Microsoft stalks the online space

Microsoft's proposed purchase of Yahoo is likely to be the first of several large acquisitions over the next few years as the supplier fights to remain relevant in an increasingly online world.

Microsoft's proposed purchase of Yahoo is likely to be the first of several large acquisitions over the next few years as the supplier fights to remain relevant in an increasingly online world.

The importance of such deals to the future of the software giant is evident from the size of the desired transaction, which when initially proposed was valued at £22.5bn in cash and stock. Such a move signals a dramatic change in its acquisition strategy.

By way of comparison, the supplier's largest previous buy was that of online advertising company, aQuantive, for £3bn in May 2007 and five years before that of Danish business applications supplier Navision for £700m.

Both purchases proved exceptions to Microsoft's longstanding rule of acquiring small companies for their intellectual property and assets in order to boost existing product lines. Instead they provided the first signs of the company's now evident willingness to buy market share and/or customer communities if it believes that such a move is necessary to maintain its market position into the future.

The aQuantive acquisition was particularly significant in that it saw the supplier put an initial stake in that very important (for Microsoft) online advertising ground. As Kevin Johnson, president of its platform and services division, said at the time, "It is a big bet on advertising monetisation for the long-term growth of the company and this is a significant step forward." He valued the sector at £20bn and said that it was growing at about 20% year-on-year.

Where the Yahoo proposition marks another noteworthy break from the past, however, is Microsoft's indication that, for the first time, it is prepared to (at least partially) finance a transaction with debt - a move that again symbolises its strategic importance to the company.

David Mitchell, senior vice-president of IT research at Ovum, says, "Its relative lack of success in online markets has shown Microsoft that its current strategy [of approaching new markets with home-grown products and supplementing them with small acquisitions] is not working for it and it needs to find a new set. To succeed, it needs to accelerate its efforts rapidly - and the acquisition of Yahoo gives it a major boost."

Nonetheless, he does not believe that the supplier will radically change its acquisition strategy in other parts of the business. Rather than one big software company, he views Microsoft as a "collection of companies flying in loose formation", with each business unit operating in a different way and competing in different markets.

This means that, although the proposed Yahoo purchase is "a major push for the online services business and you could call it a reinvention there", Microsoft's other units will "continue on their current course for the present".

But the decision to finance the move with debt also indicates that the supplier is keen not to put all of its eggs in one financial basket. Richard Edwards, information management practice director at the Butler Group, says that it is likely that Microsoft will be forced to spin off its online business due to anti-trust reasons if the Yahoo deal goes through.

"It is a bit like someone deciding whether they want to invest a certain amount in a new business and, although they have enough assets to fund it upfront, their partner says 'we have other interests and do not want to blow the lot on a deal that could bring the company down if it fails'," he says.

The partner in this instance is, of course, Microsoft's shareholders - one of which is Steve Ballmer, the firm's chief executive, and the other Bill Gates, its chairman - and, to a lesser extent, the other business units.

By the same token, however, the company understands that it can no longer afford to have all of its eggs in one technology basket either. While it has been investing in lots of areas, ranging from mobile and business applications to gaming, for many years in the hope of finding the next big cash cow to sit alongside its Windows operating systems and Office personal productivity applications, the supplier has until now failed to find a major new engine for growth.

David Smith, the lead analyst on Microsoft at Gartner, says, "This deal is of particular interest to Microsoft's bottom line. At the intersection between software and media are advertising-based business models and they have real potential. Microsoft cannot afford to have all of its eggs in one basket - that is pure software licensing - because it is at risk from the online players. It sees that and knows that it needs to diversify."

The online advertising space is also a good option because it straddles both the consumer and professional markets, and Microsoft operates in both of these worlds. As a result, Mitchell says that the supplier's probable aim is to have its online business - or at least the advertising-related piece - account for between 20% and 25% of its revenues within three years.

But to do this, says Clive Longbottom, a service director at Quocirca, Microsoft needs to "take back the initiative" from Google, its nemesis in the web advertising market. Google commands about two thirds of the web advertising market.

"With Google being a runaway financial success, something has to be done to try to get the money flowing back towards Microsoft. Tinkering at the edges just is not on and time is not on Microsoft's side. Therefore, something big is called for," he says.

But it is not any particular part of Google's business that the supplier fears most - rather its general direction. "The worry is that as Google gets its act together with its portal, news feeds and applications, people using Yahoo and MSN will see no reason to stay with those more newsy front ends. Therefore, Microsoft is worried about Google as an entity - not one specific part of it," Longbottom says.

And Ballmer appeared to confirm this view in his letter to Yahoo's board of directors, which was dated 31 January 2008 but made public the next day. The aim of the deal, he said, was to "create a leading global technology company with exceptional display and search advertising capabilities" that would provide "a credible alternative" in a market that is "increasing dominated by one player who is consolidating its dominance through acquisition".

Nonetheless, Mitchell considers that the online services market likewise poses a "very significant threat" to Microsoft into the long-term because such offerings are likely to replace traditional in situ desktop software in the same way that mainframe software was replaced by PCs. As a result, the company has been "making counter-moves" in this area for some time and the Yahoo deal can be viewed as simply upping the ante.

Microsoft's aim, therefore, is to both diversify the sources of its revenue and, says Smith, "to maintain the relevance of the products that have been fuelling its business for a long time".

In particular, this means guarding against the potential long-term margin degeneration of Office, which is one of its most profitable offerings. Office is particularly important because it is what Mitchell describes as "the wedge application". This means that the more it comes under threat, the more that supporting technologies such as Windows, Sharepoint and Exchange are likely to suffer in sales terms.

"A shift to online services is absolutely necessary for Microsoft, giving customers a wider range of choices [in terms of delivery mechanisms] - online only, offline only or blended. It is a transition that will never be completed as the goalposts will continually change. But to make a real difference, Microsoft needs to have made a very significant acceleration of its online business within the next two years - and probably sooner," Mitchell says.

The supplier currently sells Software + Services Live and Online hosted offerings such as Office Live Small Business as well as its Dynamics hosted enterprise applications. But if Google's online personal productivity Apps such as Docs and Gmail start to make inroads, particularly in emerging markets, Microsoft will need to be ready to fight back by becoming a more hybrid supplier - and Yahoo would provide it with a platform to do this.

"If the future is not buying software but consuming services, then Microsoft will be interested in becoming a services business. It has got to keep in the game and so it has to change from a product-centric to a services-centric model. And because Microsoft straddles the two worlds of consumer and business professional, it probably has to do this more than other suppliers - and sooner," Edwards says.

But, although the proposed Yahoo deal may be very important for Microsoft, it is not a do or die one. As Gates said, the company "can afford to make big investments in the engineering and marketing that needs to get done. We will do that with or without Yahoo".

Therefore, Edwards says that "if it cannot make this one work it will have a go with another company". Possibilities include AOL, Amazon, eBay or Facebook - in which Microsoft already has a stake.

But any purchase "would have to have a community aspect to it" he says, because "this is more about eyeballs than anything else. It is a numbers game" and social networking sites, in particular, are starting to offer "a corralled audience for a lot of advertising".

Longbottom agrees. "If Microsoft fails with Yahoo, it has to either sulk in a corner and look silly or respond with some similarly large gesture. It already has a stake in Facebook and it could play this as a leapfrog gesture in that combining it with MSN brings a portal news site together with social networking," he says.

Moreover, if Microsoft brought in Office Live and Office Communications Server, "it would create something that outweighs Google - a long shot, but a possibility", Longbottom says.

Even if the Yahoo deal does go through, Mitchell says Microsoft is likely to make "further acquisitions at scale - potentially two or three more in the next 12 to 18 months" in areas ranging from online advertising and applications, to content production and audio and video content indexing and search. "The mould has now been broken," he says. Microsoft, however, refused to comment.

Read more on Business applications