Microsoft and Yahoo!: Happily Ever After?

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Microsoft hopes to diminish Google's advantage through the Yahoo acquisition. If Microsoft can smoothly mesh Yahoo into its MSN and Windows Live Internet businesses, it could create a network that approaches Google's size. Google accounted for 56.3% of all Web searches in December, compared with a combined 31.5% for Microsoft and Yahoo, according to Nielsen Online. A combined Microsoft and Yahoo would "bring together critical mass," Ballmer says, and "we'll build off that strength."

It's unclear, though, whether advertisers prefer a single strong rival to Google or two lesser companies fighting for their business. Increasingly, advertisers are looking at smaller sites to target their ads, says Jarvis Coffin, co-founder and CEO of Burst Media (BRST.L), an ad network that helps place ads for such brands as Alamo, Disney (DIS), and ESPN. Getting together won't make Microsoft and Yahoo "more responsive to what the market is looking for and what consumers are looking for online," Coffin says. "It isn't going to make it any more relevant and powerful for advertisers."

What's more, smoothly integrating operations will be difficult for two such large companies with disparate businesses and clashing cultures. Microsoft and Yahoo have been gobbling up online businesses, including online ad firms aQuantive, bought by Microsoft, and Right Media, acquired by Yahoo. "They've really bitten off quite a bit to digest," says Kevin Lee, executive chairman of Didit, a digital marketing firm. "It would be quite an undertaking to combine all those pieces."

Messy Overlap of Businesses

Then, Microsoft will also have to figure out how to meld the Yahoo brand into its own stable of online businesses. "There's no doubt that Yahoo, the brand, lives," Ballmer says. Microsoft has already stumbled trying to operate its two online brands—MSN and Windows Live. Now it will need to add a third brand that's arguably stronger.

And then there's the challenge of figuring out what to do with overlapping Web sites and services—from the companies' automotive buying pages to their portals to their Web-based e-mail programs to their instant messaging services. "It's a mess," says Forrester's Li. "Users are notoriously fickle. One change and they're gone."

And, of course, Google won't be sitting idly as Microsoft addresses those challenges. "They're going to be doing this in the face of a very aggressive competitor," Li says.

A merger between Microsoft and Yahoo made much more sense three years ago, before Microsoft built and bought its online empire, says SearchEngineLand.com editor Danny Sullivan. Now, there's so much overlap that the cost has grown exponentially. And Microsoft will have its hands full figuring out how to put the businesses together. "It probably still makes sense now, but it's a much more challenging process," Sullivan says.

The deal would eclipse Microsoft's largest acquisition—the August, 2007, purchase of online ad firm aQuantive—by sevenfold. And it would drain the $21.1 billion that Microsoft had in cash as of Dec. 31, since Microsoft plans to pay for half of the deal with cash and the remainder in stock. Microsoft generates more than $1 billion a month in free cash, so its coffers could be restored in short order.

While Microsoft shares dipped on the news, falling 6.6% to $30.45 on Feb. 1, Sanford C. Bernstein analyst Charles Di Bona believes shareholders will come around. Microsoft built assets like its adCenter online advertising platform to compete with Google. But it wasn't able to leverage those offerings with the relative smattering of users it had. "What they are admitting is that they can't monetize those assets without a sizable community," Di Bona says.