Microsoft-Yahoo: Desperation Sets In

The latest talks clearly suggest Microsoft lacks a Plan B to compete with Google in search, while Yahoo is feeling the heat from Carl Icahn
Microsoft Chief Executive Officer Steve Ballmer. David Hecker/AFP/Getty Images

When Microsoft announced May 3 that it was dropping its $47.5 billion bid for Yahoo (, 5/3/08), executives said the company had "moved on." Clearly, the company has barely budged.

Microsoft's May 18 announcement that it's discussing a different transaction—not an outright acquisition—with Yahoo shows how desperate Microsoft (MSFT) is in efforts to contend with Web search juggernaut Google (, 5/8/08). "Microsoft really does not have a Plan B, especially to win in search marketing," says Collins Stewart analyst Sandeep Aggarwal. Adding to pressure on Microsoft is the prospect that Yahoo (YHOO) may soon strike its own Web search-related deal with Google (GOOG).

Discussions between Microsoft and Yahoo likely involve some combination of the companies' search operations. In April, when Microsoft executives traveled to California to negotiate an acquisition, their Yahoo counterparts proposed a more limited partnership, focused on putting together search businesses, according to one source. Microsoft was more interested in buying the company outright, so those discussions didn't progress—though they appear to have taken on new life amid pressure from billionaire investor Carl Icahn, who has nominated a slate of directors he hopes will replace Yahoo's board and be more amenable to a Microsoft buyout (, 5/15/08).

How to Gain on Google?

It remains unclear how Microsoft and Yahoo would put together their businesses. Joining forces would give both companies much needed scale, offering up a larger slice of the search market to would-be advertisers. Even then, the combined search businesses would pale next to Google's business. In April, queries on Google's search engine accounted for 62% of all searches conducted in the U.S., compared with just 17.5% for Yahoo and 9.7% for Microsoft's search engines, according to industry research firm Neilsen Online. What's more, Google grew faster than Microsoft, while Yahoo lost ground.

One possible scenario involves the acquisition of Yahoo's search-ad business, according to news reports. But removing search-ad operations would leave behind an unattractive business, says Todd Dagres, general partner with Boston-based venture capital firm Spark Capital, which invests in media, entertainment, and technology firms. "What's left after you take out the search piece is a portal. And portals are kind of the walking dead," soon to be replaced by fragmented, distributed content.

Microsoft's Search Smarts

Another scenario, this one mooted by observers, involves Microsoft buying social network Facebook and incorporating Yahoo's search business into the enlarged entity. Yet, Microsoft would probably struggle to benefit financially from a social network that has yet to master its own moneymaking strategy. And it's not clear Facebook founder Mark Zuckerberg, who's adamant about staying independent, would agree to a takeover in the first place.

With or without Facebook, Microsoft could weave Yahoo's expertise in search into niches such as desktop search, enterprise search and even social-networking search. "That's the new frontier that Microsoft wants to get into," says Forrester Research (FORR) analyst Charlene Li.

Internally, Microsoft is getting increasingly antsy to make those inroads. In an e-mail to employees, the president of Microsoft's Platforms & Services Division, Kevin Johnson, was blunt about the state of the company's Web business. "The fact is that we are not where we want to be in this business yet and we've been in this position longer than we'd all like," Johnson wrote.

Johnson didn't just lament Microsoft's shortcomings in search; he pointed out other parts of the business that need work, too. "Our brands are fragmented and confusing today, and we recognize a need to clarify and align our online branding," Johnson wrote. Microsoft's Web businesses fall under both the MSN and Live banners for reasons that often baffle users.

Wall Street's Opinion

Judging from share price performance, investors are increasingly betting that Yahoo ends up with Microsoft one way or another. Yahoo's stock was trading at $19.18 just before Microsoft's original bid. On May 5, the first trading day after Microsoft's May 3 pullout, Yahoo's stock fell to $24.37. By the end of the day on May 19, the stock was at $27.68. One arbitrageur who owns Yahoo stock believes that the percentage of shares held by investors betting on the deal getting done grew from about 25% when Microsoft walked to as much as 40% after Icahn got in. "There's no way the Yahoo board is going to prevail" in efforts to resist Microsoft, said the arb, who requested anonymity because company policy precludes commenting on the record. Other new investors include Paulson & Co., the $30 billion hedge fund that recently said it had a 50-million-share stake in Yahoo.

Microsoft's need for Yahoo will likely be brought into sharp focus on May 20 at advance08, the two-day conference where Microsoft brings its top advertising customers to Redmond to lay out its strategy and hear from Chairman Bill Gates and other industry luminaries. Without Yahoo, Microsoft will lay out its vision for competing against Google on its own. The company is set to talk about new technology, called Engagement Mapping, that promises to increase the value of display ads, where Microsoft is a step ahead of Google. It will also demonstrate new search technology that will help users organize their queries around specific tasks. That way, spouses, for example. can save and share search results as they plan family vacations.

It doesn't sound like a strategy that will bring Google to its knees any time soon. Microsoft would have preferred to have landed Yahoo before the conference. But it's clear that Microsoft hasn't moved much at all.

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