• by Diane Mermigas , September 25, 2007

While Microsoft has the financial resources and strategic impetus to acquire a minority stake in Facebook or buy Yahoo outright, history suggests it may not know how to inventively monetize either.

Such bold moves would require the software giant to break from its predictable pattern of organic and smaller-growth investments to gain footing in the social networking game, in much the same way that its recent and largest $6 billion acquisition of aQuantive put it on the search advertising map. But the real test would be how Microsoft uses its resources to become more competitive with Google. Google is the leader in metrics--rapidly expanding into new areas, including display advertising with its $3.1 billion acquisition of DoubleClick, and about to launch a new organically developed social networking initiative of its own.

Buying Yahoo outright for as much as $54 billion, or a premium $40 a share, as some suggest, makes no sense if Microsoft doesn't plan to change Yahoo's dismal $1.3 billion in annual revenues and $730 million in profits. A combined MSN-Yahoo would still run a distant second to Google in search, but would improve MSN's less than 5% contribution to overall Microsoft sales, reduce its drag on profits and make it more of a development platform.

Clearly, Microsoft's best efforts have been homegrown. "Halo 3" is being hailed as a breakthrough in video gaming. While it was late to the video game market, its Xbox and related games continue brisk sales that will be buoyed by an anticipated $200 million in first-day "Halo 3" sales and a 6 million Halo diehard player base on which to build an organic social network.

Microsoft is mindful that acquiring marquee assets does not guarantee instant or eventual dividends. Sometimes, it takes years (News Corp.'s MySpace acquisition), and sometimes, it doesn't happen at all (Time Warner's AOL merger). During its more than a decade of joint ventures with NBC, Microsoft's money and good intentions helped NBC to create MSNBC and CNBC, although the software giant never used the platform as a springboard into other traditional media. Sources say Microsoft invested at least half a billion dollars in the joint investments, without seeing any concrete return. Microsoft and NBC Universal, owned by General Electric, considered and then backed off countering News Corp. in a bid for Dow Jones last summer.

The jury is still out on how Microsoft integrates and utilizes the ad-search service aQuantive, and whether it can constructively deviate from its build-versus-buy strategy. It's a must if Microsoft wants to promote its .NET interactive interface, push sales through its rapidly developing advertising platform, and fortify its entry into the home IPTV hub with Officelive, MSNLive and other interactive tools to fire consumer connections.

Social networking and sites led by Facebook (42 million active users) and MySpace (68 million-plus active users) are the gateways to Internet users. That explains Facebook's estimated $10 billion market value, as well as MySpace's estimated $12 billion market cap, exploding from the $580 million News Corp. paid for it in 2005. The Facebook audience is growing faster, and its Web platform will be opened to Web developers, although it already has 4,000 sharable software applications.

MySpace has more than two times the monthly unique users. Plus, it's being monetized more aggressively with a new advertising platform to generate as much as $1 billion in annual revenues by 2010--much of it from an arrangement with Google--according to Lehman Brothers analyst Vijay Jayant. The privately held Facebook reportedly could generate $30 million in profits on nearly $150 million in revenues, much of it from a display advertising arrangement with Microsoft.

Moreover, Jordan Rohan of RBC Capital Markets is among the analysts who distinguish Facebook and MySpace as technology platforms--not media companies. That makes them logical fits for Google--and its goal to locate, organize and display the world's information coupled with mounds of advertising--and Microsoft, whose goal is leveraging its tech leadership in the online ad space.

So, it's time for Microsoft to either get in the game with a proven player, or not play at all. "Given the dynamic and unpredictable nature of the Internet market, we believe that Microsoft has opted to leverage its balance sheet to make sizeable investments in a few established winners to supplement its traditional approach," noted Bernstein Research analyst Charles Di Bona. Historically, the company has chosen to nurture a broad range of small internal investments and acquisitions.

Microsoft taking at least a 5% strategic stake in Facebook for as much as $500 million does not preclude Google from taking an even bigger minority stake in Facebook to ensure participation in its growth. In a digital age in which individual consumer connections are everything, Facebook's true value is found not so much in what it is today, as what it will be tomorrow: a major ad-supported, user-driven Internet hub. Likewise, the ongoing battle between Microsoft and Google is all about who and what these titans bring along for the ride as they transform the Internet and interactivity.

A battle for Facebook and the social-networking space will intensify the heated rivalry between Microsoft (valued at $276 billion) and Google (valued at $178 billion) stoke the Internet deal flames as each company puts nearly $30 billion in free cash to work, and force Microsoft to shift its strategy and spending further outside its comfort zone.