Yahoo!!!! (was Yahoo!?!?!): Why, after further reflection, I think Microsoft’s offer for Yahoo! is a brilliant strategic move

Plunking down $44.6 billion, or whatever the number turns out to be, for “change” and “social software” sends a huge message — although bizarrely enough a lot of Microsoft employees, on MiniMSFT and internal email discussion lists like Litebulb, have managed not to hear it.

It’s been several weeks since Microsoft’s unsolicited offer for Yahoo. My initial reaction was that while high-risk, it’s a good deal for Microsoft. Since then, on further reflection … I think it’s a brilliant move on Microsoft’s part — whether or not the deal goes through. And despite all the coverage around the web, I haven’t seen anybody discuss a couple of the most important strategic issues. So I thought I’d take a stab at it.

Update, 2/27: Press roundup (with some commentary) in a new thread; a meditation on cool in a comment. Also, MiniMSFT’s new thread Because the last acquisition went so well links back here, without comment, under Other perspectives. There’s plenty of discussion over there, and I’m crossposting some of my responses here as well.

To start with, Microsoft’s willingness to make an offer of this size — something that would fundamentally and irrevocably shift the center of gravity away from Windows and Office *and* outside of Redmond — is a huge signal that while some internal battles may continue, the board, CEO, and executives are willing to place a huge and risky forward-looking bet. And this is part of a coherent strategy and model; like I said in my original post, it was really striking to me how the discussion in the analyst call was couched in terms of “as we discussed six months ago”. These are both very good signs that the turnaround at Microsoft is going a lot better than anybody realizes.

And while most of my analysis here is going to be in terms of why this is good from Micrsosoft’s perspective, they’re not the only ones that matter. Sure, Sergey Brin has a vested interest, but he speaks for a lot of us when he says that he finds this deal unnerving (although interestingly enough, Marc Andreessen appears unconcerned). Anti-trust regulators here and abroad need to take a close look at this deal — especially Yahoo!’s and Microsoft’s dominance in many countries of Messenger and Mail. Microsoft has made some good recent promises in terms of openness; there’s a lot of (deserved) skepticism, and any approval of a Yahoo! deal should be contingent on the ability to hold Microsoft accountable. In the security and privacy space, the FTC Consent Decree on Passport will need to be extended to the Yahoo! properties that Microsoft acquires. And so on …

Presumably Microsoft’s anticipated this. It seems to me they really mean it when they say “we got pushed into this openness thing but now see that it’s good for us.” If that’s the case, then it’s in their interest to reinforce their commitments and be held accountable. Still, there’s no question that there’s a long history of bad behavior here; I think people are right to be skeptical — and demand a detailed anti-trust evaluation, if the deal does go forward.

Which it might or might not. Yahoo is resisting fiercely — they’ve adopted a new retention and severance package which could cost Microsoft an estimated $1-$3 billion. (Kevin Johnson’s “internal” mail published last Friday seems to imply that layoffs would be minimal, but who knows.) Yahoo!’s also frantically looking around for partners or a white knight. Microsoft has said they won’t raise their offer; they’re still mum on whether or not they’ll try to stage a proxy fight.

If the deal doesn’t go through, it’s a disaster for Yahoo! — and doesn’t really hurt Microsoft at all. Yahoo! was already reeling, laying off 1000 people, and with a major vesting (the “RSU”) in early February — right after the stock had bounced thanks to the offer — “everyone was just biding their time for the RSU to vest and the Microsoft bid just gives everyone an excuse to leave.” Thus far, their partner explorations have revealed that … hmm … they don’t have a lot of great options. If Yahoo! rejects the deal (or Microsoft takes their offer off the table), Yahoo!’s stock most likely plunges, which will add fuel to the fire of the class action lawsuits that have already started. Sometimes all you can say is “sucks to be you.”

Most people think that the search and advertising markets are both likely to be extremely profitable for the top two players if there’s a duopoly; if on the other hand it settles down as a triopoly, then the margins will get squeezed and #2 and #3 will have a hard tie doing better than break-even. Right now, in the US, Google’s #1 in both, with Yahoo! #2 and Microsoft #3.

If Microsoft acquires Yahoo!, it’s clearly #2 in a duopoly in search and in advertising, at least for a while. On the other hand, if Yahoo! rejects the offer and melts down, then Microsoft probably picks up more of their search and advertising share than anybody but Google — and Microsoft becomes #2 in both duopolies. Either way, looking a couple of years out, this alone could bring an additional ~$5-10 billion/year in profits even if the deal doesn’t go through.

Of course there are other possible scenarios … still, what’s fascinating is that it’s possible that just by making the offer, Microsoft has significantly altered the market.

Obviously, I think it would be a lot better for Microsoft if it *does* go through. Start with the geographical and cultural considerations. Silicon Valley is also on the west coast of the US, so on the one hand (depending on how the international aspects of the deal are structured) this doesn’t address Microsoft’s desperate need to globalize development … however, adding Yahoo! to Microsoft’s other resources establishes a power base outside of Redmond as formidable as Windows or Office. And this would be a huge shot in the arm for the folks at Microsoft Silicon Valley who along with some Redmond allies (Ray Ozzie’s org, Popfly, me for a while, etc.) are taking the lead at helping Microsoft to transform itself.

Clay Shirky’s excellent point about Yahoo!’s social DNA relates to this as well:

There is one thing that is true of Yahoo! and not of its rivals–it gets social apps, and it always has. Google is an algorithm-driven company. If there is a pattern in the data from which to extract value, they have a team on it, right now, and their team is smarter than your team. Microsoft has always had the individual user at the center of its universe–though they seem to have lost that particular spot with Vista, their Office suite remains the center of most business-users’ days. But only Yahoo! understands, natively, how to either build or buy applications that are designed for groups.

Indeed. Plunking down $44.6 billion, or whatever the number turns out to be, for “change” and “social software” sends a huge message — although bizarrely enough a lot of Microsoft employees, on MiniMSFT and internal email discussion lists like Litebulb, have managed not to hear it.

As for more traditional business value: not to sound like a broken record, but the positively-scaling dynamics of the search and advertising markets mean that the combined market shares are worth much more than either company’s individually. There are similar positive sum effects in Mail, Messenger, and “portal” (potentially recharging MSN’s offerings as well — everybody disses ’em, but MSN and the butterfly are hugely valuable brands). The combination of Flickr + Spaces + Photosynth + client-side photo mangement in Vista (and Zune, and XBox, and smartphones) is a powerhouse … and speaking of devices, how about customized Yahoo! experiences for Zune and XBox, and leveraging Yahoo!’s content deals? Then there’s the potential combination of Yahoo! groups + Outlook; great analytics from Yahoo! cross-fertilized with Microsoft Research; Popfly + Pipes, Mashups + Hack Days

Yeah, okay, it probably won’t all work out. And it’s possible that Microsoft really is sooooo messed up that it’ll turn into a fiasco. There’s risk. Still, the upside if even a few of these things come through is huge, and there isn’t really a huge downside other than embarrassment if it becomes a quagmire.

Apparently Microsoft was willing to offer $35/share in December, and then Yahoo! blew the quarter, and now it’s 10% less. Yahoo! may be able to get more; then again, they may well be a lot cheaper in six months. We shall see.

So to recap: while risky, there’s huge upside for Microsoft if the offer goes through. Even if it doesn’t, it’s accentuated the stresses on a competitor, and staked Microsoft’s claim to be #2 in the search and advertising duopolies.

Well done.


Update, April 29: An excellent post by Marc Andreessen looks at the options if Microsoft goes fully hostile.