Analysis: Microsoft's options, post-Yahoo

Vendor may look for other deals, focus on internal R&D — or maybe buy Yahoo after all

Poor Steve Ballmer. Having yanked his offer to buy Yahoo Inc., Microsoft Corp.'s CEO is left to run a $57 billion company that is on track for its annual orgy of profits and continues to dominate several software spheres. And he still gets to decide how — or even if — the company should spend its $26 billion cash hoard.

But these aren't breezy times for Microsoft or its top executive. There's a growing sense outside of the company that it needs to make major changes if it wants to continue thriving. For example, Gartner Inc. analysts claimed last month that Windows is "collapsing" under its own weight. And George Colony, CEO at Forrester Research Inc., said in his blog this week that a wholesale reformation is required at Microsoft.

In particular, Ballmer needs to move quickly to shape Microsoft's strategy for the Web, where, with a few exceptions, it remains a laggard behind Google Inc. and other online rivals.

That can hurt Microsoft's chances with some users even when its online offerings are equal to Google's technically. For example, the University of the Pacific in Stockton, Calif., recently joined other schools in deciding to roll out the Google Apps suite instead of Microsoft's similarly free Live@edu package.

"On paper, Microsoft's and Google's products looked exactly the same," said Rob Henderson, director of cyber infrastructure at the school. But a poll of the university's 6,000 students showed that a majority preferred Google's technology, Henderson said.

Dana Gardner, an analyst at Interarbor Solutions LLC in Gilford, N.H., said via e-mail that Microsoft "needs to become No. 1 or No. 2 in online consumer and business 'something' before its Office and desktop Windows franchises go into slow-growth and/or maintenance mode."

So how can Microsoft try to catch up on the Web, now that its bid to buy Yahoo is off the table? There are three main options:

1) Forget about Yahoo and look elsewhere. Abandoning what had become a $47.5 billion cash-and-stock offer for Yahoo showed that Microsoft is belatedly coming to its senses, said Enderle Group analyst Rob Enderle.

One upside of the failed merger attempt, he added in an e-mail, is that it opened up possible opportunities for Microsoft with News Corp. and Time Warner Inc. that may "turn out to be both less risky and more lucrative than [buying] Yahoo would have been."

Under that scenario, News Corp.'s MySpace Inc. social networking unit or Time Warner's AOL LLC subsidiary could become new candidates for acquisition or partnership deals.

Each has some potential appeal for Microsoft: MySpace is essentially the Windows of the casual social networking market, while the "A" in AOL could well stand for advertising at this point. AOL's online ad network delivers 3 billion banner ads daily, tops in the U.S., and reached the most Internet users of any network in March, according to market research firm comScore Inc. And AOL's Web properties collectively rank as the fourth most popular in the U.S., behind those of Yahoo, Google and Microsoft.

But there are downsides. Time Warner said as part of its first-quarter earnings report that advertising was down year over year on its own Web sites, leading to management changes and an internal reorganization. And a Microsoft acquisition of MySpace — or of Facebook Inc., in which it has a 1.6% stake that cost $240 million last fall — could alienate the predominantly young social-networking user base.

If Microsoft is fixated on the Web advertising business, other options might include Specific Media Inc. or ValueClick Inc. Those two companies operate the largest independent online ad networks in the U.S.

Or if it really wants to get into social networking in a bad way, it could consider trying to entice LinkedIn Corp. to agree to a buyout. The professional networking site has 20 million members, and a deal with Microsoft likely would trigger less user backlash than one between the software vendor and MySpace would. On the other hand, LinkedIn CEO Dan Nye has said the company is aiming for an initial public offering next year and isn't interested in a buyout.

2) Focus internally. Microsoft's biggest online weakness is in the core Web search market. Its Live Search engine is used for just 9% of searches by Internet users in the U.S., leaving it far behind Google's 60% share, according to comScore.

Since no acquisition apart from buying Yahoo would quickly boost Microsoft's search position, "their best priority for now would be to work on innovating around their own search business," said Forrester analyst Shar VanBoskirk. "I'd stay out of the acquisition game for awhile and spend my money on my own R&D."

Although that approach has left Microsoft floundering in search, it has worked in other areas. A case in point: Microsoft was rebuffed by federal regulators when it tried to buy Intuit Inc. for its Quicken family of personal finance software in the mid-1990s. But afterwards, Microsoft "steadily improved" its own Money application, said Burton Group analyst Guy Creese.

Microsoft may need to look inward and rethink a lot more than just its search strategy — much like IBM remade itself in the mid-1990s.

Colony wrote in his blog post that Ballmer "unintentionally dodged a bullet" when he withdrew the offer for Yahoo. What's really needed at Microsoft, Colony added, isn't a quick-fix acquisition; instead, the company has to change its culture, software development processes and financial models in order to become a true online software vendor. If it doesn't, Colony warned, "Google is going to use its citadel of advertising to attack Microsoft's heart — software."

3) Swoop back in and grab Yahoo after all. Microsoft is distancing itself from the proposed acquisition of Yahoo, which is no big surprise. But there's a possibility that the software vendor's public walkaway from its offer may ultimately end up being a high-risk but successful negotiating tactic.

The fact that as of this afternoon, Yahoo's stock price was off by only 11% from where it was prior to Microsoft's pullout — and that it remains well above the price levels from before Microsoft launched its buyout bid on Feb. 1 — is being attributed partly to investors remaining hopeful about a deal between the two companies.

Perhaps backtracking a bit under pressure from unhappy shareholders, Yahoo CEO Jerry Yang told multiple media outlets this week that a sale of the online services company remained a possibility if the purchase price was right.

But Creese noted that Yahoo needs to meet its financial targets over the next few months. "If it doesn't," he said, "Microsoft may be back with a lower offer price."

Copyright © 2008 IDG Communications, Inc.

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