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MicroHooSoft: The Undoing of an Empire?

“Do you MicroHoo?” Nah, doesn’t have the same ring does it? however, judging from the recent semi-hostile bid from the folks at Redmond, product branding and name recognition are just a couple of trivial details Microsoft has not thought through with regards to the software giant’s bid to take over number two Internet search provider Yahoo. The past week’s happenings surrounding the possible acquisition of Yahoo have proved almost as interesting a drama as the political primaries, and they’re arguably just as pointless in the final assessment. Look at the players and consider what each has to lose or win and see why:

Microsoft

While Microsoft has done many things right; a consistent and successful Internet strategy has not been one of them. Therefore, their desire to purchase an under-valued web pioneer (Yahoo) is not surprising, and on the surface looks like a shrewd move even at the current offer of 44 Billion. Notice I say “current” - expect this number to increase. The thought of the Operating System / Application behemoth mated with Yahoo’s online market share congers thoughts of a technological juggernaut previously unequaled.

Fear mongers are quick to point out that such a marriage would certainly result in a monopoly that would crush all competition and leave only Google and Microsoft to slug it out for technological and market dominance on the web. Perhaps, perhaps not – Microsoft does not have the best track record absorbing companies, and they have never bit off a mouthful like this before.

Yahoo

While Google may be the reigning Silicon Valley media darling, don’t kid yourself, Yahoo is no also ran. The undisputed veteran of the portal, Yahoo has over a decade in the space. Unlike others who have come and gone (remember: AltaVista or Dogpile?) Yahoo has not just rested on its past success, but has remained relevant via a combination of internal innovations, brilliant partnerships and enlightened acquisitions.

Yep, Yahoo has a lot going for her – and its not surprising that she is looking for a bigger Valentine’s gift then the current 62% per share premium MS is offering. But other than cash, certain to please share holders, what does Microsoft have to offer Yahoo long term?

Or does it matter, has Yahoo’s usefulness as an innovator been out lived? Yahoo Mail and Messenger platforms boast large active user counts, but so do Hotmail and MSN Messenger, is there any motivation, specifically a financial one for them to be consolidated? Sure Flickr is sexy and drives traffic, but can it be monetized successfully? By these standards Yahoo should take the money and run, what Microsoft does with the brand and properties becomes secondary.

Google

And then there is the 800 pound gorilla in the mix – Google. Frankly, there are so many upsides for Google with the possibility of a Microsoft/Yahoo merger, the entire Mountain View campus has to be watching with unabated glee. That comment might surprise some, but think about it, to start with the longer this drama plays out the more uncertainty is injected into Yahoo and Microsoft web plans and futures. Google is already firing on all cylinders in the web space and quickly reading its entry salvo into the mobile space this year. Market and personnel uncertainty at MS and Yahoo, would only serve to distract these competitors and allow Google to move even farther ahead.

So will there be a Wedding?

Others have speculated that the DOJ and EU will likely block this merger, and I don’t really have an option on that aspect of the merger. I tend to think not, primarily due to inflated share price demands that Yahoo is now seeking, but its just as well for both Microsoft and Yahoo if there is no deal.

Should this take over proceed I have to believe it will be a catastrophic disaster for both companies, but especially Microsoft. Some analysts point to the long term synergies of the two firms, and that might even be true, but the short term consequences will be staggering. For 12 to 24 months Microsoft’s focus will be redirected drastically into the morphing of Yahoo services under the MS brand. Backend systems will be impacted, staff will be transferred, and you know – general chaos!

Compounding this Microsoft is struggling with its worst OS launch since Windows ME, Apple is having a real impact in the PC space, Linux is eroding Windows market share and oh yea, the 800 pound gorilla – Google – just keeps on rolling. Therefore one has to conclude that even if a buy out is approved by all parties concerned and the proverbial “price is right” this could mark the unraveling of Microsoft.

In the history of humanity, there were not many companies in the business of creating worlds, instead of competing with other companies. The East India Company comes to mind in the 19^th Century or Microsoft in the 1980s and 1990s. As we were moving into a world based on the idea of networks, Microsoft understood several of the principles underlying such a move better than any other firm, was willing to use this knowledge to create new worlds, and was able to handsomly profit from them. These principles were network effects and path dependency. A network effect is a characteristic that causes a good or service to have a value to a potential customer which depends on the number of other customers who own the good or are users of the service. Path dependency can mean simply "history matters" or that institutions are self reinforcing (think Blue Ray vs HD DVD). Mechanisms like bandwagon and network effects are at the origin of path-dependence. They lead to a reinforcing pattern, in which industries 'tip' towards one or another product design.

With the rise of the internet other companies developed that had world creation in their DNA. Yahoo and Google come to mind. They focused on web-applications, created communities, and aggregated user-generated content (both intended as in wikipedia and unintended as in recommendations aggregated out of consumer behavior). Both were not interested in competing, but in constructing new worlds, with different philosophical foundations (portal vs. search). In the late 1990s people still joked about Sergey Brin's idea of “Don't be Evil,” but not in 2008. It is clear that Google (think Google Health, Gmail, or Picasa) wants to take over our lives. And the greatest hindrance of such a project is if you do not have the absolute trust of your “subjects.”

So in 2008 network effects and path dependency are not anymore the main competitive advantage of a firm, but trust that allows these companies to persuade their consumers that they are not evil, but unfortunately, by locking in customers Microsoft has become the example of “Evil.” The new world is about open APIs, open source open content, and open (peer) governance. Microsoft has understood this and communicated its new stance towards a world by opening its APIs, ensuring portability of data, support industry standards, and be willing to interact with open source. However, what that means nobody knows. The open source community is sceptical.

ArsTechnica quotes Sergey Brin as finding Microsoft's bid unnerving. He argues that the combination of operating system, dominant browser, and many top sites could allow Microsoft/Yahoo to re-claim a monopoly based on path-dependency and network effects. This would of course be in direct conflict with Google's approach of open standards, open source, portability, etc. meaning trust.

So the big question about the potential merger is, is Microsoft trying to grow by acquisition in order to turn back the time or to move forward and become a player in the new web-driven world? - the circumstantial evidence seems to point towards a new Microsoft (maybe even with a new name?), while history makes us skeptical.

Overview
Microsoft develops, manufactures, licenses, and supports software products for many computing devices. The company showed consistent performance through its operations and return throughout 2007. Microsoft has the type of financial stability gained through strong operating performance that enables the company to seek added growth avenues in the future. However, intensifying competition and activity threatens to Microsoft’s margins and market share.

Strengths
Consistent operating performance – Revenues for fiscal 2007 indicated that last year was one of robust growth for the Redmond, WA-based company. Revenue growth was 15.5% and reach $51,122 million. In comparison, Hewlett Packard’s sported a revenue growth of 5.7% during the same time period. Microsoft’s revenue growth was spearheaded by its Business division and Client business divisions. Operating profit registered a 12.5% increase in 2007 on the heels of strong revenue growth and increased efficiency. Operating margin of the company, at 36.2%, was well above the industry average of 25.2% and above the company’s average over the last years (2003-2007).

Strong returns – Strong returns in the last five years ending last June 2007 are characterized by the following averages over that period of time:

• Return on assets of 14.3%
• Return on investments of 18.5%
• Return on equity of 20.2%

These numbers speak to the fact that Microsoft management is fully capable of deploying assets in profitable avenues which effectively enhance investor confidence.

Brand value – Since its inception in 1975, Microsoft has worked to develop a strong brand image and in 2007 its brand value stood at $54,900 billion (behind only Google and GE, see http://www.news.com/2100-1014_3-6178310.html). In essence, this impressive level of brand value promotes greater trust in Microsoft products and services, working to boost demand for such in both perception and reality.

Breadth of product offerings – Microsoft product portfolio spans five segments: client, server and tools, online services, Microsoft business division; entertainment and devices division. Software products include operating systems for PCs, servers and an array of smart devices; server applications; productivity applications and software development tools. Additionally, the company provides consulting and product support services coupled with training and certification for system integrators and developers. Microsoft also sells Xbox video game consoles and games, PC games and peripherals.

Not to mention that 2007 featured the introduction of some noteworthy new products including Windows Live Search and Live.com in 54 markets across the world, Live Local Search in the US and UK, an expansion of MSN Video (MSN Soapbox), Virtual Earth 3D, and Windows Live Hotmail. More than just an impressive list, Microsoft’s product line up creates a larger pool of potential customers from which to draw revenue and reduces the risk associated with demand fluctuations for any particular product category.

Sound R&D strategy and investments – Despite its stellar reputation as a products company, Microsoft spent 8.2% more on research and development (R&D) in 2007 over 2006. Company R&D expenses accounted for 14% of revenue last year, with 39.2% of all employees finding work in R&D related divisions. These numbers represent a significant commitment that can pay off in the form of new products and technologies that align with a rapidly changing marketplace.

Weaknesses
Declining share of search engine market – The numbers for Microsoft’s MSN search engine indicates a declining market share in the search engine segment. Google maintained its leadership position with 52% of the global market share with the second and third spots going to Yahoo and Google U.K. Not only was MSN fourth but its market share dropped from 6.9% in 2006 to 4.3% in 2007. On the other hand Google had a market share of 50% in 2006. Microsoft’s declining market share will do nothing but limit the company’s strategic flexibility and the revenue flow from online services.

Lack of geographic balance – Even with offices in 103 countries, Microsoft has its operations concentrated primarily in the US. Just 38% of the company’s total revenues in 2007 came from other countries which creates a heavy reliance on a US market that is increasingly under duress from adverse socio-political and economic changes. For example, lagging consumer spending levels in the aftermath of the subprime-mortgage crisis will have a negative affect on Microsoft’s consumer driven product categories in particular, e.g. operating systems, Xbox consoles and games, etc.

Opportunities
Windows Vista – This is the first Windows operating system since Windows NT to represent a substantial advancement through significant improvements to the developer platform. However, initial growth rates were nowhere near original projections by Microsoft. Still with improvements in the user experience, security and reliability Vista represents the company’s best shot at remaining at the center of the end user’s complex world of information. It also represents a platform on top of which critical products including Microsoft Office and Exchange Server are based; in addition to the foundation for a new generation of innovative but yet-to-be-created applications which could help sustain the company’s double digit revenue growth.

Acquisitions – Microsoft’s aggressive acquisition strategy in 2007 resulted in the purchase of 8 companies. The overriding trend was a focus on enhancing search engine, online marketing and advertising solutions for global customers.

• The acquisition of Medstory Inc., an intelligent web search technology firm for health information, in July 2007, has the potential to further a long-term commitment to growing as a healthcare-IT contender [http://blogs.zdnet.com/microsoft/?p=546].
• In May 2007, the acquisition of both ScreenTonic and aQunative will open the door to providing solutions for digital and Internet advertising, respectively. Furthered by the purchase of AdECN, Inc. in June 2007.
• In March 2007 Microsoft acquired Tellme Networks, a leading provider of voice services. This provides a gateway to introducing an attractive array of offerings for globally-integrated, voice enabled web services.

Threats
Intense competition – Despite status as a market leader, Microsoft continues to face strong competition across all markets in which it competes. Competitors range from the Fortune 100 to single-product businesses and tiny start-ups. Companies such as Apple, HP, IBM and Sun Microsystems all compete against Microsoft in the commercial software sector with UNIX variants who vertically integrated in both software development and hardware manufacturing.

Google and Yahoo and the most notable competitors in the search engine/online services arena. Microsoft, with its heavily client computing-centric positioning, is particularly at risk to threats here since as more services migrate to the Web. These competitive compulsions could downgrade the company’s market share and margins.

The open source software model – the software development model, adopted by a growing number of competing commercial firms, is centered upon access to the source code poses a considerable threat to Microsoft. Open source software provides end users the option of modifying and distributing the software under the terms of its license. Typically, commercial open source software companies earn money offering complementary services and support for products offered at a significantly lower cost than those of the non-open source variety. If open source software continues to gain market acceptance, it will impact Microsoft sales in every major product category.

Rising levels of global piracy – In fiscal year 2006, almost 60 million PCs were sold with pirated versions of Windows, a significant blow to revenues for the company. Piracy, particularly in countries outside the US where intellectual property (IP) rights aren’t protected by legislation, is a growing threat since these emerging markets represent a substantial opportunity for Microsoft. The company has responded by, for example, attaining indemnification benefits for IP risks, but the threat of pirated products continues to exist as does its associated damage.

Security attacks – In an increasingly connected world, the security of computers and computer networks is paramount. Malicious hackers who develop and deploy viruses, worms and other malevolent software programs represent a threat to Microsoft’s business. As the producer of the dominant operating system worldwide, Microsoft is particularly at risk. As a result, the company has been active investing in protecting users from attacks. Still the security vulnerabilities that do go undetected and are eventually exploited, Microsoft is faced with the prospect of returned products, or the reduction/delay of future purchases.

Overview
Yahoo! has grown far beyond its humble beginnings in 1994 as "Jerry's Guide To The World Wide Web." For nine years after the introduction of the Internet into public use, Yahoo! was the number 1 media company on the Internet, selling the most Internet advertising worldwide. However, the explosion of search advertising has contributed to rival, Google’s growth rate outpacing Yahoo!’s by a factor of 2.3 in the past two years. Still, the Yahoo! brand, a vast line of products and services, and audience reach makes it one of the most trafficked Internet destinations worldwide. Yet its management has yet to introduce the type of strategic initiative necessary in what is a critical inflection point for the company, further opening the door for takeover attempts by other companies.

Strengths
Online reach - Yahoo! still is the portal with the greatest distribution into the U. S. Internet audience. As more than a search engine it is the starting point for the online activities of millions of users across the world. As a result the company is equipped to expand and grow in a number of directions. Yahoo! offers an extensive array of services in the following categories:

• Search: Yahoo! and oneSearch

• Communication: Yahoo! Mail and Yahoo! Messenger, My Web, Yahoo! Personals, Yahoo! 360°, and Flickr

• Content: Yahoo! Sports, Yahoo! Finance, Yahoo! Music, Yahoo! Movies, Yahoo! News, and Yahoo! Games

• Mobile: Yahoo! Mobile

• Commerce: Yahoo Shopping, Yahoo! Autos, Yahoo! Real Estate and Yahoo! Travel

• Small Business: Yahoo! Domains, Yahoo! Web Hosting, Yahoo! Merchant Solutions, Yahoo! Business Email, and Yahoo! Store

• Advertising: Yahoo! Search Marketing, Yahoo! Publisher Network, Panama

• Incubation: Yahoo! Next*

A vibrant partner ecosystem – Yahoo! counts the following as partners: MLB, NFL and VISA. These, among others, are top flight associates with which the company already has a working relationship. This is due, in no small measure, to the value of being able to leverage Yahoo! as a distribution platform. This also arms Yahoo! with a considerable arsenal of resources to leverage as part of its strategic inventory.

Weaknesses
Search engine algorithm – Yahoo! must find the time and money to invest into perfecting the core of its search platform, the ad serving algorithm. The company’s Panama ad serving engine, launched last February, is similar to Google's AdSense and Microsoft's AdCenter. With the key improvement that ads are placed based on expected Click Through rates (CTR) and revenue yield, instead of just placing the highest bid ad at the top. Panama represented a much needed upgrade to the company’s ad serving system but has yet to impact the company’s bottom line in a meaningful manner. As a point of reference, it has been estimated that Google gets as much as 9 to 10 cents per search where most analysts estimate that Yahoo!'s number is about 30% less than Google's. In order for Yahoo! to compete effectively it must work to boost revenue per search (RPS).

Stronger competition for the portal – While Yahoo! has done a notable job of establishing itself as a top notch starting point for web activities they have spent millions of dollars buying the various web commodities that entice users to continue use. This was an effective strategy three years ago: all before the dawn of social networking. Today, competitors in this arena are beating Yahoo! at their own game. Social networking sites allow users to connect while integrating user generated content, uploaded images, etc. The end result is that the Yahoo model of providing users with content through which they can sift is successfully challenged.

More creative text advertising – Yahoo is the only search engine that not only quantifies anchor words which connect to another site but also surrounding keywords. However, this needs to be expanded to meet the needs of independent webmasters who handle various, niche sites. Currently, Yahoo! has the ability to distinguish between words that precede and follow keywords but needs to be utilized in more ways than it is. For example, there is room to open their text advertising to outside publishers, a la Google, through a profit sharing arrangement that would spur growth of text ads.

Opportunities
Performance marketing – Progress in performance marketing will help Yahoo! even if it won’t save the day. Regardless, Yahoo! will benefit from winning the race to be the first to make display ads and rich-media ads as relevant, and in relation as effective, as search ads. The reality is that currently, search ads are worse than display and rich-media ads at getting consumers’ attention while consumers are looking at Web pages. By finding a way to make display and rich-media ads more relevant within the consumer sphere, ads will become much more attractive to advertisers and thus change the competitive landscape quite a bit. More relevant display ads might increase the market share of display ads once more.

The recent acquisition of BlueLithium, and its behavioral marketing technology will increase the effectiveness of display and rich-media ads. In the same breath, Google also obtained comparable technology with its acquisition of the digital marketing specialist DoubleClick. However, Google is currently less of a threat because it has hardly any display and (sellable) rich-media ad inventory, but this is subject to change.

The mobile market – Mobile is another field that will move colossal amounts of money moving forward. Today, it is still a nascent market and only serves to help Yahoo! over the last five to ten years. Thus far, Yahoo!’s performance in the mobile field has been sundry. Interestingly enough the company’s mobile offering is more complete than Google’s, which is missing instant messaging (IM), sports, finance, entertainment and weather forecast options. Yahoo! Go 2.0, a new mobile widget, gives Yahoo! users a mobile Internet experience that is far easier to use and more integrated and aesthetically appealing than any WAP-based browsing experience.

Additionally, Yahoo! appears to retain a slight upper hand with regard to mobile ad technology. It has operated mobile ad platforms that support search and display ads since the early part of 2007. In comparison, Google’s AdWords for Mobile only supports search ads and was just launched in September 2007. However, AdWords for Mobile does integrate with the standard AdWords service, enabling clients to purchase ad space across Web and mobile products, Yahoo! has the opportunity to advance its platforms which don’t allow this yet.

Online video advertising – While Google scrambles to integrate and fix YouTube, a window of opportunity has opened for Yahoo! to enter this field with some added punch. The crux of the issue is that Yahoo! does not possess enough video supply against which to sell video advertisements. Its video service (Yahoo! Video) does not have nearly enough traffic.

Yahoo! can look to cut more distribution deals such as those that it has with NBC Universal and News Corp.’s joint venture Hulu.com, where Yahoo! displays video content from traditional media companies such as NBC Universal, ABC, CBS, CW, Viacom, and Walt Disney. It can be the first online location to offer consumers a comprehensive offer of popular video content that has consumer appeal. In this way Yahoo! can play a role in harnessing larger traffic levels associated with premium content. In the process, the company can emerge as a single point of access for video content that mirrors the way in which users get video offline: the television set.

Threats
Google command of search – Google currently commands over 50% of all online searches, a figure which has increased every quarter. Google search succeeds because it remains uncluttered, relevant and accurate. These factors serve to draw users back and attract new ones. If the company allows Google to continue to garner a larger share of all online searches every quarter, year after year, the improvements to relevancy and search monetization made by Yahoo! will have a minimal (at best) effect on market share trends. And since search ads command a 41% share of the Internet advertising market the more effective Yahoo! is at monetization in this area, the healthier its bottom line will be.

Stagnant growth rates – Wall Street has taken notice that the company’s revenue growth rate isn’t going to erupt anytime soon and the stock price took a beating. In mid-June 2007 investor pressure spurred the replacement of CEO Terry Semel by co-founder Jerry Yang. Aside from the boost courtesy of Microsoft buyout rumors, Yahoo! has not demonstrated enough sustained growth to buoy its share price. If time passes and Microsoft does not acquire Yahoo! the company will be faced with generating investor confidence in its status as a viable Google competitor.

Realities surrounding the potential merger
In order to capably determine where a Microsoft - Yahoo deal may be headed it is critical to assess the realities surrounding the deal from a number of angles. In this light, the following facts are worth mentioning:

• It’s no secret that Microsoft wants to be in the media business. A series of investments in online properties such as MSN, MSNBC and WebTV have failed to generate an acceptable level of profits to which Microsoft shareholders have become acclimated. They also underscore the fact that the company’s online services business is losing money. Speculation has it that Microsoft was also in the bidding for DoubleClick but lost out to Google.
• Microsoft can’t organically grow into a Google competitor. Over the next 4 to 10 years one-quarter (25%) of Microsoft’s revenue will come from interactive advertising, according to CEO Steve Ballmer. Nonetheless, it is going to take far more than organic growth to transform a $3 billion business into a $15 billion one. This dramatic growth is only attained through additional acquisitions, hence the bid for Yahoo! all in spite of the company’s revenue losses and declining market share.
• The acquisition will cause disruption. Cable MSOs and telecommunication carriers will experience a disruption to their core businesses. A Microsoft-Yahoo will spark an arms race in Internet media where Google and Microsoft-Yahoo will go head-to-head on features. Consumers will undoubtedly benefit as more media will be driven to the web but MSOs and carriers will be relegated to the roles of “dumb pipe” providers.
• Antitrust laws may be minimized. Recently, the European Union (EU) has aggressively regulated deals of this size. However, Google’s dominance in Internet search and services might speed regulatory approval in the U.S.
• Benefits might be stifled by the weight of reality. Acquisitions are typically messy and one of this significance would be no difference. Considering the fact that this merger will determine the destiny of well-established, competing brands like Yahoo! and MSN.com, the prospect of integrating everything from strategic visions to organizational philosophies while bearing the burden of maintaining “business as usual” looks like a mammoth challenge to say the least.
• Online ad growth is set to get a kick. A Microsoft-Yahoo merger has the potential to boost levels of online spend in display media. A consolidated Microsoft-Yahoo will make it easier for advertisers to buy and scale online ad campaigns. Also, the pull of Microsoft’s AdECN and Yahoo!’s Right Media Exchange will create a display ad network which will have broad advertiser appeal. This network will be capable of better connecting advertisers to the appropriate inventory, limiting unsold media and generating more overall ad sales.
• Facebook becomes an easier to swallow post Yahoo acquisition. The combined audience and user base of email and instant messaging users creates would create a foundation for a formidable socially connected crowd. Currently neither Microsoft nor Yahoo! is a contender in the social media space. However, armed with Yahoo!’s existing assets and Microsoft’s strategic investment in Facebook, it would be a natural extension for the newly merged entity to target Facebook at some point down the line.

• Both the iPhone and gPhone are opening up to developers, threatening to transform devices into platforms. (There's already mobile versions of Google Docs, Gmail, and GTalk.) The handheld world is finally acquiring the long-sought ability to act as dumb terminals — cheap (and energy-efficient) devices that can tap into a central supercomputer through a wireless connection. And the FCC's spectrum auction will bring a wider availability for the crucial broadband wireless. (Which is another reason Google was anxious to enter into the spectrum auction.) This has always been the missing ingredient...

  There's already been speculation that a plan is afoot to connect Apple's popular devices to Google's supercomputers. (Google's Eric Schmidt joined Apple's board of directors, citing Google's broadband/services architecture and saying "We're a perfect back end to the problems that they're trying to solve," noted Nicholas Carr.) "What's at stake is control over personal computing itself," Carr write in October, "and Microsoft knows that, confronting the combined front-end and back-end skills of Google and Apple, it's at a big disadvantage. It will likely lose this war."

  This may be personal. Gates has been talking about "network computers" since 1996. It was the focus of his speech when he dedicated the William Gates computer science building at Stanford, and Gates even discussed it in 1995 in his book The Road Ahead. Now the Yahoo bid comes, just as Bill Gates is approaching a switch to part-time status at Microsoft in July. And in an interview Wednesday, Gates specifically mentioned this so-called "cloud computing" — acknowledging that Microsoft would use the same architecture for both search and cloud computing. (He talked about marrying the architecture to "mobile and video and neat new things for advertisers with targeting, and just the basic search algorithms.") It was in response to a question about his interest in Yahoo, and Gates indicated a desire to bulk up in in that area to "pursue that agenda more rapidly."

  It's clear he's still thinking about the iPhone and other mobile devices. Tuesday Gates even confirmed that Windows 7 will incorporate touch-based gestures. And he seemed to drop another clue in the Wednesday interview. Gates began talking about "a better search," but then immediately amended that to "better portal" for "a very broad set of customers." Gates has obviously been watching closely for the arrival of a "network computer," and he seems to sense that the turning point is finally approaching.
  
  

• Gates spoke about "breakthrough engineering" — but maybe he's alluding to another great opportunity. The dream for mobile devices has always been position-based advertising. Yahoo's expertise has always been in successfully monetizing its (smaller) piece of the search engine market, and Microsoft's official position is they want to establish "a compelling #2 competitor for internet search and online advertising." Maybe the "breakthrough engineering" opportunity is simply the ability to combine Microsoft and Yahoo expertise to make that happen. Of course, in The Road Ahead, Gates also predicted that "the smart card of the future will identify its owner and store digital money, tickets, and medical information." That's another great opportunity in the mobile space — the highly anticipated "mobile commerce."



• There's another opportunity. Microsoft is a major player in the corporate server space. When Microsoft releases Windows Server 2008 next week, it will include a beefed up capabilities for network access protection, in an obvious nod to the growing importance use of mobile devices. The last few years have also seen numerous stories about the loss of sensitive personal information. (Sensitive records have been breached over 165 million times, according to The Privacy Rights ClearingHouse.) Whether corporate networks move to laptops or another mobile device that's less powerful, Microsoft will want to argue that the best solution is using Microsoft servers and a Windows OS. But that argument may become moot unless it has a sufficiently large installed base using Windows Mobile. Owning Yahoo's compelling mobile content can only help.



• A Yahoo deal is also a good investment — since Microsoft has the deep pockets to pull off the acquisition, and a long-term strategy to monetize them. One immediate benefit of the deal is it eliminates a search competitor, and makes Microsoft an advertising powerhouse. With Yahoo relegated to "also ran" status, maybe Microsoft just sees them as a bargain. And acquiring Yahoo also means acquiring category-dominating sites like Flickr and Del.icio.us.



• Microsoft could also be trying to expand its presence in the "social media" markets. (This fall Microsoft signed a three-year advertising deal with Digg, and they're obviously interested in the huge number of consumers available on social media sites.) But social media has always had one very tantalizing promise. Most social media sites are easily portable to mobile environments.

Microsoft's standard mode of operation is to destroy their rivals by launching a competing product which is well-funded for the long run, and backed by lots of research. Products like Zune and the XBox were inferior competitors in their first incarnation — but Microsoft stayed in the game, determined to close the distance or at least successfully divide the market. Even the Microsoft Network was originally launched as a competitor to AOL. Why would Microsoft be any less aggressive in the emerging mobile device and advertising market?

The next step is this drama is becoming clear. Microsoft just hired a proxy solicitation group. Analysts were already predicting a proxy battle, worrying that more engineers would leave before Microsoft could take control of the board. (David Winer asked whether a recent round of Yahoo layoffs was the ultimate poison pill.) But C|Net noted that earlier, Yahoo's shareholders withheld an unusually high 30% of the votes for re-electing directors on the compensation committee. Yahoo is exploring deals with News Corp (which owns MySpace) and Google, as well as AOL Time-Warner — but after all this publicity, no white knight has emerged.

I predict Microsoft will succeed in its proxy battle, there will be a noise about possible antitrust violations — and the deal will go through.

Yahoo

Yahoo's strengths as an internet company are substantial.   Yahoo remains firmly in the number two spot in search traffic and is consistently among the top handful of hugely trafficked web properties like Google and FOX Interactive.  Yahoo's "Web 2.0" efforts have arguably been stronger than Googles.   For example Yahoo's Flickr photo application is generally considered superior to the Google offerings as well as more in line with the new web open standard sensibilities.  Yahoo's developer and new business teams are brilliant, innovative, and respected so much by Google that people are routinely poached to the Googleplex.

Yahoo's weaknesses, however, are more substantial.   They have *dramatically* failed to monetize their search traffic nearly as effectively as Google.   Mike Arrington recently suggested the search monetization ratio was 9 cents for average Google search to to 4 cents for an average Yahoo search.   Yahoo's publisher network and "Panama" monetization routines have not resulted in the monetization gains Yahoo had hoped for.

Yahoo's decision to outsource search to Google years ago may have become their achilles heel in that Google continued to improve while Yahoo search languished.  Although they have now created a viable search algorithm to compete with Google, most studies continue to rank Google slightly higher and more importantly most users now have a Google search habit which is proving difficult for Yahoo (or any other competitors) to break. 

Another significant Yahoo weakness is low morale at the company, anecdotally reflected in the lack of passion and presentation quality one finds from some of the Yahoos at conferences compared to the wild enthusiasm of many Googlers.  Extensive recent layoffs and a stagnant stock price (until the Microsoft offer) only added to the morale challenges.

Another weakness suggested by some analysts is that under the leadership of Terry Semel Yahoo management simply did not respond effectively to the pressures from Google and the changes that came over the internet landscape.   Semel came from an entertainment media background rather than a technical one, and technologist-centric Google swept in and ate Yahoo's search dominance for breakfast as they built a superior search tool and monetization routines that lined up beautifully with the needs of the growing number of internet searchers.    Where Yahoo became a media production company in a world where users increasingly wanted to do their own media, Google became a search company in a world where everybody was increasing their use of search and happily clicking on advertising that matched their queries. 

The current board appears to be a challenge to Yahoo as well as they appear to many to be more concerned about preventing a Microsoft takeover than directly  improving the prospects of their languishing company.   Desparate times call for desparate measures but it's not clear the board sees things that way.  In fact despite the managerial shakeups of last year that placed Jerry Yang in charge again it is clear Yahoo is fairly comfortable with their current approaches and unlikely to sponsor any major changes in direction at the company.   

Opportunities at Yahoo are very much in line with their substantial strengths.   As the "number two" internet company in the world, Yahoo can leverage their hugely popular and recognizable brand, user base, and advertiser relationships. 

Microsoft

With respect to the potential Yahoo deal Microsoft's strengths are huge size and capitalization, excellent profitability, large cash on hand, and a huge global footprint.   Microsoft's enormous capitalization and global influence give the company its own gravity, allowing them to move markets and structure things in unique ways.   Despite statements to suggest the importance of the internet to Microsoft their profits are largely from boxed and enterprise software markets.   The Yahoo acquistion appears to be a bold move by Microsoft to "buy" a second place position on the internet and work to leverage this to battle Google on their own online terms.   It is significant that Microsoft is willing to pay a high premium on Yahoo's pre-offer share price, and that this would be by far the largest acquistion by Microsoft.   I do not think there a precedents here as generally Microsoft want to absorb companies where here they want Yahoo's  influence to spread to *them*, though on their own terms.

Microsoft weaknesses are abysmal internet performance, especially in search where Microsoft maintains only a trivial market share.  Despite the quality LIVE project Microsoft has failed to increase market share or make more than trivial headway as an online player.    Microsoft's antagonism to open source (recently publicly reversed) has certainly cost them credibility and reputation in the online space although I'm not clear that open source solutions offer Microsoft much more than heartaches and reduced profits. 

Opportunities presented by the merger are discussed below and mostly relate to the increased internet influence of the combined company.

In the merger context there are several threats to Microsoft.  Most of those begin with the word "Google".   Google is doing a much better job than Yahoo or Microsoft at most things relating to the internet.   The merger must *improve* Yahoo to be competitive and nobody has yet presented a clear path to that improvement.   Also, the merger places a large premium on Yahoo compared to current market valuation without the merger.   In a bad case scenario the merger could become an AOL Time Warner fiasco where the high price premium fails to bring synergy value, and shareholders become disillusioned with Microsoft.

Ironically the merger may present good news for a flailing Yahoo where the board is fighting it tooth and nail but a huge challenge to profitabilty to Microsoft where the board is fighting to make this happen.   In this sense the biggest threat is simply that no synergies mean failure of the combined enterprise.

Microsoft Yahoo Merger Prospects

I believe that Microsoft will soon acquire Yahoo with a bid of about $34-35 per share.   Recent rumors of a Yahoo / News Corp deal appear to have been somewhat exaggerated, and given the size of the Microsoft offer and News Corps  capitalization it seems unlikely News Corp could approve anything approaching the same bid as Microsoft without risking shareholder wrath if the merger failed to be wildly profitable.  

Microsoft is likely to win a proxy battle as investors are unlikely to risk losing the recent huge increase in Yahoo share value.  I would suggest the proxy battle could be avoided if Microsoft agrees to keep Yahoo largely intact and moving under the direction of the current board, though it's not clear to me that is the best course of action given the boards clear contempt for the Microsoft Merger.    I believe Microsoft wants to "learn from* Yahoo rather than control and change them, and that the Yahoo board is failing to see the potential for huge synergy as both companies leverage the huge global web traffic and online branded footprints to their mutual advantage.   

Google has expressed great concern over this merger for good reason - the combined company, unlike either alone, will pose a significant challenge to Google's current dominance in the online space.   Neither company alone has or will pose a threat to Google anytime soon.  However even Google reasonably fears the potential here with Yahoo's technologies, the capital Microsoft can afford to devote to the online space, and the combined internet footprint of these two giants.  Google correctly suggests technologies and approaches by Yahoo may not remain as "open" under a merger agreement.

That said, it's not clear how Yahoo employees will view the merger.   If there is more than a moderate level of hostility to the new Microsoft masters morale at Yahoo could continue to sag at a time when productivity is important.   Yahoo's corporate culture is generally considered to be compatible with Google but not Microsoft, though my personal feeling is that Yahoos are likely to respond in kind to Microsoft.  Openness and respect will be reflected back at the mother ship, and there is no reason to think Microsoft's intentions are to bulldoze the morale of Yahoo employees.

Disclosure:  Long on Yahoo