Tuesday, May 20, 2008

Is Microsoft Pursuing the Wrong Breakup?

Today's Wall Street Journal (5/20/08, p. B1) reports that Microsoft offered to buy Yahoo's online search ad business. The proposal also included a sale of Microsoft's Asian assets, and the acquisition of a minority interest by Microsoft in the residual Yahoo. The Journal also cites sources close to Yahoo as indicating Yahoo's board isn't likely to embrace this proposal.

That Yahoo's board wouldn't like this idea is no surprise. Microsoft, in essence, proposes that Yahoo sell Microsoft its crown jewel, then offload its Asian assets (does that make sense when Asia is the fastest growing part of the world's economy?) and then let Microsoft take a minority stake in the crumbs left on Yahoo's plate. Yahoo would presumably get enough cash to unburden itself of pesky shareholders like Carl Icahn and now Boone Pickens. But it would lose much of the heart of the company and have Microsoft, as a powerful minority shareholder, thereafter looking over its shoulder and potentially constraining it from ever again being a threat to Microsoft. In essence, Microsoft is proposing that Yahoo pretty much liquidate itself. Unless Yahoo can get a very good price for its search ad business and its Asian assets, this deal would not make much sense for Yahoo. And it's in Microsoft's interests to give Yahoo the lowest price possible.

Short term risk arb-type shareholders such as Icahn and Pickens shouldn't open the champagne bottles yet. If Yahoo's management feels too much under the gun, it may agree to terms that are unfavorable to Yahoo (and therefore to its shareholders). And if Yahoo's management did a deal with Microsoft, they could essentially eliminate Microsoft as a potential acquirer of Yahoo. That would reduce the profit potential of Yahoo for the Icahns and Pickenses of the world.

Microsoft's proposal would largely achieve the same result as an acquisition of Yahoo would have accomplished (i.e., get Yahoo's crown jewels and allow Microsoft to face only Google in the contest for online search business), at a lower dollar cost. But is it a good idea for Microsoft? One could say that Microsoft is fighting, not the past war, but the war preceding that one. Using search engines to draw Internet traffic was a hot idea at the end of the 1990's and at the beginning of the 2000's. Google has largely won that war. Since then, social networking sites like MySpace and Facebook took off as the hot new way to draw Internet traffic. That's another train that Microsoft missed (although Google and Yahoo also didn't cover themselves with glory when it came to social networking). By trying to buy Yahoo, or at least its search ad business, Microsoft is taking a large step backwards and trying to buy a rather old hot new thing.

Yahoo's search ad business is a mature business, not a sizzling start up. In the high tech world, buying mature businesses hasn't been a particularly rewarding strategy (recall Time-Warner/AOL, and Hewlett-Packard/Compaq). The big rewards come from getting in at the ground level. But Internet start ups present almost a conflict of interest with big, established businesses. The name of the game for an Internet business is to draw traffic. Over time, there have been a variety of ways to do this--AOL's subscription model, Yahoo's portal model, Google's search capabilities, and now the social networking phenomenon. Each of these innovations succeeds in part by drawing traffic away from older businesses. How can an established company truly be innovative when innovation could involve cannibalizing itself?

That seems to be Microsoft's problem--it saw the Internet as a threat and had trouble embracing the threat. Apparently, it never heard the adage that one should keep one's friends close and one's enemies closer (attributed variously to Sun Tzu, Machiavelli, Vito Corleone and perhaps others). So they protected their core PC operating system business while the rest of the world moved on.

Microsoft isn't solving its real problem by acquiring Yahoo or Yahoo's online search ad business. It still has the conflict of interest with its operating system business. While Microsoft wages war on itself, the real innovators in the high tech world are developing hardware and software that would make PCs and their operating systems irrelevant. One hundred new applications (mostly mobile) are blooming and contending with each other for the future of the Internet. But Microsoft isn't among them, nor has it shown any real talent for acquiring the up and coming ones.

Microsoft should break itself up. The Windows business should be split off from the rest of the company, and Microsoft's shareholders given stock in the spinoff. In this way, Microsoft's enormous resources could be redeployed, probably with greater latitude and ability to innovate. Of course, the two offspring could easily end up competing with each other. But the net benefit to shareholders is what really counts. Instead of devoting billions to purchasing mature businesses (which, in the high tech world means those whose future potential is unclear), Microsoft just might produce greater long term gains for its shareholders by splitting itself up. The current struggle among Microsoft, Yahoo and Yahoo's short term shareholders to generate gains from Yahoo's stagnant online search ad business may require a little too much wishful thinking to be successful for all. And if no win-win solution is possible, whatever outcome eventuates won't be pretty.

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