• by Diane Mermigas , July 25, 2008

Microsoft and Yahoo are demonstrating the dismal results of becoming entangled in the economics of failure.

The economics of failure is about missed growth opportunities and financial expectations, rampant brain drain and stalled competitive position. These can be fatal flaws in an intense, fast-moving global marketplace in which the more savvy rivals Amazon, Google and Apple are gaining, despite double-digit pullbacks in consumer and advertiser spending.

The economics of failure result from not executing transformative must-do strategies and resorting to alternative drib-and-drab gains that fail to accomplish the mission. This reality is taking hold at both companies, evident in their most recent quarterly earnings and in comments from management during meetings with analysts.

Yahoo CEO Jerry Yang and Microsoft CEO Steve Ballmer essentially concede they cannot come to terms on their defunct $47 billion merger or a lesser search alliance; their employees and shareholders will have to settle for incremental financial and competitive growth maneuvers. Their financial results and comments underscore both companies' escalating vulnerabilities and challenges, which could undercut the gains they are projecting for the remainder of 2008.

For instance, after reporting a $1.2 billion net loss on its online business in fiscal 2008, Microsoft said it will increase its planned investment in the unit by an additional $500 million--without providing a convincing plan of action for the new fiscal year. Just ahead of an annual review with 250 analysts in Redmond, Wash., Thursday, Microsoft abruptly announced the departure of Kevin Johnson, president of Microsoft's platforms and services division, who oversees the struggling online business as well as the virtual conversion of the Windows franchise. Microsoft is in a race against time as Google and Apple begin squeezing its longtime operating system stranglehold with their own operating systems, applications and cloud computing strategies.

The best Microsoft could come up with Thursday was a lot of double talk, references to marginal efforts like its new cash-back search, and announcing a live search ad partnership with Facebook in which it has a minority stake. That's hardly a sure bet--since, despite its 90 million users and recent international growth, Facebook is a case of another social network unable to monetize itself.

In complete indifference to Yahoo's 20% market share, Ballmer characterized search as a "mission critical" two-horse race between Google (70% share) and Microsoft (with 9%). He conceded that under current conditions, Microsoft cannot hope to match Google's estimated $25-per-search revenues until it can increase its user queries, which increase advertising, keywords and price bidding. All this could have been achieved through a Yahoo deal. "We're done [with Yahoo]... there are no discussions," Ballmer said for the umpteenth time this year, once again leaving open the door to future talks.

Instead of encouraging Wall Street with examples of new revenue and profit-generating products and innovations in pursuit of what Ballmer says is "a $1 trillion Internet opportunity," Microsoft executives talked about plans for using Xbox as a Trojan horse for all things digital in the home, adding avatars, Netflix movie streams, television shows and interactive advertising that extends to smart phones. In fact, Ballmer & Co. were most demonstrative in their snide references about competition from Apple and Google, and in their commitment to moving the company's PC-rooted competencies to more mobile devices, online and the computing clouds.

Yahoo delivered a similar rehash during its second-quarter earnings call earlier this week. Yahoo's painfully slow growth is just made worse by its tacit dismissal of Microsoft's overtures, the falling market value of its Asian investments and failure to use its cash on any intriguing acquisitions. After missing second-quarter net revenue and earnings-per-share estimates, Yahoo narrowed its full-year guidance. (That did not include a proposed search deal with Google, which may be its only significant uptick for 2009.)

At best, the outlook for both companies is a mixed bag, analysts say. Clearly, both companies have lost time and value with the distraction that has cost Yahoo more than $22 million in related legal expenses, directly cutting into operating cash flow. Microsoft is said to have spent even more. The frustrating, tense counterproductive environment that has cost Yahoo a steady stream of high-level executive exits could begin taking a similar toll at Microsoft.

It certainly appears the companies would have more going for them together than apart. None of their existing operations or plans promise to create the same level of value or excitement that their combined search effort would offer against Google. In a protracted economic downturn, in which revenue growth and profit margins will be tighter than ever, that can only mean more shareholder disappointment and balance sheet angst. It could even mean that Microsoft and Yahoo continue to fail to reach their own and Wall Street's financial projections and stated goals.

The view from the cheap seats is pretty clear: Microsoft and Yahoo should take heed to something Ballmer emphatically declared Thursday. "We're going to have to ante up in a significant way even to be in this game."