• by Laurie Sullivan  @lauriesullivan, February 4, 2008

Microsoft has been the dominant player in technology through its monopoly on the desktop, but its hold on the online market for the first time has begun to erode. On Friday, the Redmond, Wash. company made a bid to acquire Yahoo for $44.6 billion, which would be a record-setting deal consolidating two major Internet players.

Analysts say that consumer behavior, specifically related to technology and online advertising, is pushing Microsoft into taking "radical steps" and a "high-risk acquisition" that may not generate long-term returns. Laura Martin, senior Internet analyst at Soleil Securities in Los Angeles, says the deal would accelerate innovation in online marketing and advertising services based on technology from the two companies.

Other analysts agree. Shar VanBoskirk, Forrester Research principal analyst, says if the deal passes regulatory hurdles and Yahoo's board of directors approves the sale, two of the largest technology firms would emerge as top media companies. "The deal has huge ramifications in reshaping the industry," she says. "It means that the tools providing access to services that serve up ads, from advertiser to consumer, have become much more important than the content."

No one denies the Microsoft/Yahoo combination would create a powerful online advertising network. Experts say it's a market worth $40 billion today that will reach $80 billion within the next few years. Microsoft insists that a merger would allow it to gain economies of scale and reduce capital costs.

While the deal would bolster Microsoft's position in search advertising and behavioral targeting, it also would create an integrated brand platform to more accurately market to consumers. Yahoo spent more than $1 billion last year to acquire ad exchanges/networks Right Media, Blue Lithium, and Zimbra, while Microsoft plunked down more than $6 billion to acquire AdECN and aQuantive. And let's not forget, the company bought Paris-based ScreenTonic SA last year to move into mobile advertising.

Microsoft also would gain access to Yahoo's network of more than 1,000 ad partners like Comcast, Cars.com, eBay and WebMD, as well as a revenue-sharing agreement for mobile and PC with AT&T. Not to mention the slew of possibilities for ad placement, from Yahoo.com and MSN.com, and partner sites such as The Wall Street Journal. Yahoo also has deals to sell online and display video ads with Comcast, eBay, and Viacom.

Yahoo reaches more than 500 million Internet users, according to Marianne Wolk, analyst at Susquehanna Financial Group. Some estimate the number of Internet users at 1.3 billion. "Combine that advertising and user base with Microsoft's technology, and you can improve the platform for behavioral targeting to more accurately deliver ads."

David Hallerman, eMarketer senior analyst, suggests Microsoft might benefit from spinning off its advertising business unit to create a stand-alone agency.

"Microsoft's online advertising business has been a fifth wheel in the company," he says. "While they keep making acquisitions and talk about the importance of online advertising, it's difficult to provide the resources to a division that only contributed about 5% of worldwide revenue during the fourth quarter last year."

Microsoft may not have a choice if it wants to compete. Google took 75% of the paid search advertising market in 2007--up from 60% in the prior year, compared with Yahoo's share of 9 % in 2007, according to a recent eMarketer report.

In theory, the acquisition would make sense. Practically, there are many hurdles to clear that could take years to sort through. For starters, it's not clear whether the two companies' ad exchange networks--Microsoft's AdCenter and Yahoo's Panama--run on compatible platforms.

Cowen and Co. analyst James Friedland doesn't think the deal will give Microsoft the much-needed boost near term to compete with rival Google. "We have a bearish view on the merger and expect Google to benefit from the likely disruption [at Yahoo]," he says.

Although a potential Microsoft/Yahoo combination looks good on the surface, Friedland believes Google will continue to gain share as it pours $2.2 billion into research and development this year and invests 70% of resources into its core search business. Google's dominant market share allows it to improve relevancy via analysis at a greater rate than competitors.

While engineers and top executives typically get retention bonuses to stay on at a company that is gobbled up, a Microsoft/Yahoo combination--where there's nearly 100% overlap in services and departments--would likely create turf wars, sending disgruntled employees packing or becoming less productive during the transition period.

This increases integration risks. "We expect Redmond vs. Sunnyvale [Calif.] turf wars to erupt from combining engineering talent at both companies," Friedland says. "Google's recruiters will surely make the rounds to pick off talent from the disruption in the coming months."