Why Does Microsoft Really Want Yahoo?
February 7th, 2008
Daniel Eran Dilger
Microsoft finally went public with its $44.6 billion offer to buy Yahoo, following years of aggressive efforts to talk the company into selling out in private negotiations. Why does Microsoft want Yahoo so badly, why hasn’t Yahoo jumped at the deal, and how would such a merger work out for Microsoft, Yahoo, and the tech industry in general? History suggests some answers.
[graphic courtesy Alf: Microsoft se intenta quedar con Yahoo “por las malas” [Actualizado] | www.faq-mac.com]
Why Microsoft wants Yahoo.
According to CEO Steve Ballmer, Microsoft’s interest in Yahoo is all about growing in online stature to rival Google while benefitting from shared costs and operational efficiencies. Ballmer’s open letter to Yahoo shareholders sounded suspiciously similar to Carly Fiorina’s giddily optimistic but ultimately disastrous plan to merge Compaq into HP.
“While online advertising growth continues,” Ballmer wrote, “there are significant benefits of scale in advertising platform economics, in capital costs for search index build-out, and in research and development, making this a time of industry consolidation and convergence.” Ballmer specifically noted “synergies related to scale economics” would help the combined companies to compete in a market where “there is only one competitor at scale,” clearly a chair thrown in the direction of Google.
“Expanded R&D capacity” would “unleash new levels of innovation,” Ballmer continued. Using Microsoft’s definition of innovation, that would have to mean that the deal would be all about tying Windows and Microsoft’s other proprietary technologies to Yahoo’s online properties and services.
Ballmer also noted “operational efficiencies” as an upside to “eliminating redundant infrastructure and duplicative operating costs.” That means either lots of pink slips for MSN and a simple rebranding of Yahoo’s technology under the Microsoft label, or massive layoffs of Yahoo employees skilled in Unix and open source and a Hotmail-style transition of Yahoo’s systems to a Windows-powered infrastructure.
Lastly, Ballmer highlighted “emerging user experiences,” where he again repeated an intent to “drive innovation in emerging scenarios such as video, mobile services, online commerce, social media, and social platforms.” Ballmer is describing a replay of the “Windows Everywhere” of the early 90s, albeit applied to the web rather than office equipment and gadgets.
How Microsoft Innovates.
If Microsoft plans to convert Yahoo’s services into more “innovative” ones running on its own platforms and tied to Windows, wouldn’t it be easier to just develop it all from scratch? Why would Microsoft pay through the nose for Yahoo’s existing online businesses largely built upon FreeBSD, only to sack them or spend significant resources converting things to run on Microsoft’s platform?
In all fairness, Microsoft has long tried to build an “innovative” online and search business from scratch. The original MSN was a clone of AOL created in 1995 just in time to see the emerging open web topple the interest in proprietary online services. The next year, the company rapidly developed a new Internet strategy involving the purchase of Internet Explorer, and tying it into Windows to prevent any alternative open development platform from emerging.
After purchasing Hotmail in 1998 and embarking on a mission to develop a wide range of other Internet services under the reinterpreted MSN brand, the company still found itself unable to build a profitable business online over the next decade, despite all its efforts to leverage the Windows monopoly desktop platform.
The web had quickly established that there was no real money in pay per view content, nor in web site subscriptions, nor fee-based services. Microsoft’s huge investments in online properties had only served to prevent competition to Windows, not to build any real value or result in any new revenue sources.
Google Builds A Money Maker.
In 1996, two Ph.D. students at Stanford University, Larry Page and Sergey Brin, developed a new search engine designed to evaluate search relevance based on how other sites linked to information on a page, rather than just scanning a page to see what words were on it. After hosting the new service publicly in 1997, Google quickly became regarded as the best way to search the web.
What Google lacked was the best way to make money from providing search services. That had been pioneered by GoTo.com, which also launched in 1997. GoTo developed a system that let advertisers bid on search terms to place their advertising as the top result for users’ queries. This worked well for creating a market for selling and presenting advertisements.
However, GoTo’s non-paid search results, which brought in the searching audience to begin with, didn’t work so great because they were based on simple web content indexing. Google copied GoTo’s bid for placement advertising to combine its own improved PageRank searching with GoTo’s new ad sales model.
Google’s unique contribution was to move away from the garish, annoying banner ads of the late 90s and replace them with relevant, subtle text ads that didn’t anger and annoy users. Because Google’s textual ads were actually relevant, users were initially less likely to ignore them in the way they had been subconsciously tuning out the increasingly desperate and irritating conventional banner ads.
GoTo, Overture, Yahoo vs. Google.
In 2001, GoTo renamed itself Overture. Following the dotcom bust, the new Overture struggled to compete against Google in ad sales. By 2002, Google had worked its way up to third place in online search behind Yahoo and MSN. While third in page hits, Google attained three times the average time period users spent in search compared to Yahoo and MSN.
The top two leading search engines’ hit numbers came, not from offering a good product that attracted users like Google, but because both Yahoo and Microsoft had signed agreements with ISPs to make them the default search site for customers. However, those customers were spending more time on Google’s site because they were actually using it, not just being presented with it as their default choice. Google was getting attention via word of mouth for suppling a better product for users, while Yahoo and Microsoft were cramming so much content and advertising into their portal sites that they no longer even looked like functional search engines.
Overture supplied the ads for Yahoo and MSN, so it was directly threatened by Google’s rapid gain in popularity. Overture responded to Google’s success by suing the company in 2002 for copying its patented business ideas of bid-for-placement ads and pay-for-performance search. At the time, Overture was still bringing in 2.8 times the annual revenue of Google.
While trying to compete against Google in pay for placement ads, Overture also announced a partnership with Gator spyware in 2003 that involved installing the spyware on users’ computers to record and report their activity. Overture also used the Gator spyware to pop up ads that it had sold from advertisers who thought their ads would be presented on reputable sites.
When advertisers began catching flack from consumers outraged over having their ads popped up over and under web browser windows, Overture’s reputation began to sink. The company was bought up by Yahoo that same year. Yahoo inherited Overture’s three year spyware contract headache and the company’s patent suit against Google. The following year, Yahoo settled with Google in an agreement that granted Yahoo 2.7 million shares of Google in exchange for a perpetual license to the Overture patents related to paid search, setting Google free to develop its position as the new first place provider of web search.
Build It And They Will Come.
Google had entered a market dominated by two entrenched rivals and bested both by delivering a better product for consumers. That resulted in Google also being able to offer advertisers the most valuable audience. Four years later, Google services more than 53% of the web’s search, with Yahoo in second place with 19.9% and Microsoft in third place with 12.9%. Those numbers reflect the fact that Yahoo is bundled with AT&T Internet service and that Live Search is bundled with Windows. Google’s real share of the market for search is actually much higher.
Yahoo has struggled to maintain feature parity with Google, but has been unable to grow its revenues or profits. In 2005, Google reported $6.1 billion in revenue and $1.5 billion in net profits while Yahoo had $6.4 billion in revenues but only $751 million in net profits. In 2006, Google had boosted its revenues to $10.6 billion and profits to $3 billion, while Yahoo reported only a modest gain in revenues to $6.9 billion and a drop in profits to $660 million.
In 2007, Google continued to grow. In the winter quarter, it reported having boosted its earnings by 50% year over year and its earnings by 17%. Investors were still unhappy with its outlook, which triggered a stock selloff that plunged the company’s valuation, much as Apple’s best quarter ever with a conservative outlook was met with a similar panicky reaction.
Build It Again And They Will Not Necessarily Come.
After building a revenue monster on top of its superior search results, Google discovered that it couldn’t neatly duplicate the effort in every arena. The company built its own Google Video alternative to YouTube in order to enter the promising world of attaching ads to amateur and public domain video content, only to find that it made more sense to actually acquire YouTube instead.
Microsoft similarly tried to beat YouTube with its own SoapBox, an offering that most people never even heard about, let alone evaluated using. The value of existing properties related to the potential for squeezing ad revenue from them has triggered a desperate bidding war between Google, Yahoo, and Microsoft to gobble up every online venue with a significant audience.
This effort is largely speculative and only optimistically hopes that advertising on these sites will someday turn a functional profit. Google is not pulling revenue from YouTube yet, and knows it can’t anytime soon. However, while Google is still pulling impressive revenues and profits from search placement it also knows it needs to find new markets to develop for the future. The struggling and increasingly desperate online services of Yahoo and Microsoft are even more aware of the problems they’ll face if they do not push ahead aggressively into new ad markets.
The New Search: The Old Ads.
Yahoo has been working to develop a web service portfolio, acquiring Flickr and del.icio.us and building out a music business. None of these has done anything to reverse the company’s backward slide, because developing a popular audience requires massive long term investment that often can’t sustain itself, even with ads plastered throughout.
With Google having largely tapped out the concept of pay for placement advertising and contextual ad positioning, the search business has turned back the clock to user tracking technologies remarkably similar to the spyware ads of the late 90s.
Last year, Google managed to snap up DoubleClick for $3.1 billion in cash, expanding beyond its core competency of pay for placement, and into the old world of cookie-tracked banner advertising that aims to be more relevant to users by following them around and taking notes about what they do. The old banner ads that Google replaced with its subtle textual links are now the new thing, because Google’s contextual text ads are not only being increasingly ignored, but also because their functional relevance isn’t often very good.
Microsoft and Yahoo complained to the FTC about Google’s DoubleClick acquisition plans because there aren’t anymore DoubleClicks to buy, and putting together new spyware platforms and cookie ad networks will be as increasingly difficult to construct from scratch as building an alternative to YouTube.
Microsoft’s Last Ditch Effort to Grow.
By buying Yahoo, Microsoft hopes to cobble together something that can compete with Google in terms of size. Growth the way Google originally succeeded, by offering better search results or using a better business model, is no longer an option in a market that has matured.
The problem for Microsoft is that its best acquisition target just isn’t very good. Buying Yahoo to compete against Google would be a bit like Daimler-Benz buying Chrysler, or TimeWarner buying AOL, or Borland buying Ashton Tate. What’s the attraction to buying a troubled company in flaming free fall? There are certainly plenty of warning examples of why this has failed dramatically in the past.
In particular, Yahoo presents a number of serious challenges for a Microsoft takeover:
Any “synergy” between the two can already be realized through friendly partnerships. Yahoo and Microsoft have already signed deals on linking their proprietary instant messenger systems to compete against open chat protocols backed by Google. Both companies can already collaborate on jointly marketing ad space on their search properties, even if nobody is really visiting them. Forcing the two together isn’t going to result in something of greater value because anything they can productively do together they can do apart.
The two partners have massive product overlap that exceeds even that of the merged Adobe and Macromedia. These redundant properties and services can’t be effectively joined together because they’re all built on very different foundations. Yahoo Mail, IM, search, music, maps, blogs, video, and so on would all have to either go away and be replaced with the Microsoft version, or alternatively replace Microsoft’s current offerings. Combining Yahoo Mail and MSN Live/Direct/Xbox HotMail (or whatever the latest brand name for it is) is not “synergy” but rather a subtractive value destruction.
Yahoo doesn’t need to be involved with or purchased by Microsoft in order to go out of business and fire all its employees. And conversely, replacing Microsoft’s MSN with Yahoo services wouldn’t really do anything to expand the company’s audience nor suddenly make its online services profitable.
Microsoft and Yahoo share little culture and vision. Yahoo is struggling to be like Google and works to support various open source projects, including PHP, FreeBSD, YUI, Squid, and Linux. It serves as an alternative to Microsoft products in a variety of its businesses; for example, Yahoo recently acquired Zimbra, an open source alternative to Microsoft’s Exchange Server and Outlook client email software.
Microsoft loathes open source in general and Linux, PHP, Zimbra, and other Windows-eroding products in particular. Microsoft intends to promulgate its Silverlight, .Net, and other proprietary solutions on the web, none of which would ad value to Yahoo’s existing properties, and would instead tend to cause mass defections.
Brain Drain. Microsoft’s absorption of Yahoo would destroy huge amounts of synergy-resistant products and services. Who would benefit from this? Google. Microsoft’s purchase of Yahoo would either intentionally result in the dismissal of brilliant open source engineers who would likely take their knowledge directly to Google, or simply send out cultural ripples that would prompt employees to leave voluntarily.
Microsoft is already suffering a tremendous brain drain as Google hires away all the smart people. Even Google is worrying that it can’t find enough qualified people to hire. Should Microsoft pay incredible billions for Yahoo, bust it up, and send its talented brains to its greatest rival?
Fleeing Customers. In addition to lost employees, Microsoft would also likely trample to death Yahoo’s remaining products by innovating new Windows-centric ties, sending the very audience Microsoft is hoping to buy in other directions. Flickr users would likely be tempted to move to Google’s Picassa, Yahoo IM users to GoogleTalk, Yahoo Mail users to GMail, and anyone who still uses Yahoo search might likely defect to using Google as well.
Anyone who wants to use Microsoft’s search and online technologies likely already are because that’s the default choice for most users. The majority of Windows users are choosing to not use Windows search services and instead use Google, and no expansion of search services tied to Windows will change that, particularly if it comes directly from Yahoo, another site people are intentionally choosing not to use.
Fleeing Partners. In addition to an exodus of customers–many who aren’t even paying to use Yahoo’s services–a hostile takeover of Yahoo by Microsoft would also have a chilling effect on Yahoo’s current partnerships with open source projects and its increasing integrations with partners such as Apple. While Google and Apple have established themselves in tight partnerships, Apple has also gone out of its way to develop a relationship with Yahoo.
Why? While Apple and Google cooperate, they also compete in some areas, or simply work at cross purposes. Google directly supports FireFox while Apple maintains its own KHTML-based Safari browser (which also integrates with Google search); Apple offers its own fledgling .Mac services that compete to some extent with Google’s; Apple has its own smartphone strategy that stands distinct from Google’s Android. The two companies have independent ideas about the future of productivity software. These don’t make Apple and Google enemies, but they do create reasons for Apple to develop parallel partnerships with other companies in the search engine space.
Apple’s stock Widget in Mac OS X and the identical Stocks applet on the iPhone are both connected to Yahoo Finance rather than Google’s similar service. Search features on the iPhone can also be run through Yahoo as an option to Google, and the Weather applet is also based on Yahoo’s data. Apple also promoted Yahoo as its partner in offering push email on the iPhone.
While Apple also forms partnerships with Microsoft in promoting Office for Mac and in building interoperability with Microsoft’s proprietary OOXML file formats and its Active Directory and Exchange Server, Apple would likely be hesitant to build online partnerships with the company that expressly worked to destroy the Macintosh after having cloned it, pointedly tried to kill QuickTime and OpenGL and every open file format, openly dismissed the iPhone as an expensive joke, and has a long standing grudge against open, interoperable technologies of any kind. Other Yahoo partners have similar reasons to abandon the company were it to be acquired by Microsoft.
Microsoft’s Failing Monopoly Powers.
The search business is not in a massive adolescent growth phase. That ship sailed; Google earned its place at the top, and won’t be fiercely toppled by a merging of two very dissimilar runners up who both failed compete well individually against Google over the last decade. Adding Yahoo to Microsoft will actually serve to dismantle the existing competition to Google rather than binding the two also-rans together as a stronger rival.
Microsoft probably realizes this. Yahoo certainly does or it would have accepted Microsoft’s previous offers dating back over the last several years. The problem for Microsoft is that it has no other obvious alternatives to improve its showing in the online and search market. The power of the Windows monopoly has begun to dissolve, making the company unable to force itself into new markets with a threatening iron fist.
Particularly since 2000, Microsoft’s monopoly position has:
- failed to advance Windows ahead of Apple’s Mac OS X in the consumer market.
- failed to prevent widespread server adoption of Linux among Enterprise users.
- failed to beat or even match the success of the iPod over years of exclusive licensing deals with hardware makers in Media2Go and PlaysForSure.
- failed to successfully establish its various Windows Media strategies against Apple’s Quicktime and iTunes in digital downloads.
- failed to establish Windows Smartphones against the Enterprise adoption of RIM’s Blackberry and the consumer adoption of the iPhone.
- failed to push console sales against Sony and console profitability against Nintendo.
- failed to stop the renewed growth of Firefox in the browser market, and prevent new competition from Safari and Opera, particularly in mobiles.
With Microsoft increasingly unable to expand or even maintain its monopoly powers, or successfully use them to force the adoption of its own products, what benefit would there be in buying up Yahoo and attempting to use it as an expanded version of the same online strategies that currently aren’t working?
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Would Buying Yahoo Kill Microsoft?
In addition to just being an all around loser idea in general, a hostile takeover of Yahoo at $44.6 billion or more would take all the cash Microsoft currently has and then some. The company reported around $21 billion in cash and short term assets at the end of 2007.
Microsoft has been frittering away its cash stockpile by paying dividends to shareholders and buying back its own stock. Dividends and stock buyback are what a company does when it decides that its investors can do more with its money that the company can itself.
Microsoft has been betting against its own future, essentially giving away its cash position because it saw nothing it could effectively do with it. If it were able to turn that cash around to buy strategic products or companies to expand its position, or to invest in building out new growth of its own, it would hold on to its savings just as Apple has been.
Apple is dramatically expanding its campus, expanding its online services business, expanding its iPods into a WiFi mobile platform, expanding the iPhone into a worldwide smartphone development platform, expanding its Macintosh market into new directions, expanding its retail operations, and expanding its online media sales. It also wants to be ready to acquire the next application team or innovative company it has the opportunity to buy. Apple is therefore sitting on its cash, not giving it back to investors.
Microsoft is currently generating a lot of cash from its desktop, server, and office businesses. It wouldn’t have any trouble going deep in debt to buy Yahoo and then quickly repaying its loans from its rich income. However, what would that accomplish? The company would be burning up its cash pile and marking all of its future profits for the same flames, all to acquire a company that’s a bad match and which would almost certainly result in a huge employee, customer, and partnership defection. All that money burnt for the shell of Yahoo’s struggling operations.
It would take at least five years for Microsoft to merge Yahoo into its own holdings. Yahoo has only recently finished integrating Overture into its own operations, despite having purchased the company way back in 2003. While Yahoo and Overture were a sensible match with less overlap, a similar vision, and complementary products, that merger was fraught with crisis and problems and management politics. Is Microsoft going to gobble down Yahoo any faster without the same kind of heartburn?
Five years from now, Microsoft’s monopolies will likely be in far worse shape than they already are. Over the last half decade, Microsoft lost its desktop reputation to Mac OS X and saw its Enterprise role slip precariously as the rest of the industry has aligned behind Linux-oriented strategies. In concert with those changes, the credible threats to Office have emerged in the Enterprise with OpenOffice, now sold by IBM under the Lotus Symphony brand, and Apple’s iWork among consumers.
Microsoft doesn’t even have to lose many sales to rapidly feel the heat of increased competition; once its monopoly position begins to melt, there will be a massive rejiggering of where software profits flow and in what quantities.
Microsoft’s billions in revenue are based on its ability to sell Office licenses to consumers for $500 and license Exchange and Server products for $15,000 a pop to small workgroups. Competing against $79 consumer packages and IBM’s free productivity software tied to Lotus Notes and its Linux services, Microsoft simply won’t be able to extort that kind of cash anymore, even if it can continue to sell the majority of the software pie in terms of units. The company has already been forced to dramatically re-price Office for Mac and offer far more generous licensing terms, just because of the arrival of iWork.
That strongly suggests that in 2012, Microsoft will be bringing in much less revenue and slimmer profits, just as it would be finishing up its Yahoo online services merger and selling Windows Seven and Office 15 against free alternatives on the PC and better integrated products from Apple.
There’s also no reason for believing that a bigger MSN could effectively compete against Google’s offerings in the online space, or even that MSN would be bigger at all after suffering through a painful transition that involved mass defections of Yahoo’s former employees, customers, and partners.
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Better Off Dead?
A cynic might suggest that such a brutal merger might provide just what the world needs: a dramatic reduction in Microsoft’s power and a disassembly of the largely ineffective Yahoo in order to better use the resources that it currently sits upon. At the same time however, such a consolidation threatens to put too much power in one place. While Google has complained that Microsoft’s Yahoo bid might result raise antitrust issues, the biggest problem created might be the elimination of any check to Google itself.
Without Yahoo, and with a desperately retooling MSN consumed by its own internal merging and reconstruction, Google would end up as the only credible choice in online search and advertising. It would enjoy something like five years of depressed competition, allowing it to either sit back and coast, or to spring forward and clean up the business, establishing itself as even more of an impossible to dent rival than it already is.
Google is already buying up ad networks and depressing the price of advertising, creating a notable pinch on ad supported content sites. Unchecked, Google could become the only way to advertise online, and the only effective way to buy advertising space.
All of these scenarios demand pause for thought, as Google’s current leadership position as the “Do No Evil” company with a reputation for resisting government oppression both in the US and in China could be relaxed once there’s no other game in town.
Given Google’s fairly stellar record in those areas, particularly when compared to Microsoft and Yahoo, it’s certainly too early to be castigating the company for imagined problems of the future. We do know however that a lack of competition makes companies fat and less responsive to the needs of their customers. Massive consolidations in the tech industry have chilling effects on competition and innovation.
What do you think? How would a Microsoft takeover of Yahoo change the position of Google and other tech companies, impact Open Source, the development of innovative new products, and competitive forces in online advertising?
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