Microsoft and Yahoo Together: Still Number 2

“This is a decision we’ve thought long and hard about and confident that it’s the right path for Micrsoft and Yahoo,” Ballmer said on a conference call with financial analysts and press.

The problem with that statement is Yahoo is already second to Google in search and online advertising, and has shown some promising signs of life in terms of advancing the state of the art in contextual and mobile search.

Microsoft, on the other hand, is the third largest search engine by traffic and has made gains in traffic volume at the expense of both Yahoo and Google. However, its single-digit market share is nothing compared to Google’s massive market footprint.

Microsoft is placing a giant bet that acquiring Yahoo will catapult it into a better competitive position against Google. The company that brought us Windows Vista, Outlook and SQL server will empty its war chest of $23 billion and hand out a near equal amount in its common stock to buy the failing Yahoo. The risk may be worth the reward since, according to Microsoft, the online advertising market will double by 2010 to $80 billion annually—most of which is currently owned by Google.

Microsoft executives could barely contain their excitement during the conference call announcing the proposal. While PR people read all the safe harbor and forward looking statements required by the Securities and Exchange Commission, it was pretty clear that the Microsoft team was already taking measurements for new carpets and drapes for the Yahoo offices in Sunnyvale, Calif.

Ballmer said he spoke with Yahoo CEO Jerry Yang on the eve of Microsoft’s announced takeover and admitted that Microsoft has been courting Yahoo for the better part of 18 months. However, he stopped short of characterizing Yang’s sentiments.

How does Yahoo feel about this marriage proposal? Yang and company are mum. In a statement, Yahoo said, “its Board of Directors will evaluate this proposal carefully and promptly in the context of Yahoo!'s strategic plans and pursue the best course of action to maximize long-term value for shareholders.”

Yahoo may be having a hard time keeping up with Google in online advertising and search, but it’s Microsoft that needs this deal. As Google presses into applications—from consumer to enterprise apps—and continues to dominate the search market, Microsoft is endanger of being disintermediated.

The fact that Microsoft and Yahoo have been dancing around each other for 18 months shows Microsoft wanted to build its own market rather than going the acquisition route. One of the steepest challenges Microsoft faced was building an infrastructure that had the speed and capacity Google currently enjoys.

According to analysts, Microsoft needs 500,000 servers around the world to effectively compete with Google. Microsoft is building massive data centers in Washington state and Siberia, but its infrastructure build out efforts have been stymied by a painfully slow deployment process. According to one analyst, Microsoft discovered that it could only effectively install and provision 5,000 servers a month. That may seem like a lot, but the pace puts it at 10-year build out schedule after which it would still be behind Google.

"The combined assets and strong services focus of these two companies will enable us to achieve scale economics while reaching R&D critical mass to deliver innovation breakthroughs," said Kevin Johnson, president of the Platforms & Services Division of Microsoft. "The industry will be well served by having more than one strong player, offering more value and real choice to advertisers, publishers and consumers."

Is that worth the 63 percent premium that Microsoft is paying for Yahoo? Microsoft’s critics charge that these acquisitions reflect Microsoft’s desperation to find an answer to its Google problem since its paying premium prices for these companies. According to the Wall Street Journal, Microsoft is paying 48-times Fast’s estimated 2010 revenue. Likewise, the newspaper reports, Microsoft paid a whopping 85 percent premium to pick up aQuantive after losing to Google in the race to acquire DoubleClick.

Microsoft believes an immediate $1 billion in new revenue will result from the synergies created by the merged companies. Looking forward, the company believes it will break even on the acquisition costs in the second year after the completed merger.

Will this be enough to slow or stop Google? Probably not.

Yes, Ballmer is correct that advertisers and content publishers want an alternative to Google for competitive reasons. Yes, Google needs to improve its customer service and be more responsive to its constituents. But, to Ballmer’s point about the need for an alternative, is it better to have two dominant online advertising machines than the three we have today?

As Microsoft has proven time and again on the Windows desktop, it’s hard to dislodge a dominant player who has a superior business and marketing plan.