Microsoft and Yahoo: Does It Make Sense (and Will It Work)?Published: February 06, 2008 in Knowledge@Wharton
On Friday, February 1, Microsoft announced it was making an unsolicited bid to acquire Yahoo for $44.6 billion in cash and stock, a 62% premium over Yahoo's stock price at the time. If the deal is completed, it would be the largest acquisition in Microsoft's history and, the company hopes, would jumpstart its struggling Internet search and advertising businesses, as well as add to its online portfolio a number of popular web sites such as Flickr, Yahoo HotJobs and Yahoo Personals.
Yahoo is officially "evaluating" the offer and, according to reports, is talking to other companies as possible suitors. MySpace.com parent News Corp., AOL parent Time Warner and AT&T are a few of the companies named as potential alternative partners. Meanwhile, Google seems determined to derail the deal. According to media reports, Google CEO Eric Schmidt contacted Yahoo's Jerry Yang about helping Yahoo fend off Microsoft's overture. David Drummond, Google senior vice president and chief legal officer, was even more blunt, stating in an official Google blog that he finds the proposed acquisition "troubling" and asking: "Could Microsoft now attempt to exert the same sort of inappropriate and illegal influence over the Internet that it did with the PC?"
What's going on here? Does this deal make sense, and for whom? And, if the deal goes through, how difficult will it be to meld these two giant technology companies into one? Knowledge@Wharton spoke with Wharton management professors Larry Hrebiniak and David Hsu to get their views on Microsoft's offer. An edited version of the conversation follows.
Knowledge@Wharton: Microsoft claims that there are many synergies between the two companies. Is this true? Will Microsoft get what they want out of this deal if it goes through?
Hrebiniak: If you look at what the expected benefits are, Steve Ballmer is thinking that, in fact, there are a lot of synergies. [In] the little bit that I have seen about the discussion, they have talked about scale economies. They've talked about scale economies in advertising, in capital spending, in R&D; synergies in search and non-search activities; expanded R&D capacity; [and] operational efficiencies. Some of this we hear in every merger, in every acquisition.
Synergies seem to be hard to come by, but they are talking very strongly about synergies and benefits that they expect to get from this. I saw somewhere that someone at Microsoft said that if you look at their R&D budgets alone, they can save $1 billion a year or something like that, by combining the two companies. Now, whether that is exaggerated or not, I'm not sure, but certainly they are looking for synergies. Whether they are going to realize them all is an execution question, and we'll come to that later. Let's just say that, in fact, there are probably some synergies to be gained.
Hsu: I largely agree. If you look at the assets Yahoo has and think about their assets as primarily being about consumer experience across their products of email, instant messaging and some of the other ways in which they touch the consumers -- there have been reports that they get some 500 million monthly users -- that is quite distinct from what Microsoft in terms of their core strength, which is their Office products or their Windows products. They have had initiatives in Hotmail and in other products that touch the users, but when we talk about the battle with Google, this is where it really comes [to] gathering data on consumer usage patterns and whether the various strengths of Yahoo and Microsoft can be deployed together to effectively fight for the online advertising dollars, or whether they want to engage in that battle head on. We'll have to talk about that a little bit later on in the discussion.
Knowledge@Wharton: Let me ask about that battle for the online advertising dollar, particularly the search-based advertising dollar, which is clearly a driving force underlying this deal. Does this make sense? Both Microsoft and Yahoo have had difficulty getting traction in this space. Do two faltering plans combined really lead to a better outcome?
Hrebiniak: We come back, in part, to the synergies. Let's face it, [Microsoft is] looking to compete with Google. Google has -- what is it? -- 75% share of the online advertising market. They have roughly 60% of all search inquiries. You're right, Yahoo hasn't been able to catch them [nor has] Microsoft. We'll come back to this when we talk about execution.
But Microsoft has been strong in other areas. They're not strong in this area and Yahoo has been faltering. But the thought is that 1 and 1 together is going to be 3. Somehow they are going to get large enough that they're going to be able to compete, they're going to be able to develop new products and services and appeal to advertisers.
I think that their scale will give them some benefit. Let's put it this way: There is no other hope if they want to compete with Google. I can't think of any other way to compete.
Google is growing rapidly. They are taking over the entire market. Individually the firms couldn't do it. The only possible way to even think about competing would be through acquisition. There have been a lot of acquisitions in the industry, so there is a model that they are following. They have to acquire in order to get to size, to scale. What did Rupert Murdoch say, years ago, when he was talking about Disney buying ABC: "It was a song of synergy and a song of size and a song of scale." And I think that this is it. We've mentioned synergies, but they are also singing a tune related to scale and size as the only hope of getting close to Google.
Hsu: I think that is largely right.
I'd like to step back and think about the whole Microsoft strategy, going back to various battles. When they fell behind with the web browser, they were able to successfully come in with Internet Explorer and beat Netscape. [It was] the same thing with the Xbox in terms of gaming. [They did not do] so well in the MP3 player space with their Zune products, relative to the iPod.
What they are trying to do is: They realize that they're not as sophisticated on search -- which turns out to be the enabler of online advertising. In the past, they have been able to move in as a "second mover" very rapidly and aggressively. It's been okay that they haven't been the "first mover" because they have all the other complimentary assets to compete successfully.
Whether or not that's the case here remains to be seen. But I agree, Larry, that [with] these market shares it's not encouraging at all. They cannot cede the space because who could ignore the whole category of online advertising. The question becomes: With this integration, with Yahoo, will they be able to beat Google at their own game? That doesn't seem so likely.
If I were to advise the management of Microsoft or Yahoo, I would encourage [them] to think about extending out some of their strengths and to try to think about what is going to be the next battle.
Of course they want to be a player in the online advertising space. But Google may yet be disrupted by a startup, or [by] Microsoft-Yahoo, in the provisioning of better advertising. Let's not forget that there is a whole other industry of providing advertising. The incumbent players are probably not lying down and ceding this space as well.
The upshot is that you have to have some network effects, if you think about how Microsoft is able to come in. If there can be synergies across their products, as in the Windows and Office products -- which may or may not be legal, [we can] come to some potential anti-trust concerns a little bit later on. But they would have to get some leverage somehow. It can be very difficult to beat Google in all of the efforts that they have in their advertising infrastructure to make an aggressive move in that space.
Hrebiniak: Let me add something to what you just said. You [made] a point that I want to build on. Microsoft impresses me in that they learn well -- they make mistakes, but they learn. I was part of a team years ago which did some work with them. We were out there and talked to some of their people.
For example, we talked about things like Xbox. When they got into Xbox, they made a lot of mistakes. They assumed because they had the capabilities and software, because they were Microsoft, because they had all of this money, they were going to break into a whole new market. They didn't really do the industry analysis, the competitor analysis, the kinds of things that you think about: Is the industry attractive? Do I want to go head-to-head with Sony and others in this new industry?
To them it was like, "Yeah we can do it. Don't worry about it. We're Microsoft." Well, they went in and they've gotten hurt badly. They have lost billions of dollars. And, yet, this is the first year, I think, that they are going to make a profit.
I always thought that they were resilient. Even though they wouldn't admit to their mistakes, they knew that they made them -- they kept them quiet -- but they adapted, they changed, they developed Xbox [and] they hit a few good games.
The resiliency is there -- plus they had lots of money. So, building on your [points], they have a lot to learn. I'm a little concerned, but I have a feeling that they might be able to pull this off and hit new products and do new things based upon that combination. But, as they say, we'll have to see.
Knowledge@Wharton: It certainly helps to be resilient if you have some cash. [Laughs.]
Hrebiniak: [Laughs] Absolutely. Money cures lots of evils, doesn't it?
Knowledge@Wharton: Coming back to Google: If Eric Schmidt, the CEO of Google, were to ask you for your advice on what should Google do, what would you say?
Hrebiniak: Well, I think that Yahoo and Google are talking. Google has to look back and say, "Look at all of the things that we are looking at. If they form this combination, are we vulnerable?" If they decide that they are not vulnerable, they might just turn around and say, "Fine, do it. You're not going to cut into our market. We have other stuff in store. We're going to keep on growing. We're not worried about you."
But if the CEO decides that there might be something to this combination, there might be some sort of synergy that might affect [Google], I might more proactively approach Yahoo.
Yahoo and Google are talking about doing things. Yahoo is not crazy about the idea, but Yahoo doesn't like Microsoft -- they don't like Google, but who do you like less? I guess that is the question.
If I were really worried at Google I would approach Yahoo and say, "Look, we'll make a deal with you: We'll do your online advertising, we'll share this, we'll do this, we'll share some technologies and, in effect, we'll form an alliance to keep you away from Microsoft." But I don't think that Google is going to be that concerned quite frankly.
Hsu: I would like to pick up on your final thought that the last thing that the CEO of Google wants to see is a stronger competitor. Yet, at the same time, I think that we have to take a step back and reflect on how we got into the situation where Yahoo is vulnerable as a takeover target. We have to reflect on the choices that they have made and some of the disappointments in their auctions, their music, their photos, their social networking and online video -- all leading up the recent layoffs.
They failed to innovate in the way that others have in the industry that would be the basis of an upward trajectory. It's not the first time that Microsoft has approached Yahoo, but now it's a very different bargaining game as a result of the downward trajectory of [Yahoo].
And as we think about Google's strategy and whether they want to try to bid-up the sale price of this asset, I'm not so sure, given the portfolio of assets that Yahoo has. As we think about Google, my impression is that what they are trying to secure all of the on-ramps on to the web, so that they can channel that into their online advertising revenue model. To that end, they've [introduced] their Android product for the handsets, OpenSocial for the social networking, the Maps application, media, YouTube -- all that stuff to collect data about user experience so that they can develop better products. Meanwhile, they are experimenting with Google Labs, lots of different products and acquiring a lot of consumer data through Gmail and other products.
What they are preparing for as Google is personalization of software. That is why I think that [the combination of] Yahoo and Microsoft makes a lot of sense, because there are synergies that Microsoft simply does not have. I believe they are offering a 60% premium because they see those synergies. I don't think Google -- either for antitrust reasons or more pragmatically for the assets that Yahoo has -- is going to be bidding. But they would, of course, like to not have to face a stronger competitor in this space.
Hrebiniak: Just focusing on Yahoo for a second: They're not doing well. The last five quarters their profits have been going down and down. They're not in a strong position. It's not like they can sit back and say, "Let's fight it out, guys, and come up with a deal." It will be interesting to see what they wind up doing.
Frankly, I think that they are going to take the deal from Microsoft. The premium is, what, $31 a share; they are talking now about maybe $35. It's already a big premium.
And I think that Ballmer has to win this one. He wants to win this to look good because a lot of stuff that he has done outside of his traditional software area hasn't worked. He really wants to do something to regain cachet.
Knowledge@Wharton: We've talked about the synergies that may make this deal make sense. Let's talk about the difficulties of actually doing it if the deal goes through. Are these not very different companies? Even though they have some similarities in their products, in terms of their culture, they seem to be very different. How difficult is it going to be to meld these into one large company?
Hrebiniak: I think that they are going to have some difficulties, you're right. To me -- let me use my terminology -- this I see as "unrelated diversification."Even though there are some similarities, Microsoft is going into new space. Just like the Xbox example, when you go into new space, you have to learn that it's very hard to pull [it] off. There are going to be some problems.
What they are going into is far removed from what they've normally done and it's going to present some problems. We know from the history -- we've got all sorts of consulting and other companies telling us -- that you pay a premium price, you go into an unrelated diversification and you often wind up depleting or decreasing shareholder value. That's going to be over his head, he's got to worry about that.
There are other practical questions. How do you take 14,500 employees and meld them into 80,000? You've got structural change. You've got duplication of some resources.
Traditionally, this industry has looked very much down on acquisition and layoffs. All of a sudden, we are getting more acquisitions. All of a sudden, the companies are beginning to act a little bit more like, as someone in the Wall Street Journal said, "big utility companies." You know a traditional, Company A buying Company B.
So, [it's the] melding of people, melding of structural units, melding of cultures. It's not only two different cultures of Yahoo and Microsoft -- but Microsoft within is changing culture. They've traditionally had their own engineering people and software people [and] created stuff internally. It was a heavy R&D focus: "What we do is good."
Suddenly, what are they doing? There are buying capabilities. They have begun to hire people from the outside. VPs have left because they don't like the change in culture. They are hiring people from the outside so that some of the distinctiveness of what they've done is changing. So not only do you have a potential cultural integration issue of Yahoo and Microsoft, you have some cultural problems within Microsoft that you have to worry about.
Hsu: I think that that answer is right on. When you think about the scale of this particular acquisition, it's unprecedented for Microsoft. And Microsoft itself has done quite a bit of acquisition over the years, starting, I believe, in 1986. But, what goes counter to the culture of innovation in some of these spaces [is]: either you are going to be acquiring smaller startups or preferably you are going to be doing it organically in-house. When we think about the previous cases of success versus failure in these mega-acquisitions in the technology or Internet space, that track record does not look good.
If you think about AOL Time Warner, think about perhaps HP and Compaq -- it's notoriously difficult because there are very strong cultures associated with these companies. The integration, the redundancies, all of those things have to be managed. At the end of the day, you have to think: What are the possible synergies? What do we have to deliver as an integrated company? How are going to be able to get up to that frontier much fast than our competitor, Google, in this particular instance?
Whether the answer is going to be a direct attack on the online marketplace model or some other new battleground, remains to be seen. The management of these companies has to be mindful of the difficulties and the logistical integration difficulties associated with this type of size.
Hrebiniak: Just one other point to hitchhike on what David just said. I remember, maybe a year or two ago, Steve Ballmer was looking at Google and he said "Well they are just consolidating dominance through acquisition. They're just acquiring people." -- with the hint that this wasn't the right thing to do.
So, how does he combat it? They are gaining dominance through acquisition. What you dumped on a company for doing two or three years ago, you are now doing. If your own people agreed with you two years ago that, "We can't act like this. We have to grow organically. We're great." All of sudden, you are turning around and saying "Well, the rules have changed -- we're going to dominate through acquisition. We're going to become more like Google and some of these other companies who have done this before."
That's why I think some people are leaving and don't like what they're seeing changing. We're going to have to see if Ballmer can handle that transition. He's a qualified person, but he is going to face an uphill battle on some of this.
Knowledge@Wharton: Speaking of dominating through acquisition, you both mentioned the antitrust factors. Could you speak to a little bit about that and what it might mean for consumers?
Hsu: In the antitrust analysis, you have to understand what the relevant market is. Google is clearly playing off the dominance -- not really the dominance, but the high market share of both Microsoft and Yahoo in the space of email and instant messaging. Of course, Microsoft's reply is, "Well, let's pay attention to the online advertising space." Yahoo plus Microsoft don't even begin to approach the market share that Google has.
With the size of this merger, there's clearly going to be some review. To your earlier question of: Is it a credible threat that Google would come in with its own acquisition of Yahoo? I don't think that as a likely scenario. I think that the Microsoft and Yahoo merger faces a lower hurdle with respect to integration on antitrust grounds.
We also have to think about the pricing side of the equation. For consumers, a stronger competitor for Google could be a good thing on the online advertising space, in that there may be some platforms for advertisers. A different competitor is always going to put downward pressure on prices.
I suspect that consumers will end up being the beneficiaries of a Microsoft-Yahoo deal, not only in advertising online space, but in the consumer products that are associated with the Yahoo assets.
Hrebiniak: I agree with David, except for one little thing. I'm not much of a blog follower, but I started looking at the blogs to see some of the things that people were saying. I found an awful lot of reaction and industry comment on the fact that most of the synergies talked about are going to benefit Microsoft-Yahoo or Google. They talk about more market share. They talk about competition. They talk about synergies.
The number of times that I saw things mentioned like "the customer is going to benefit" were far fewer. I'm not saying that it won't happen, but it's just that now you have a dominant firm and, if the combination goes through, it's basically an oligopoly with a couple of dominant firms. Whether they will drop the price, or whether they will compete in other ways, I'm not certain.
I'm hoping that the customer benefits. I'm hoping that there would be some increased competition, but right now I'm not 100% convinced that the consumer or the customer is going to win from this. I think that the company is more focused on how they are going to win and beat each other.
Knowledge@Wharton: Given how big and complex this is if these two companies do join, what advice would you give to Mr. Ballmer? If he called you and asked you "What can I do to make this work?" What would each of you tell him?
Hrebiniak: One of the things that I would strongly suggest is to consider developing a good implementation or execution plan and look at the things that are part of that plan. Talk to the companies involved. Talk to the top managers. Do a kind of "work out" session to get [to] the feelings of what the concerns are, what the fears are, what the issues are. Put together a SWAT team, right away, from both organizations -- even if it's dominated by Microsoft -- to start looking at these critical issues, to take a look at strategies, to take a look at structure, to take a look at elimination of redundancies, to take a look at some basic issues: How do we keep people from leaving? Are there retraining issues involved? How fast do we move?
This is one question that always comes up that people seem to ignore. People will say, "Do it quickly, get it over with." I think that you have to talk about what is done quickly and what takes a little longer, and lay out an implementation plan to execute the integration well, decide what should be integrated [and] how, and just get people involved in that discussion so you're not pulling major surprises and driving people away.
Ballmer is a strong person. If he starts doing too many things unilaterally, without getting input from both sides, [his people] -- especially the scientists, the technologists -- are going to say, "This is not the kind of management style we signed up for." and he is going to run into some problems. In a nutshell: Think about all of the critical issues in an implementation or execution plan and try to follow through with them.
Hsu: I think that is right on, Larry. You are the expert on these implementation issues.
I would advise Ballmer to think about the broader vision, the broader strategy of what this merger is trying to accomplish. Whether it's likely that the combination of these two companies is going to be able to beat Google at its own game, or there will be more fertile ground for them to explore via the combination of these two companies.
I might point to three specific battlegrounds or areas that they might want to think about at Microsoft.
The first area is personalization -- whether in the domain of financial services, health care, [and so on]. All of these things that are inputs to personalization require lots of consumer data. I might advise him to think about developing a clear view about in which area you are going to be the most sophisticated, and try to drive the merged organization to be excellent in providing that service to the consumers.
The second area you might think about is software services. Google has developed capability in this area. Microsoft, of course, has a vested interest for this not to materialize. But I think they have to be realistic about the decoupling of software onto a given hardware machine and the emergence of software as a network service.
And third, an area that I think is going to be a future battleground is the mobile phone space, both the hardware and software sides. That might include the domain of online advertising via mobile phones or, more generally, the advent of the iPhone and Android platform. There's going to be lots and lots of competition and that is going to open up, both on the hardware and software sides, [opportunities] that each of these companies -- Google, Yahoo and Microsoft -- will have to think hard and seriously about how they want to play in that particular game.
On top of these implementation issues and transitioning the organization, I would advise Ballmer to think about: What do we want to do in the future? Maybe we haven't been so quick about getting onto the online advertising space. We're not going to cede that whole space. But, we're going to try to save our strength for the next big battle.
Hrebiniak: If I could just add: I right away jumped into some execution issues, but I agree with you. When I talk about execution or implementation, I always start with strategy. I made that assumption before and I jumped right into execution. The first thing that has to be done before you develop an implementation plan is to create a strong statement of what the strategy is going to be.
This will help define the capabilities that you need. It will define a lot of the demands that the strategy will make in terms of people, in terms of structure, in terms of incentives [and] controls -- all of the things that we typically think about -- but it does start with strategy.
So first take David's point: Talk strategy. Get the right people involved. Give a clear blueprint of where you are going because that will define a lot of the changes, execution issues and capabilities that you have to develop to make all of this pay off.
Knowledge@Wharton: Considering what is happening in the online advertising market, what should be the strategy?
Hrebiniak: That's closer to you David...
Hsu: Larry, if we knew, we wouldn't be Wharton professors. We would be out there trying to start a company!
Hrebiniak: We would all be rich tomorrow -- that was my first thought.
Hsu: [It's a] very difficult question, but the one thing that immediately comes to mind is: Is the platform of [Google's] AdSense and the online marketplace for [keywords] that is driving the advertising revenue, is that where history ends with respect to how online advertising is provided? Or might there be a next generation -- whether tagged videos or tagged graphics -- that then begin the basis of search? Or would it be a better search algorithm? Or, will it be not paying for clicks, but rather paying for a bigger percentage on actual calls that are rendered or purchases that are made?
I think that there is a lot of tinkering on the business model side and the revenue model side that could be the basis of some incursions. I think that Google is probably smart enough in that they are experimenting and trying to do localized experiments about how to optimize this particular model, given that it's basically their cash cow.
From a technological side, could there be a technological solution that will get better matches between buyers and sellers of advertisements -- whether a result of personalization and understanding and collecting all of this data or whether it's more of a business model innovation where you are giving different economic incentives to different actors. I don't know the right answer -- it's all speculative. But with the kind of stranglehold that Google has, there are lots of incentives, not only from Yahoo and Microsoft, but from the innovative startups all around the world that are trying to make progress in this dimension.
Hrebiniak: The only thing that I will add -- and, again, I agree with David -- is that you are getting into online, but there are other services, business apps services, things that Microsoft is doing. I'm not focusing on the online, but this is a way to get access to small and medium size companies that currently aren't dealing with you. It's a way to use one aspect, the online, to gain more insight into other customers, or access to other customers to execute your software plus service strategy that you have always done. So, there's another side of it -- maybe not make a lot of it or change it online, but use it for something else. But I think that what David said is right on.
Knowledge@Wharton: Either way, it will be interesting to watch this play out. If the deal does go through, perhaps we can come back six months later and assess how things are going.
Hrebiniak: Sounds good to me.
Hsu: Sounds great to me.
Hrebiniak: In the meantime David, we should call Steve Ballmer and suggest that we provide for him our services. How's that?
Knowledge@Wharton: Hopefully, he'll tune into the podcast. Thank you very much for joining us.