By Matt Rosoff [bio]
Posted: Feb. 11, 2008

• Sidebar: Online Services Timeline
• Chart: Online Services from Microsoft, Yahoo, and Google

The following is the full text of an article published by Directions on Microsoft, an independent research firm focused exclusively on Microsoft strategy & technology. More samples of our content, as well as a list of upcoming articles and reports are also available.

After more than a year of fruitless partnership discussions with Yahoo executives, Microsoft announced it will offer US$44.6 billion in cash and stock to Yahoo shareholders to acquire the company. The massive size and aggressive nature of the offer show Microsoft's anxiety that Google is on its way to building an insurmountable lead in online advertising, which could fund projects that eventually cut into sales of traditional Microsoft software, such as Office and Exchange.

Yahoo's board of directors rejected Microsoft's initial proposal, but even if the companies reach an agreement, the deal will face intense regulatory scrutiny, particularly in Europe. If approved, integrating the two companies and eliminating redundancies to improve efficiency could prove exceptionally difficult and time-consuming, giving Google more time to build its lead and perhaps distracting Microsoft from its traditional core businesses. The move would also deplete Microsoft's cash hoard, putting an end to the multibillion-dollar share buybacks of the last four years and making it harder to bolster the company's other businesses through acquisitions.

Forcing Yahoo's Hand

Microsoft's offer was detailed in a letter from CEO Steve Ballmer to Yahoo's board of directors and shareholders, which was published on Microsoft's Web site on Feb 1, 2008. In that letter, Microsoft offered to acquire Yahoo directly from shareholders with a combination of cash and Microsoft stock worth US$44.6 billion—a 62% premium over Yahoo's share price at the close of the previous day's trading. After the announcement, Microsoft acknowledged that it might issue bonds and assume some debt—a first in Microsoft's history as a publicly traded company—in order to close the deal.

Until this proposal, the largest acquisition in Microsoft history was the US$6 billion deal for online advertising aQuantive in summer 2007; the company also invested US$5 billion in AT&T in 1999. In the technology sector, the size of the acquisition would be exceeded only by AOL's 2000 acquisition of Time Warner for US$164 billion in stock.

In the letter, Ballmer claimed that the two companies had been in partnership discussions since late 2006, and that Yahoo had rejected a merger deal in early 2007, claiming that it needed more time to improve its financial results, in part by implementing a new paid search platform known as Panama. However, Google continued to extend its lead over Yahoo in Internet search market share and online advertising revenue. On Jan. 29, 2008, Yahoo reported that its earnings for the last quarter of 2007 had dropped 23% from the previous year, and that it would begin to cut expenses by laying off 1,000 employees.

At press time, Yahoo's board of directors had rejected the deal, claiming that it "substantially undervalues" the company. While the company's leadership may be reluctant to approve the deal, shareholders will find it attractive given Yahoo's recent performance and lagging stock price—the company's shares rose almost 50% immediately after the deal was proposed. Possible next steps include Microsoft raising its bid to a level that the Yahoo board approves, or a shareholder revolt resulting in a new board of directors that will approve Microsoft's proposal.

Even if both companies reach an agreement, regulators might stop the acquisition because of antitrust concerns.

Urgency Driven by Failure to Catch Google

The acquisition proposal is a tacit admission that Microsoft's online strategy has failed.

The most recent iteration of this strategy dates back to 2003, when Microsoft began to build its own search engine and search advertising platform. (Both had been outsourced to companies that were eventually acquired by Yahoo.) Microsoft's online efforts accelerated in late 2005 with the introduction of Windows Live, an overhaul of Microsoft's online services for consumers, and culminated in Microsoft's surprise announcement in spring 2006 that it would spend about US$2.4 billion more in the coming fiscal year than financial analysts had expected, with much of that extra expenditure going to new hires and data centers for consumer online services. (For a timeline of Microsoft's actions in consumer online services since 2003, see the sidebar "Online Services Timeline".)

Despite these expenditures, Microsoft's Online Services (formerly MSN) business segment has performed poorly compared with Yahoo and Google, with whom it competes for advertising dollars. Microsoft's online revenues for the four quarters ending in Dec. 2003 were US$2.05 billion; four years later, they had grown only 39% to US$2.85 billion. During that same period, the segment's consistent but small profits, which peaked at US$411 million for the four quarters ending Sept. 2005, gave way to rapidly mounting losses, which stood at US$948 million for the four quarters ending Dec. 2007.

Over the same time period, Yahoo's annual revenues grew fourfold from US$1.63 billion in 2003 to US$6.97 billion in 2007, and annual profit nearly tripled from US$238 million to US$660 million. Google, meanwhile, increased revenue more than tenfold (from US$1.47 billion in 2003 to US$16.59 billion in 2007), and profit more than 30 times (from US$106 million to US$4.20 billion).

Microsoft's online finances are hurt by its declining dial-up ISP business, which these competitors don't have. Even so, other metrics tell a similar story:

Search share. According to both ComScore and Nielsen, Microsoft's market share of search queries among U.S. users has hovered around 10% for the last three years with no significant appreciation, and it continues to trail behind Yahoo (with more than 20% share) and Google (with about 60%). In Europe, Google is even more dominant, with about 80% share.

Users. According to Hitwise, which counted market share among U.S. Web users for the week ended Jan. 26, 2008, Microsoft's online properties trail Yahoo's in nearly every area where the two compete, including e-mail (where Google is a distant third), maps (where Google leads), news, financial information, and online shopping.

Traffic. According to ComScore, Google surpassed longstanding leader Microsoft (including Windows Live, MSN, and Microsoft.com) in global visitors in Apr. 2007. Yahoo is in third place.

Google's success could be bolstered by its acquisition of DoubleClick, a company that provides tools and services for online advertisers and publishers. According to a filing with the U.S. Federal Trade Commission (FTC), which Microsoft submitted in hopes of blocking that acquisition, the combined company would serve 78% of all advertisements on Web pages outside of Microsoft and Yahoo, which have proprietary ad-serving systems. (The FTC approved the Google-DoubleClick acquisition, but it's still under investigation by European competition regulators.)

DoubleClick, combined with Google's search market share, would give the company a dominant position across the online advertising industry, raising barriers to new competitors and perhaps enabling it to establish monopoly pricing power. With the profits from online advertising, Google could continue to improve its hosted business applications, including e-mail and online productivity software, until they become a credible competitor to Microsoft applications such as Office and Exchange—today, business software applications contribute more than 30% of Microsoft's revenue and more than 40% of its operating profit. Eventually, if Google builds a successful suite of hosted applications, it could also reduce demand for other Microsoft platforms and development products, such as Windows Server, SQL Server, and Visual Studio.

What Microsoft Could Gain

Buying Yahoo would immediately vault Microsoft into first place in nearly every measure of online audience and display (i.e., graphic) advertising, make it a serious second-place competitor in search advertising, and give the company an infusion of talent with a demonstrated record of online success.

Search. Today, each of the three major search providers—Google, Yahoo, and Microsoft—requires advertisers to plan and track search advertising campaigns with different tools and interfaces. In this environment, advertisers and search engine marketers may ignore Microsoft, with only 10% market share of search users, to avoid the expense of planning and running three separate campaigns. But if Microsoft and Yahoo consolidate their search engines and search advertising platforms, and maintain their combined market share of greater than 30%, more advertisers will split their search advertising budget between Google and the Microsoft-Yahoo combination.

Display advertising. With the exception of search, the combined Microsoft and Yahoo online properties would have the largest audience of Web users in nearly every category, and would serve far more display advertisements than any other online company. This could help Microsoft rapidly increase its revenue from display advertising to make up for its lack of traction in search.

Contextual text advertising. The Yahoo Publishing Network places contextual, text-based advertisements on third-party sites and splits the revenue with them. Although Yahoo doesn't break out results from the Publishing Network, it contributes to the company's advertising revenue from affiliate partners, which amounted to more than US$500 million in gross revenue in the last quarter of 2007. Microsoft has built similar technology, known as ContentAds, but so far sells those advertisements only within Microsoft sites and those of a few select partners, such as Digg. Acquiring Yahoo would advance Microsoft's position in this market, which today is dominated by Google's AdSense program.

Advertiser services. The aQuantive acquisition gave Microsoft a number of tools and services for advertisers. Owning Yahoo could give Microsoft a massive amount of online advertising inventory to connect to these tools and services. For example, aQuantive's Atlas tools could be adapted to help advertisers create and place appropriate banner advertisements on Yahoo and track the performance of those campaigns, and Yahoo's inventory could be placed into the pool of DRIVEpm, aQuantive's advertising network. (On such networks, advertisers essentially bid for placement within online inventory across many sites.)

People. Yahoo's approximately 14,300 employees have demonstrated their ability to build and market a growing, profitable online business. If Microsoft can retain these employees, they could help the company overcome its past online failures.

What Could Go Wrong

Some of the barriers Microsoft faces include regulatory scrutiny, the complexity of integrating the largest company Microsoft has ever acquired, and the difficulty of retaining employees during a long and politically fraught integration process.

Antitrust. Google was quick to criticize the acquisition on antitrust grounds, suggesting in a public blog posting that Microsoft might try to "extend unfair practices from browsers and operating systems to the Internet." Regulators seem to be taking these concerns seriously: two U.S. congressional subcommittees have announced plans to investigate the antitrust implications of the deal, and European Commissioner Neelie Kroes, who launched two new investigations into Microsoft's business practices in Jan. 2008, said her office would scrutinize the acquisition as well. Even if the deal eventually passes regulatory hurdles, the delays could serve to Google's advantage, as it continues to invest in its technology while Microsoft and Yahoo hesitate to make major investments that might be made redundant by a merger.

Integration. Microsoft has never integrated a company the size of Yahoo, and the challenges of any acquisition, such as consolidating facilities and benefits programs, will be the hardest that Microsoft has ever faced. Datacenter consolidation could be particularly thorny, as many Yahoo services operate on non-Microsoft software, including open source OSs such as BSD. While Microsoft has not been adamant in moving acquired companies to its platform—Hotmail used some Unix systems for well over a decade—the company wants to use the quality and reliability of its services as a testament to its software.

A bigger problem: Microsoft will have two of nearly every imaginable consumer online service or Web site. (For a chart showing where Microsoft, Yahoo, and Google overlap, see "Online Services from Microsoft, Yahoo, and Google".) Microsoft has said it expects more than US$1 billion in annual "synergy" to result from the deal, and much of this synergy would presumably be achieved by consolidating duplicate businesses. However, consolidated businesses could be smaller businesses, as users who prefer one of the services find it replaced, or users who visit both services today cut their visits in half; this audience loss, in turn, could reduce the advertising revenue Microsoft gains from the deal. Worse, some displaced users could migrate to Google or other competitive properties. Turf battles could complicate the decisions—for instance, will Microsoft be willing to cut an underperforming MSN or Windows Live business in favor of a Yahoo business, and who will make that decision?

Retention. If Yahoo shareholders and regulators approve the deal, Microsoft expects it to be completed by late 2008, but the integration challenges mean that it will be several years before employees from both companies are certain of their position in the combined company. This gives employees—particularly Yahoo employees who Microsoft is depending on to bolster its online competitiveness—plenty of time to hunt for other jobs.

Focus. Ballmer and Platforms and Services President Kevin Johnson will have to spend considerable time on the integration of Yahoo (not to mention the integration of aQuantive, which is still far from complete), giving them less time to focus on other Microsoft products, such as the Windows desktop OS, which remains Microsoft's most profitable product. Similarly, with President Jeff Raikes retiring in fall 2008, the company is relying on a new hire, Stephen Elop, to oversee development of Office and other business applications, which account for a significant portion of Microsoft's revenue and profits.

Cash. Historically, Microsoft's cash balance has been extraordinarily high for a technology company, at one point topping US$60 billion. Microsoft has used its cash for several purposes, most notably to repurchase nearly US$60 billion worth of stock between 2004 and the end of 2007 in order to reduce dilution caused by company stock grants. In addition, this cash hoard helped Microsoft meet its legal expenses, including more than US$7 billion in antitrust fines, and protect against major legal setbacks, such as the 2000 U.S. District Court ruling to break the company in two (a ruling that was later overturned by an appeals court). Moreover, the company's cash has helped fund strategic acquisitions that helped Microsoft quickly enter new markets, such as game development (Bungie and other game development studios), business management software (Great Plains and Navision), Web conferencing (PlaceWare), virtualization (Connectix), new forms of advertising (aQuantive, Massive, and ScreenTonic), and enterprise search (Fast Search and Transfer), among others. Depleting the company's cash to purchase Yahoo will reduce the company's ability to make further buybacks, protect against legal expenses, and make other strategic acquisitions in its core software business.

Microsoft's top executives have apparently judged that the cost of losing the online services battle to Google is high enough to justify these risks.

Resources

Microsoft's letter to Yahoo's board and shareholders, as well as a link to a conference call discussing the proposal, can be found at www.microsoft.com/presspass/press/2008/feb08/02-01CorpNewsPR.mspx.

The European Commission's Jan. 2008 investigations into Microsoft's business practices are covered in "Europe Launches New Antitrust Probes" on page 29 of the Feb. 2008 Update.

Microsoft's online advertising strategy, including the products and services gained in the aQuantive acquisition, is dissected in "Understanding Microsoft's Advertising Business" on page 18 of the Oct. 2007 Update.