Microsoft and Yahoo!: Happily Ever After?

If the No. 2 and No. 3 Web search titans tie the knot—via Microsoft's multibillion-dollar bid for Yahoo—they may only just keep up with No. 1, Google

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by Jay Greene

Having spent north of $10 billion buying and building a Web business, Microsoft (MSFT) finally acknowledged its best efforts have done nothing to stall Internet leader Google (GOOG). On Feb. 1, the software giant took its most audacious step yet, announcing an unsolicited $44.6 billion bid for online rival Yahoo! (YHOO).

The deal would combine the second- and third-largest players in Web search. For Microsoft, it may be something of a Hail Mary pass, a last best attempt to catch Google while it still can. "We have been making good progress," says Microsoft CEO Steven Ballmer. "We're in this game, and we're going to be in this game. But the market leader is getting stronger."

Microsoft offered a 62% premium on a share price that's been sliding for the better part of a year amid five consecutive quarters of profit declines. So the overture will be hard to resist and a rival bid is unlikely. Some analysts said the deal makes strategic and financial sense, especially for Yahoo. The company's stock surged 48% to $28.38.

Still, whether and how quickly a combined Microsoft and Yahoo can mount a meaningful counteroffensive against Google is by no means clear. The cost savings won't be easy to achieve in an economy veering toward recession, the companies will struggle to elegantly combine disparate operations, and Google can be expected to use the time to lengthen its lead in the quickly growing online ad market. Regulators will probably approve the deal, but not before a lengthy review that could involve imposing conditions aimed at ensuring competition.

Microsoft vs. Dominant Competitor

Microsoft believes it can eke out $1 billion a year in cost savings from the combined operations. Anant Sundaram, a professor at Dartmouth's Tuck School of Business who has studied mergers and acquisitions, says that may be ambitious. "With the economy looking increasingly wobbly, it is not clear that the revenue synergies will start to happen any time soon," Sundaram says.

Ballmer's keen awareness of that deterioration was evident in a Jan. 31 letter to Yahoo CEO Jerry Yang. Ballmer noted the two had discussed partnerships in late 2006 and early 2007 but that in light of Yahoo's worsening outlook, "the only alternative now is the combination of Microsoft and Yahoo! that we are proposing." Yang even rejected merger overtures in February, 2007, Ballmer wrote, hoping a new ad strategy and reorganization would brighten prospects. "A year has gone by, and the competitive situation has not improved," Ballmer wrote.

There's little doubt that Microsoft's interest in Yahoo has grown more fervent as Google's lead has increased. The battle to catch Google grows harder by the day. "I think Microsoft is desperate," says Forrester Research (FORR) analyst Charlene Li.

In Google, Microsoft sees a foe that is very much like the one it was in the early days of personal computing. Back in the 1980s and '90s, Microsoft created what's known as a network effect, whereby a service becomes more valuable as more people use it, with its Windows operating system. The more people used it, the more applications got written for it. That made Windows ever more appealing to computer users, ultimately helping the company garner more than 90% of the operating system business.

Benefit to Advertisers Unclear

In online search and advertising, Google is having a comparable impact. As more people search the Web using Google, its search results become more relevant. That in turn makes advertising through Google all the more appealing to marketers. Google not only sells ads to accompany search results, but it is also becoming an online ad network, serving as the go-between for advertisers and site publishers across the Web. Web publishers increasingly turn to Google's network to sell ad space because the company has the largest collection of advertisers interested in buying.