitions: Flickr, Oddpost, Zimbra, and Overture.

And Microsoft's Internet acquisitions? None of recent note come to mind except for the advertising outfit aQuantive—another catch-up play. And Microsoft has bungled the older ones I can remember. WebTV was a dud before you bought it. After buying Hotmail in 1998, your heavy-handed company ruined a blessedly simple e-mail service, saddling it with ads and "convenient" integrations with other MSN services. And as for your own innovations? Please. Smart Displays and SPOT watches certainly looked cool in the promotional videos at CES. Duds both.

You know what you need Steve? Focus.

Why Not Stick to Software?

You've heard this said about Microsoft before. It's a sprawling company often at cross-purposes with itself. In 1995, Microsoft's prospects seemed limitless. Since then, the company has grown in an uncontrolled manner, buying its way into businesses that are only barely connected to software: TV networks (MSNBC), phone answering software, and video games, to name a few.

Meanwhile, look at all the trendy Internet opportunities that both Microsoft and Yahoo have missed: social networking, video sharing, blogging, and so on. (Yes, Microsoft's now got a piece of Facebook. But that $15 billion valuation? It's hard to get a good deal when you buy your plane ticket at the counter just before takeoff.) The Internet's rapid shift to user-generated content, browser-based applications, and widgets has been unapologetically platform-agnostic. Windows is all but irrelevant in this arena. Had Microsoft kept its focus on its core business, this might not have happened. Instead, your efforts on the Web have tended to focus more on bending the Web to your will than making your software enhance it.

Take Microsoft Office. If someone took it away from me, I could get by using a Web-based office suite like Google Docs and Spreadsheets, or Zoho and others like it. You should have had Office on the Web five years ago. Meanwhile, as Web-based upstarts were quietly invading this turf, you've been wasting time, effort, and attention trying to be a consumer electronics company, a digital media company, and now an online advertising company. Before long you'll probably want to sell me telephone and TV service, too. Enough with the identity crisis! Microsoft is a software company. Everything else is superfluous.

Learning from the Other Steve

So who has focus? That other Steve. You know, the turtle-necked guy in California who keeps annoying you by selling iPods and computers that typically don't run on Windows. You could learn a lot from him. Focus saved his company from oblivion. Apple (AAPL) does what it's good at, and it expands into new areas carefully. (Examples: iPod, iTunes music store, Apple retail store, iPhone.) Consider this: With sales data showing that Mac computers are growing more popular than ever among consumers, you might think it's a perfect time for Apple to ride that momentum and go after corporate computing. But it won't. Why? Apple knows it wouldn't work because you have the corporate market all tied up with your pals Dell (DELL) and HP.

And why is the Mac growing more popular among consumers? Well, let's be honest. Windows Vista isn't exactly winning you many friends despite all the extra time you took to "perfect" it. (How many deadlines did you miss again?) At the same time, Apple's cleaning your clock in the smartphone business—the iPhone is now the second most popular smartphone in the U.S., behind the BlackBerry (RIMM). I haven't heard anyone talk enthusiastically about Windows Mobile, since…well, since there's been a Windows Mobile.

Eventually you'll get Vista fixed to the point of being tolerable. And overall, desktop software is one of many things Microsoft is awfully good at, and you make a pile selling it. Then there's server software and Microsoft Office. Between those three units, you've got a $43 billion business that's generating 62% operating profit margins. What's not to like?

You know what would be a bold move, Steve? Admitting that Microsoft doesn't belong in the music player business, or the search business, or the advertising business, or the automotive entertainment business. The Zune? It's a joke. Kill it before you embarrass yourself further. And are the combined forces of Yahoo and Microsoft really going to make a dent in the Google search advertising juggernaut? That's like asking two fifth-graders to play Kobe Bryant in a game of two-on-one. The results will speak for themselves.

Buy It and Spin It Off

It all sounds very misguided, how you say that by spending all that money on Yahoo you can grow so much bigger, when what you really need is to be smaller.

But since it's clear that I'm not going to change your mind about buying Yahoo, here's what you should do: Once you close the deal, package Yahoo with your online services division, the entertainment and devices division (yes, the Xbox, too), and spin the whole thing off.

Remember that bit about focus? This would help you get it back. Put all those things that Microsoft isn't very good at, put them in a box with Yahoo and cut the apron strings. Sure, keep an equity stake, even a majority. But this formidable new entity would function best outside the Windows-centric reservation. If this new company's plans don't coincide perfectly with some future set of features coming to Windows, so be it.

The alternative, if you force these businesses to fester within Microsoft, is that these businesses will always play second fiddle to Windows—and fail to meet their potential.

This new entity is going to have to be nimble to compete with Google, Facebook, and probably one, two, or five other companies we haven't heard of yet. With luck you'll have enough time to whip the whole thing into fighting shape before it's too late. That's assuming it's not too late already.

    Before it's here, it's on the Bloomberg Terminal.