• by Diane Mermigas , February 4, 2008

Microsoft's plans to utilize Yahoo's community, search and display advertising platforms to "transform" its software business to more effectively harness the power of the Web could undermine the proposed $45 billion acquisition that is reigniting the strategic deal market.

Microsoft is expected to legally challenge any efforts by Yahoo and Google to form a partnership in an effort to fend off the hostile takeover. The battle for Yahoo could come down to a stand-off between giants Google and Microsoft in the courts and with Washington regulators.

Even after the unprecedented tech transaction passes regulatory scrutiny as expected, its stiffest test will be execution: integrating the companies' contrasting corporate cultures and disciplines to create a rival to Google's online search and advertising. Microsoft executives could provide critical details of their integration plans in a meeting with analysts this morning, but experts agree that success is not guaranteed by combining firepower in what the market already has dubbed MicroHoo.

One of Microsoft's objectives is to thwart Google's growth in the multibillion-dollar online display ad market dominated by Yahoo. Although Microsoft-Yahoo becomes "the instant gorilla" of online display, there is no guarantee it will effectively leverage that power to improve targeting and behavioral measurement, UBS analysts said.

Microsoft also aims to become "a competitive and compelling No. 2" to Google's dominant share of global online search. That effort is fortified by recent acquisitions in this area by Microsoft (aQuantive, Tellme, Fast Search) and Yahoo (Blue Lithium, Right Media in addition to the launch of Panama). Even with its powerful and efficient algorithms, Google still represents less than 5% of the total advertising market. The Microsoft-Yahoo merger could help online advertising comprise more of the mainstream market by boosting the market beyond estimates of $80 billion by 2010.

However, Microsoft's ultimate goal is to tap Yahoo's online resources to bring its core Office and Windows operating systems social, Internet-extended relevance in the interactive age. Google threatens Microsoft's search advertising, as well as its primary software applications. In a race to develop the next-generation interactive platform, the three players plan aggressive shifts to wireless mobile devices over the next 18 months. Yahoo Go recently added Viacom's MTV Networks, News Corp.'s MySpace and eBay as mobile application partners--one of many ways it will instantly make Microsoft "cool."

Still, the proposed deal's strategic flaw could be Microsoft's inability to successfully execute its Internet strategies by capitalizing on and nurturing Yahoo's strengths. This is the biggest, most expensive survival bet Microsoft has made in its 32-year history.

"The Internet is not an extension of anyone's operating system. Yahoo monetizes the Internet in a way that Microsoft has not been able to do. Anytime a company has tried to make its business dominant focus, the Internet wins. That's why Google has been so successful. It is entirely Web-based," said former AOL chairman and CEO Jonathan Miller. "The consolidation of Google's rivals is an inevitable response in this market."

In fact, the blogosphere is ripe with speculation that after buying Yahoo, Microsoft must move to acquire eBay to bolster its e-commerce and Ask.com to further boost its search to match Google's dominant footprint. Initially, a merged Microsoft-Yahoo would represent a viable enough alternative to encourage national marketers to shift more spending to online advertising, online video and social networking and from more traditional television and print media. The price of key word searches and search rights also will benefit from two strong competitors.

Short-term, the proposed merger is a mixed bag, at best. While working through laborious integration issues and flushing out at least $1 billion in annual savings and revenue synergies, MicroHoo could lose focus and resources developing an aggressive alternative. Although such chaos could scare some advertisers, consumers and publishers to embrace Google, its recent first-time ever miss in forecasted quarterly revenues suggests that all online advertising could be vulnerable to the economic slowdown. Even with scale in search, MicroHoo would need to significantly invest in a combined infrastructure and servers before reaping the rewards. The biggest underlying risk is the "substantial operational, technological and cultural integration challenges," according to Bernstein Research analysts.

The hostile buyout is widely viewed as the best solution to reverse weakening core business trends at both Microsoft and Yahoo. However, their different approaches to mining Internet gold do not assure that one plus one will equal three. Microsoft's closed, desktop-centric approach is frustrating to users, while Yahoo has an open, Internet-centric, and user-friendly approach.

Microsoft's upgrade-dependent software monopoly is waning, even as advanced online video and mobile applications require such support. Google's free, in the clouds, OpenOffice computing promises to be formidable. Microsoft's branded online efforts, MSN and Windows Live have had a lukewarm reception. Microsoft considers Yahoo's 500 million unique monthly users a captive audience for its products and services, despite their overlap.

Such competitive heft, built on amassing deep personal data on users, will be the focus of a House Judiciary Committee hearing Feb. 8. The Justice Department and the European Commission also will scrutinize the deal, and are expected to impose regulatory conditions on the controversial concentration and use of personal data, sources say.

Even Google sounded the alarm Sunday in a posting on the Official Google Blog asking: "Could Microsoft now attempt to exert the same sort of inappropriate and illegal influence over the Internet that it did with the PC? While the Internet rewards competitive innovation, Microsoft has frequently sought to establish proprietary monopolies-- and then leverage its dominance into new, adjacent markets."

It is unclear what Google means to do to thwart a Microsoft-Yahoo union.

The combined Microsoft-Yahoo will have more than $25 billion in operating income on $72.5 billion in revenues, based on analysts' 2009 estimates. Google is expected to post $10 billion in operating income on $32 billion in revenues in fiscal 2009--but missed estimates for revenue growth for the first time ever last quarter, and reported a loss of core search share to Yahoo in December, according to comScore. Microsoft-Yahoo would have a 31.5% share of the domestic search market compared to Google's 56%, according to Nielsen Online. Microsoft sells ads for Facebook and Digg.com, just as Yahoo does on eBay and Comcast, and Google does on AOL and MySpace.

"Microsoft now recognizes that in the online world, technology alone is not sufficient--and that in order to monetize its formidable portfolio of technologies, Microsoft needs to couple them with general traffic and community, something that Yahoo promises to provide," Bernstein analysts said.

Many warn that the strategic rationale and potential pitfalls of MicroHoo are similar to Time Warner's ill-fated merger with AOL in 2000. Microsoft's high-tech culture does not jibe with Yahoo's free-spirited, consumer-friendly manner and products. Microsoft could fumble in capitalizing on user-generated and third-party content from the likes of Yahoo Music and Flickr. Microsoft could retain its Windows-based branded services over Yahoo's similar, but hipper offerings. Or worse, try to blend them. The overlapping portfolio would include the branded Yahoo and MSN front pages and portals, Microsoft adCenter and Yahoo Search Marketing (Panama), Microsoft Live Search and Yahoo Search, and both companies' branded email, games and international offerings. Yahoo's $12 billion equity stakes in the Chinese search Alibaba and Yahoo Japan could also be pivotal springboards into emerging markets. JP Morgan estimates the merged company would have nearly one-third of all global searches.

Not as obvious are the ways that MicroHoo can gain a video edge building on Yahoo's massive audience and its Flickr upgrade to challenge Google's YouTube. Endeavors such as Xbox Live, Yahoo's Jumpcut online editing tools, and Microsoft's IPTV services could be powerful digital platforms for telecom, broadcast and print media allies. A significant small business play also could be anchored by Yahoo's open Web hosting and search, and Microsoft's strict security and privacy functions.

In the past 18 months that Yahoo has rebuffed Microsoft's steady merger overtures, Google has been advancing with its tactical DoubleClick online advertising acquisition, OpenSocial initiative and entree into mobile with the prospect of winning the current 700MHz spectrum bidding.

The catalyst for Microsoft's unsolicited offer was Yahoo's excruciatingly public struggles and plummeting stock price, nearly reversed on a 60% gain on Friday's deal news. For its part, fear and need prompted the uncharacteristically assertive bid from Microsoft, despite well-founded concerns the combined entity would be too unwieldy to manage. Yahoo founding CEO Jerry Yang reportedly was stunned when Microsoft CEO Steve Ballmer last week instructed Yahoo's board that it had two days to accept before the proposed take-out would be made public.

Yahoo will likely accept the bid. The abrupt board resignation last Thursday of former CEO Terry Semel, who has stalwartly opposed a Microsoft deal, was no coincidence. All the same, Yang and company spent the weekend talking to potential counter bidders, if for no other reason than to squeeze several more dollars per share out of Microsoft. As one high-level insider concedes, a Microsoft-Yahoo union appears inevitable even though it offers no easy or certain fixes. After all, "what choice do they have?"