The Battle for AOL Heats Up

It’s no secret that Microsoft has been drooling over AOL for over a decade. It is rumored, in fact almost legend, that Bill Gates once threatened AOL’s then-CEO, Steve Case, in the early stages of building the online service: “I can buy 20% of you or I can buy all of you.”

Since January of this year, MSN has been in talks with AOL, pushing the online service to utilize their search engine instead of Google’s.  But now in the face of recent events going on at Google, will these talks escalate?  The AOL-MSN talks have been temporarily suspended, with no agreement having been reached.  Those talks have included various discussions including pay-for-placement advertising, and of course using MSN databases for AOL search.

The Wall Street Journal (WSJ) reported last week that, “AOL and Microsoft once were fierce rivals, and the rapprochement indicated by the talks shows how much the Internet landscape has changed. Just a few years ago, AOL and Microsoft battled over dial-up Internet customers and Web browsers. Now the dial-up business is in decline and the big prize in the industry is advertising revenue, an area in which both AOL and Microsoft lag behind Google and Yahoo Inc… The talks also signal a strategic shift for Time Warner, which had long resisted pleas from some investors to get rid of all or part of its ailing Internet arm, which came to the company when the old AOL bought Time Warner in 2001 in what became a disastrous merger. Time Warner Chairman Richard Parsons declared last year that the company wouldn’t sell or spin off AOL “any time soon,” citing the promise of capturing a greater share of the Internet ad market.”  The WSJ goes on to say that even though AOL reports a steady decline in subscribers, the unit still generates lots of cash.

Last week, the $4.1 billion that the search engine giant, Google, raised in a secondary stock offering, created speculation about what the search engine company plans to do with the money. One report suggests that Google is planning to bid on AOL too.  Is this idea so far-fetched?  Not if you consider that AOL’s ad offerings make up a whopping 12% of Google’s ad-driven revenue, which translates to about $382 million.  If AOL defects to MSN, then it will decrease Google’s earning per share between 5 and 10%, according to the WSJ.  Losing this much revenue at a time that Google has many irons in the fire could really hurt.  After going public just over a year ago, Google’s stock (GOOG) has been trading at an average of $117.80 – $319.22 per share over 52 weeks, compared to MSN’s (MSFT) average of $23.82 – $30.20 per share over 52 weeks, and Time-Warner’s $19.90 – 15.82 per share over 52 weeks.

Let’s fantasize for a moment. As of August, 2005, according to Forbes.com, Google sits atop the #1 spot with 37.3% of search engine queries, up from 36.5% reported in July, 2005, with Yahoo a close second at 29.7%, down from 30.3% in July. Spots three and four are only separated by one percentage point, and are occupied by MSN, with 15.8% of the offering, up from 15.5% in July; and AOL Search, with 9.6%, down from 9.9% in July. An AOL-MSN team-up would put give them about 26% of the searchers, an even closer third to Google and Yahoo than it is currently, and on its way up. AskJeeves and AltaVista take positions 5 and 6, with 3% and 1.6% respectively.

While merging with MSN would throw the search engine industry into a tail-spin, close to unseating Yahoo from the #2 spot, the battle for AOL has really only just begun. MSN is seeing its numbers increase on its own, thanks in part to its new RankNet technology, while Yahoo’s numbers are declining. But MSN still needs some help. Time-Warner’s CEO, Dick Parsons, understands how important a merger would mean to MSN, and they are not going to finalize any deal without walking away with a big prize. So what does MSN have to offer AOL that Google does not? And what would AOL gain from a merger or even a co-op with MSN? According to David Card, an internet analyst at Jupiter Research, a hookup between the two “is risky for AOL unless there’s a big payoff.” Analysts say that while an outright buyout of AOL is probably unlikely, a partnership could bring some benefits to AOL, if the price is right.

Google states in its latest 10-Q quarterly filing with Securities and Exchange Commission (SEC), “We rely on our Google Network members for a significant portion of our revenues, and we benefit from our association with them. The loss of these members could adversely affect our business…advertising and other fees generated from one Google Network member, America Online, Inc., primarily through our AdSense program, accounted for approximately 12% and 11% of our revenues in 2004 and in the six months ended June 30, 2005, respectively.” What is ironic is that AOL sold some of its stake in Google for $195 million, in May of 2004, retaining 5.1 million shares; then almost a year later, sold off the remaining shares for a cash amount totaling $940 million, reported in the second quarter of 2005.  (Figures are from the Washington Post.)

In a second SEC filing, Google also says, “We expect that Microsoft will increasingly use its financial and engineering resources to compete with us….They can use their experience and resources against us in a variety of competitive ways, including by making acquisitions, investing more aggressively in research and development and competing more aggressively for advertisers and web sites. Microsoft and Yahoo also may have a greater ability to attract and retain users than we do because they operate Internet portals with a broad range of content products and services.”

While this may be considered educated guesswork on the part of Google, no one is really fooled here.  AOL had presumably also talked with both Yahoo and Google, so it’s highly likely that Google may have an insider’s view into what AOL is looking for.  Google’s insight writing in its secondary filing would certainly indicate a good motive for MSN wanting to acquire AOL.  But is there more to it than simple financial competition?

As the battle for AOL heats up between Google and MSN, it’s a pretty good position for AOL to be in.  While AOL may go to the highest bidder, you can probably expect that this will continue well into next year, even though executives at MSN say they would like to have this wrapped up in the next couple of months.  Further, with the hotheads over at Microsoft, chair-throwing CEO Steve Ballmer in particular, Google’s rumored bid attempts of AOL cannot be going over well.  In fact, the once considered chess-match has seemed to escalate into an all out war.

Earlier this year, Microsoft sued Kai-Fu Lee after he defected to Google over a non-compete agreement he signed with MSN.  “Accepting such a position with a direct Microsoft competitor like Google violates the narrow non-competition promise Lee made when he was hired as an executive,” Microsoft said in its lawsuit.  “Google is fully aware of Lee’s promises to Microsoft, but has chosen to ignore them, and has encouraged Lee to violate them.

“He has access to sensitive information, to trade secrets about our search technology and business plans and our China business strategies,” [Microsoft’s] Deputy General Counsel Tom Burt told CNET News.com. “He has accepted a position in direct competition with Microsoft in those areas.”  In the first of the hearings held in early September, 2005, to uphold the injunction Microsoft asked for, not allowing Lee to have anything to do with Google’s search technology until after the trial next year; making him no more than a highly paid recruiter. 

A former engineer, Mark Lucovsky, testified to Ballmer’s reaction to the news of Lucovsky’s resignation, which was throwing a chair in anger, then allegedly saying, “Just tell me it’s not Google.”

On top of that, there is another recent competition between Google and MSN over VoIP (voice over IP) technology, both having offered consumers Internet phone-call capabilities within one week of the other.  Google Talk is a downloadable Windows-based application for instant messaging and PC-to-PC voice calls; Microsoft’s acquisition of VoIP startup Teleo, Inc. includes plans to expand voice over IP capabilities over its instant-messaging software, MSN Messenger.  The same day Google released its messaging/VoIP software, Microsoft disclosed an upgrade in MSN Messenger to version 7.5, offering voice-chat quality and other features.

The renewed vigor and motive(s) for MSN acquiring AOL now seem more like a personal vendetta than a strategic financial move, so I’m surprised that more speculation regarding Google’s latest stock offerings concerning MSN didn’t emerge immediately.

MSN’s user base for their search engine has been on the steady decline, from 28% of the market share in 2000, to roughly half that today.  However, they’ve seen a rise in revenues from advertising increase from 30% to 57% in the past three years, and up to $337 million in the last quarter from $228 million from the year-ago figure.

AOL’s subscriber revenues have continued to dwindle over the last few years as well, and what may look like a last ditch effort by Time-Warner’s CEO, Dick Parsons, to put AOL front and center really comes as no surprise to analysts.  After Time-Warner acquired AOL in 2001, it was projected that AOL could increase Time-Warner revenues by 10%.  Instead, the company has seen several quarters of billions dollar losses.  Throw in a few settlements with the Department of Justice and the SEC totaling over $700 million, and you could probably see how this could add up to some huge financial difficulties.  Despite the fact that subscriber revenues keep falling, AOL’s ad revenue is increasing at a fast pace.  But powering this ad revenue is Google.  Will AOL bite, then, the proverbial hand that feeds them?  In 2004, AOL received about $300 million in revenues from the arrangement between Google and AOL.

According to BusinessWeek Online, “AOL hopes that by combining ad sales over AOL Web properties and MSN, which attracts about 114 million unique monthly visitors, it would top Yahoo, with 121 million unique monthly visitors. But even without such a move, AOL is expected to increase ad revenues to $1.35 billion this year, vs. $1 billion last year, according to Internet analyst Richard Greenfield of Fulcrum Global Partners.”  This is happening right when AOL was planning a re-launch of its AOL.com portal to make it more widely available to non-subscribers, a lot more content to the portal that was previously only available to subscribers.

Currently, AOL Search is 80% powered by Google, as the result of an agreement made in 2002, replacing Overture’s search, which was acquired by Yahoo.  No one knows, except perhaps AOL and Google, how long the tenure of this agreement is, but considering AOL sold its entire stake in Google, I’m willing to guess it’s fairly short.

Some analysts consider the possibility that this wouldn’t be a merger at all.  Tim Arango, a reporter for the New York Post says, “Under the plan being considered, Microsoft would pay some money to Time Warner for the AOL stake, leaving the two companies approximately equal partners in the venture. While the deal could fall apart, the companies are hopeful they can wrap it up within the next couple of months. … The media giant has also had discussions with both Yahoo! and Google over a sale or venture with AOL, according to a source close to Time Warner.” (Arango’s report comes from two unidentified “sources familiar with the matter”.)

Whether we believe that an AOL-MSN merger or cooperation will happen, or that Google will swoop in and secure its place as King of the Search Engines with its own co-op plans; it’s just too soon to say.  The ramifications either way are bound to shake up the search industry and very well could have SEOs crawling back to square one.  Until that day, however, we’ll just keep one eye open, and just do the best we can.

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