Microsoft and Yahoo: Mergers and Other Options

When major news sources start reporting the possibility of the biggest merger in the history of search, it’s impossible for a responsible journalist to ignore it. Even with the odds stacked against such a merger, it’s obvious that something is going on, and equally obvious why. In this article, we will try to shed some light on the possible scenarios going forward.

The New York Post, the New York Times, and the Wall Street Journal were all abuzz with the “news” that Microsoft had entered into formal talks to purchase Yahoo; one of them even put a price tag of $50 billion on the second-place search engine company. I put “news” in quotes because this isn’t the first time we’ve heard about the two companies being in talks; they were reportedly in talks a year ago, at which time Microsoft was rebuffed. This particular round of talks has supposedly been going on for months. Naturally, both Microsoft and Yahoo have refused to comment.

The various unnamed sources of the major publications seem to agree that at least informal talks between the two companies have been going on for months. Nevertheless, a number of analysts think that this move has a certain air of desperation about it. Indeed, the two companies are so different that only one thing could make them even consider joining forces so closely, and its name is Google.

Google had no comment on the rumors either. Even so, at least one analyst didn’t think it was beyond the pale to speculate on Google purchasing Yahoo, in much the same way that Google swooped in recently and purchased DoubleClick out from under Microsoft’s nose for $3.1 billion. For the sake of this article, at least, let’s put that possibility to the side and examine instead the what and why of a Microsoft buyout of Yahoo.

The Wall Street Journal article featured an excellent chart that compared various aspects of Microsoft, Yahoo, and Google. I can’t reproduce the chart here, of course, but it does a good job of showing why Microsoft feels threatened by Google, and why the software giant may think purchasing Yahoo makes sense. It doesn’t all boil down to numbers of course; the Post cited one banking source as saying that Microsoft was “getting tired of being left at the altar.” But it’s a good place to start.

The first thing you notice is that Google’s market value is only half of Microsoft’s. But Google is accomplishing this with less than twenty percent as many employees as Microsoft. There’s also Google’s rate of growth to consider. It took Microsoft more than thirty years to achieve its current size and market value. Google achieved its size and market value in less than ten. So not only is it already a significant fraction of Microsoft’s size, it’s growing faster with fewer employees, making it a lot more nimble. In another ten years or less it could overtake Microsoft completely in market value.

Microsoft must see this. While it’s true that executives at large bureaucratic companies aren’t always renowned for their skill in taking the long view, Microsoft has an example from its own history to remind them what happens when a larger company is blindsided by a nimbler, more technologically savvy competitor. Back then, Microsoft was the nimble competitor, and the larger company was IBM.

The vast majority of Microsoft’s resources and revenue are still tied up in its operating system and software. In fact, in 2006 only about five percent of its revenue came from online ads. Compare that with Yahoo and Google, who made two thirds and 70 percent (respectively) of their 2006 revenue from online ads. When you combine the numbers with Microsoft’s attempt to buy DoubleClick, what you see is a tech giant belatedly realizing how badly it needs to get into a new technology field, but not being sure how to do so effectively — and not being as motivated as it has needed to be up to now because its revenue from other areas has been insulating it. That sounds very suspiciously like the IBM of Microsoft’s past.

What kinds of numbers would emerge if Microsoft purchased Yahoo? The two companies’ combined online ad revenue for 2006 is close to $7 billion, which compares favorably with Google’s $7.3 billion in online ad revenue for the same period. The two companies’ combined share of the search advertising market would reach 27 percent; that’s still not wonderful against Google’s 65 percent, but it’s better than either of them have been able to achieve alone.

Looking past the numbers for a moment, the Post mentioned some ways in which the two companies complement each other — the differing demographics the two companies draw with their content offerings, the possibility of using Yahoo content on Microsoft devices, and so on. In short, despite the fact that it would be by far the largest purchase Microsoft ever made, a buyout of Yahoo would make a certain amount of sense for the software giant. “I can’t imagine a more perfect deal,” notes Peter Lobravico, vice president of risk arbitrage sales/trading at brokerage Wall Street Access.

While the numbers make a buyout look sensible, anyone familiar with the vastly different cultures at the two companies must be shaking their heads. Yahoo co-founder Jerry Yang is said to dislike Microsoft so strongly that he avoids using their products. A purchase of Yahoo by Microsoft might encourage many top Yahoo employees to leave the company.

There’s also the fact that the Internet is still only one very small of what Microsoft does. To Yahoo, it’s life itself. Henry Blodgett, in his Internet Outsider blog, makes an excellent point about the friction this could lead to: “Why would the best Internet talent want to work in a small division of a massive company, kowtow to Windows/Office kingpins, and get paid in stagnant Microsoft options, when he or she could become a billionaire at the next Google?”

Besides, there are many alternatives to a full-fledged buyout. Microsoft and Yahoo have certainly partnered before; at one point, Yahoo was providing Microsoft with search technology and advertising. That partnership ended last year when Microsoft went live with its own online ad system, which has failed to attract as many advertisers as the software giant hoped despite initially good reviews.

There’s also a somewhat more convoluted option suggested by Blodgett. It involves Microsoft buying Yahoo but then immediately spinning off a combined Yahoo-MSN as a separate company, with Microsoft taking a minority stake. Blodgett argues that such a solution would let the spin-off “recruit the best talent, run it’s [sic] own show, and, if necessary, compete with Microsoft…The company could have an exclusive technology deal with Microsoft and get first crack at all partnerships.”

With Yahoo apparently unenthusiastic about a buyout, Microsoft’s best bet might be simply to continuing pursuing partnerships with the search engine. It might also try to get its own house in better shape, as the Wall Street Journal suggests, by putting new management in charge of the online group, and unifying two separate groups. As things stand now, one vice president is in charge of the online services group, while a different vice president handles the technology related to that group. If both the services and technology were handled by one group, it could move more quickly to meet the challenges of the marketplace.

The stock market certainly seems to like the idea of a Microsoft buyout of Yahoo. Yahoo’s shares gained as much as 19 percent on the Friday the story broke, but lost about half of that gain when the New York Times reported that a joint venture was more likely. Microsoft shares fell very slightly on the news.

From the standpoint of competing in the Internet space, Microsoft needs Yahoo a lot more than Yahoo needs Microsoft. Microsoft’s market share has been faltering, while Yahoo has at least been holding its own. Granted, Yahoo’s introduction of search advertising platform Panama has generated disappointing results this quarter, but there’s a good chance that will be made up for next quarter (if it isn’t though, Yahoo’s shareholders could easily get restless).

But Yahoo has also made some good purchases and partnerships recently. For example, it bought out the 80 percent stake of online ad exchange operator Right Media that it didn’t already own. It also made deals for other sites to carry its ads with 12 publishing companies representing more than 260 newspapers, plus the Comcast web portal. Yahoo has also been working to combine redundant services in order to streamline the company; it recently closed Yahoo Photos in favor of Flickr, for example.

These are all signs that Yahoo may be picking up momentum. The company will need it; Google’s purchase of DoubleClick means the search leader is entering Yahoo’s graphical-display ad field, where Yahoo has been the leader. But even with the threats on Yahoo’s horizon, and the fact that its performance has been lackluster in recent years, Microsoft’s online business is in worse shape: that sector of the software giant’s revenues grew only 10 percent in the most recent quarter, which is below the industry average; it also posted an operating loss of $200 million.

Still, one has to wonder how long Yahoo thinks it can keep hanging in there. If it allowed Microsoft to buy it out, it may become part of one division rather than remain an entire company focused on the Internet — but it’s hard to resist the kind of resources that Microsoft could presumably bring to bear. It’s been said that combining two weak performers rarely yields a strong performer, but in this case the weak performers have complementary strengths that could work well together.

If a merger does happen between Microsoft and Yahoo, though, the cultural differences could doom it before it has a chance to succeed — and surely neither side would be comfortable admitting the kind of desperation that would drive them to do this. A partnership of some kind is far more likely, and far less threatening to all the egos involved. No wonder Google isn’t worried.

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