Microsoft

Investors panned Yahoo's search and advertising deal with Microsoft on Wednesday, sending Yahoo's stock down 12 percent. IDC's analysts called it a "strategic mistake."

But here's what's good about it: After a year and a half of public scrapping, behind-the-scenes drama, and dysfunctional communications through leaks to the press, Microsoft and Yahoo now can get back to business.

The Microhoo concept has been reduced from a giant cloud of uncertainty hanging over both companies to merely a complicated partnership between two rivals with Google as a common foe. The range of possibilities for Microsoft and Yahoo, which ran all the way from nothing to Yahoo disappearing altogether, has been pruned back to a much more manageable scope.

Nobody will notice any difference immediately from the outside. First comes regulatory scrutiny, with the companies hoping for approval in early 2010. But already, the deal provides a framework that should make it easier for the companies to establish their new identities.

With Microsoft acquiring license to Yahoo's search technology, applying its search-ad auction process to both companies' searches, and offering jobs to many Yahoo employees, it appears Redmond is carrying more of the Ph.D.-intensive fight to Google. Yahoo, keeping its display advertising business and focusing on its home page redesign, becomes more of a hub for people's online activity and platform for outside Web sites' developers.

Some awkwardness remains where those two visions overlap. One is the work Yahoo has done to augment search results through a program called SearchMonkey, which can interpret tags on others' Web sites so they can be spruced up with new information when those pages appear in search results. To work, it requires the cooperation of the Web crawlers that index the contents of Web pages and the servers that present the search results.

To me, that looks like the sort of chore that will require Microsoft and Yahoo to work together in search. Fortunately, Microsoft and Yahoo have a 100-page playbook that had better address such aspects, and Microsoft Senior Vice President Yusuf Mehdi declared Wednesday he likes the SearchMonkey approach.

The companies also gave themselves two full years to fully implement the deal, too, so there's time to work out such details. In the meantime, Yahoo can't afford to stand still. SearchMonkey is one element of a new hybrid search page that Yahoo said it will start testing with its users starting in August.

There's some important context for these changes and for the Microsoft-Yahoo deal: search results are growing beyond the plain list of 10 hyperlinks with accompanying snippets of text. Google, for example, blends in ever larger quantities of "universal" search results such as maps, YouTube videos, photos, and news.

Yahoo plans to make its search pages more like its main page.

(Credit: Screenshot by Stephen Shankland/CNET)

Yahoo's new search results page include not only SearchMonkey, but also display advertising and the key element of its new home page, a customizable list of applications down the left side. The search results themselves become just part of a broader package, so Yahoo outsourcing the actual search engine duties to Microsoft isn't giving away as much of the core business.

Outsourcing search has a cost, of course. The partnership means Yahoo will get only 88 percent of search-ad revenue on its sites for the first five years, down from 100 percent today. Yahoo, though, also gets lower operational expenses and thus, it expects, greater profitability over the long term. Yahoo expects $275 million more each year in operating cash flow.

Carol Bartz, Yahoo's new chief executive, has shown herself to be a pragmatist who prefers picking her battles. With the Microsoft deal, she's chosen to sit a big one out, freeing the company from having to out-Google Google. What the company sacrifices in ambition it gets back in goals that are actually attainable.

For Microsoft, though, the struggle against Google becomes more intense. The combined search market share of Yahoo and Microsoft still is half what Google has, and the fact that Wednesday's Yahoo pact is smaller in scope than some earlier possible incarnations means Microsoft has that much more hard work before it.

The company clearly wants to make a third big business out of its online operations to complement its Windows and Office cash cows. Getting Yahoo's search technology and Web site traffic gives it a better stronghold but by no means a victory.

Microsoft's search deal with Yahoo is the culmination of months of well documented negotiations, but in many ways, it is just the beginning of the long road ahead.

In the coming months, Microsoft and Yahoo will not only have to win regulatory approval for the deal, but also figure out how to bring together disparate approaches to the search market.

Microsoft has spent much of its energy in the last couple years refining its core technology, improving in vertical categories, and rebranding its Web search under the Bing moniker. Yahoo, meanwhile has put a lot of energy into tools that allow others to build on its technology, including the BOSS (Build your Own Search Service) and SearchMonkey efforts.

Mehdi

As part of the deal announced on Wednesday, Microsoft will now be responsible for trying to merge those efforts. In an interview, Microsoft Senior Vice president Yusuf Mehdi said Microsoft hasn't looked at the specific lines of code in that area, but is open to trying to take Yahoo's best ideas and integrate them into Bing.

"We like the approach that Yahoo has done," he said, referring to SearchMonkey and BOSS.

Both Mehdi and Yahoo Executive VP Schneider acknowledged that there are integration challenges, but Schneider said there is a clear delineation of who is responsible for what.

"At the same time we are integrating, we are really divide-and-conquering," Schneider said in the joint interview with Mehdi. "The reality is in the way we structured (the deal), it allows each of us to innovate in the areas that will jointly bring advantage."

The fact that the companies have already spent time thinking about these issues reflects the different nature of the discussions this time around.

Whereas last year's negotiations were done with Yahoo's board and a keen eye on Wall Street, the deal announced on Wednesday is much more focused on how to build a search business for the long term.

CEO Steve Ballmer noted on the conference call earlier Wednesday that the two sides have a 100-page playbook as opposed to a two-page term sheet and also noted that the negotiations were handled by management as opposed to representatives of the company's boards.

Schneider

In addition to being run by the top management from Microsoft's online group, including Mehdi, Senior Vice President Satya Nadella, and online unit President Qi Lu (a former Yahoo executive), Mehdi and Schneider said the negotiating teams routinely called on the companies' engineering and sales ranks to make sure the deal they were structuring made operational sense.

It wasn't just the typical few business development executives in a room hashing out financial details, the pair said. "We really have got a great vibe with Yahoo's operating team," Mehdi said.

The two companies will be able to do some work on their joint plans while the deal is pending, but there are limits as to how much collaboration can take place.

"We will do all of the pre-work that we are allowed to do in terms of preparing," Mehdi said. "We feel like we can make a lot of progress."

Ultimately, though, the two companies said they expect just integrating Bing's results into Yahoo in the U.S. will take several months, while moving from Yahoo's Panama ad-serving technology to Microsoft's AdCenter could take a year. It could be two years from the deal close before the two companies can fully implement the deal across the globe.

Microsoft's Mehdi didn't close the door on an eventual expansion of the deal into some of the areas the two companies had at one point considered, such as joint work on display advertising.

"Today is a start on a fantastic partnership which we are very excited about," Mehdi said. "By starting this partnership it allows us to over time build greater and deeper relationships. Right now the focus is on getting to a credible No. 2 player in search and paid search."

One of the open questions is what will happen to each company's business and workforce during the time that the deal is pending. Schneider said the companies have a communications plan for employees as well as the sorts of retention bonuses planned to keep key employees in place.

"We believe this is a winning plan," she said. "People want to be part of a winning vision."

Ultimately, Yahoo CEO Carol Bartz said some of Yahoo search employees will move to other parts of the company, some will be offered jobs at Microsoft, while others will eventually lose their jobs.

For his part, Mehdi said the company will continue to beef up its search staff while the deal is pending. "We are continuing to hire and invest in search."

As finalization of a Microsoft-Yahoo search deal reportedly nears, activist investor Carl Icahn--who played a key role in trying to broker a broader partnership between the companies last year--is speaking out in favor of such an agreement.

"I've been a strong advocate of getting a search deal done with Microsoft," Icahn, who owns about 5 percent of Yahoo and sits on its board, told Reuters in a phone interview Friday. "It would enhance value if a deal got done, because of the synergies involved."

According to an All Things Digital report late Thursday, several top Microsoft players--including online executives Yusuf Mehdi, Satya Nadella, and Qi Lu--are in Silicon Valley to try to finalize a search deal with Yahoo.

The report says the two sides are "down to the short strokes" after years of closely watched on-again, off-again talks. A deal could come within a week, All Things Digital said.

Icahn, for his part, wouldn't comment on where the latest supposed negotiations between Yahoo and Microsoft stand, according to Reuters. Icahn was a central figure in Microsoft's highly scrutinized $47.5 billion takeover bid for Yahoo, which fell apart last November.

During the negotiations, he launched a proxy fight in a bid to take over Yahoo's board. Among his wishes was that then-CEO Jerry Yang step down. The company and Icahn eventually reached an agreement that got him a seat on the board, and the number of seats was expanded, with Yahoo appointing two new members from Icahn's slate of candidates.

Since the full-out acquisition fell through, both Microsoft CEO Steve Ballmer and current Yahoo CEO Carol Bartz have indicated they are open to some sort of a search deal.

As my CNET News colleague Ina Fried pointed out, with Microsoft's Bing getting some good reviews and Microsoft having billions in cash on hand, the pieces would seem to be in place if both sides have the will to make it happen.

It's unclear whether they brought the requested "boatloads of money," but several top Microsoft executives are in Silicon Valley to try to finalize a search deal with Yahoo, according to an All Things Digital report late on Thursday.

According to the report, the two sides are "down to the short strokes" after years of excruciatingly well publicized on-again, off-again talks. A deal could come within a week, All Things Digital said.

Included in the Microsoft entourage, according to the report, are three of its top online executives: Yusuf Mehdi, Satya Nadella, and Qi Lu.

Yahoo CEO Carol Bartz said in May that she was open to a search deal if she believed in the partner's technology and they provided said boatloads of money. Microsoft CEO Steve Ballmer has indicated for more than a year now that he would like to strike some sort of search deal, although he no longer wants to acquire all of Yahoo as the company offered to do in February 2008.

With Microsoft's Bing getting some good reviews and Microsoft having billions in cash on hand, the ingredients would seem to be in place, if both sides have the will to make it happen.

Updated 10:30 a.m. PDT with comment relating to Yahoo's new management.

Throughout 2008's on-again, off-again talks between Yahoo and Microsoft, many financial analysts declared the belief that some sort of deal--either Microsoft acquiring Yahoo outright or later just its search business--was a matter of when, not if. One report released Tuesday, though, shows at least one change of view.

Jim Friedland of Cowen & Co. said the relative financial results of Yahoo and of Microsoft's online-services business (OSB) gives Microsoft a bad bargaining position. Specifically, he said operating revenue from advertising dropped 16 percent annually for Microsoft in the first quarter of 2009, compared to a 12 percent drop for Yahoo and a 5 percent increase for Google.

"OSB's profitability has deteriorated substantially due to ballooning depreciation from underutilized data center capacity combined with unprofitable ad deals whose already poor performance has been exacerbated by the recession," Friedland said in a research note. "We believe Microsoft's underperformance in the Internet business limits its options in negotiations with Yahoo, and we have updated our view of the likely outcomes: (1) no deal--70 percent probability; (2) a search-only deal--10 percent probability; (3) an exchange of Microsoft OSB and cash for a large stake in Yahoo--15 percent probability; and (4) a purchase of 100 percent of Yahoo--5 percent probability."

Compare that to Friedland's October opinion, which predicted three possible deals: "In our view, Microsoft is unlikely to allow increasing OSB operating losses to continue in perpetuity, and we expect the company to implement one of the following strategies within the next 18 months: (1) the purchase of 100 percent of Yahoo; (2) the purchase of Yahoo's search business; or (3) the exit of its online-ad and access business, potentially by exchanging MSN/Live.com for a minority stake in Yahoo."

In addition, Friedland added in an interview Tuesday, the arrival of Yahoo Chief Executive Carol Bartz also may make things harder for Microsoft.

"The previous management team bungled Microsoft's generous acquisition offer last year. Yahoo's old management may have been more open to a search-only deal to create a near-term value driver for shareholders in order to compensate for its initial mistake," Friedland said.

"We believe that new CEO Carol Bartz will consider all potential transactions. However, Yahoo is in a solid financial position and Bartz is negotiating from a position of strength. Yahoo has a number of competitive challenges, but it doesn't need to do a deal and there are some serious strategic risks to selling its search asset," he added.

Regarding a search-only deal specifically, Friedland was skeptical.

"In order to get a search-only deal done, we think Microsoft would be forced to offer Yahoo high guaranteed minimum payments and pay a high traffic acquisition rate," he said, referring to the ad revenue shared with Yahoo. "We also believe that the integration of the Yahoo-Microsoft search assets could be challenging. Further, a search-only deal could initially result in an increase in Microsoft OSB's operating loss."

What, exactly, is behind Friedland's assessment of Microsoft's online weakness?

"Microsoft OSB generates a run rate operating loss of $2.3 billion and has been unprofitable for the past 13 consecutive quarters due to: (1) the signing of unprofitable ad partner and toolbar distribution deals with companies such as HP, Facebook, and Verizon Wireless; (2) aggressive spending on R&D, which has not yielded any killer apps...; (3) expensive marketing initiatives, like Live Search Cashback, that have not reversed share loss; (4) an aggressive build-out of data centers ahead of demand that has not materialized; and (5) a secular decline in high-margin dial-up revenues."

Discussions between Microsoft and Yahoo about a search partnership, while still preliminary, have taken place in recent weeks, according to a report on the All Things Digital Web site.

The talks have included a face-to-face meeting between Microsoft CEO Steve Ballmer and Yahoo CEO Carol Bartz, the report said. AllThingsD stressed that the talks are centered on what sort of search and advertising partnership might be possible, rather than an all-out acquisition.

Ballmer has been saying for months he would be open to a search deal, while Bartz has appeared less than eager for such an arrangement, in her far more limited comments on the subject.

Microsoft's position has strengthened somewhat in the past few months, with Redmond having hired a number of Yahoo's top search folks, including Qi Lu. The company has also grabbed a few business deals aimed at boosting its query share and begun testing of its next-generation search product, code-named Kumo.

But the software maker also needs the share boost that Yahoo could give it. Microsoft is preparing to back Kumo's launch with a big ad push and would benefit from spreading those costs over more than its current single-digit share of the market.

Yahoo, meanwhile, has held more than double Microsoft's share, but could be headed for a decline after losing several toolbar deals to Microsoft and Google. A report Thursday said the lost deals could cost the company as much as three percentage points of share, or 15 percent of its search volume.

Microsoft is continuing its one-employee-at-a-time acquisition of Yahoo.

The software maker confirmed late Wednesday that it has hired Larry Heck, a Yahoo vice president.

Microsoft said that Heck will start in a few weeks and report to Satya Nadella, senior vice president of the online services division of Microsoft's R&D group.

"We look forward to welcoming him to the team," Microsoft said in a statement.

Heck is the latest in a string of executives to move from Yahoo to Microsoft, with the most notable being Qi Lu, who now runs Microsoft's online unit. Other high profile hires by Microsoft include Sean Suchter and Scott Moore.

Heck's early tenure at Yahoo was marked by controversy. After he joined the company from speech recognition technology maker Nuance Communications, Nuance sued Yahoo, saying Heck helped poach a dozen workers from Nuance.

Microsoft, which last year offered billions to buy Yahoo, has said it remains interested in a search partnership.

Heck's hiring was reported earlier Wednesday by Bloomberg News.

A year ago Sunday, on February 1, 2008, Microsoft Chief Executive Steve Ballmer told the world his company wanted to buy Yahoo.

Despite months of discussions, the deal never materialized, distressing many Yahoo shareholders and hastening Yahoo's replacement of CEO Jerry Yang with Carol Bartz. But what if Yang had gotten up on the other side of the bed one day a year ago and led his company to accept the offer?

It's impossible to know what would have happened, of course. But an exercise in speculation can be illuminating, as Philip K. Dick showed with The Man In The High Castle, a novel in which Nazi Germany and imperial Japan won World War II.

So let's suppose that Yahoo agreed to Microsoft's acquisition offer after bargaining Microsoft up a notch on the price tag to, say, $31 per share from the original $29.

First would have come the challenge of antitrust approval. But the Justice Department has shown itself to be more concerned with checking Google's power, taking Microsoft's side when it came to the ill-fated Yahoo search-advertising deal with Google.

The European Union has shown more antipathy toward Microsoft, but it, too, likely would have been spooked enough by Google's might that it would sign off. And given that the EU is only now getting around to the issue of Microsoft bundling a Web browser with its operating system, any big compunctions about Microhoo probably wouldn't have set in until 2015.

So Microsoft and Yahoo probably could have cleared that hurdle, but not quickly, and there are other details to reckon with, so let's suppose that the deal closed in August. Yahoo shareholders would have received a chunk of Microsoft shares and a wad of money that looks princely in comparison with the present $11.74 value of their Yahoo shares.

Sure, there would be some bellyaching, but all those institutional investors who were publicly griping about Yahoo's management would have been mollified--especially because revisionist history or not, the economy in August 2008 already was well on its way downhill, and Yahoo's stock likely wouldn't look so great.

So next up would have been the big challenge: integration, which, as former Sun Chief Executive Scott McNealy famously described it regarding the merger of Hewlett-Packard and Compaq Computer, is like watching two garbage trucks collide in slow motion.

Executives fond of competing pet projects would be pitted against each other, tooting their horns and trying to fend off others' with candid assessments--and Yahoo already had enough internally competing projects on its own, as documented in Brad Garlinghouse's Peanut Butter Manifesto.

But Microsoft actually saw the HP-Compaq merger as an example of how to make Microhoo happen: pick a product and go with it, rather than mess with grueling efforts to combine separate and often incompatible properties. So in all likelihood, Microsoft would have treated the acquisition with the alacrity it deserved.

Integration hell
Some parts of the Microhoo integration would have been relatively straightforward. First, top management.

Given that we've already rewritten history with Yang signing off on the deal, which implies that he would have gotten past any over-my-dead-body, burn-the-furniture attitude, he probably would have stuck around a year for appearances' sake--and he's a helpful sort of fellow who probably would have worked at least for a time to try to hand off his baby to its new parents. It wouldn't be easy, but Yang at least already has years of experience reporting to another CEO.

So which company has the better brand online? Yahoo.

Microsoft has been hobbled by its MSN vs Live branding muddiness, and the Yahoo brand has long history of great recognition. In April 2008, Yahoo's front page had 61 percent portal market share to MSN's 20 percent, according to Hitwise. But brands live a long time, and with the merger only closed for a few months by now, Microsoft probably wouldn't have had much of a chance to make big changes.

Technologically, Yahoo and Microsoft are worlds apart. Yahoo's widespread use of open-source software and fondness for the Firefox browser would raise hackles all over Microsoft. But for the sake of expediency, and to avoid spooking the Yahoo administrators and coders who actually know how the Internet property is wired, Microsoft almost certainly would have left things stand as is for at least a year. It had already had undergone the long and painful experience switching Hotmail from Unix to Windows.

Philosophically, though, Microsoft and Yahoo are converging, partly because the Internet is only becoming more important and partly because they're being driven in the same direction by Google's competitive threat. Both want sophisticated online services, both want a better search site with more traffic, both want to be a hub for people's lives on the Internet, both want to be an unavoidable part of online advertising.

Service winners and losers
The nitty-gritty of integration would have involved figuring out what to keep when the two companies had directly competing offerings. Yahoo's got the traffic, it's got the brand, and its services in general probably would have come out ahead.

Search would have been an obvious decision: keep Yahoo's search engine, redirect Microsoft search traffic to it, and get the combined engineering team cracking as soon as possible. It has more volume and more advertisers. The tricky part would be migrating advertisers to Yahoo's technology, but Microsoft would have a huge incentive to build as much critical mass as possible to try to check Google's dominance as soon as possible.

Yahoo has another big asset: Yahoo Open Strategy. Even in the real history, YOS is only just arriving now, but even a year ago, its potential was clear: it offers Yahoo users more to do online, energizing Yahoo properties by linking them together with social activity and building them into the broader fabric of the Internet.

Yahoo took ages to retrofit its site with the Yahoo Open Strategy technology, including interfaces that can broadcast user activity such as rating a movie; delaying YOS even more by mashing it up with Microsoft's online sites would have increased its risk of irrelevance.

With some big properties, a type of merger would be needed. With Yahoo Messenger vs. Windows Live Messenger, the companies already have done interoperability work, easing the pain of merging two largely incompatible networks into one.

The ugliest part would have been e-mail. Each company already has two options--Microsoft's Exchange-Outlook combination for businesses and Hotmail for consumers, and Yahoo's Zimbra for businesses and Yahoo Mail for consumers. Two e-mail offerings already are too many, and four are way too many, but e-mail is a core part of customers' lives, and it would have been hard to move gracefully.

So by this time in the companies' merger, users probably would see nothing different. But if Microsoft were smart, it would have determined that Yahoo Mail had the better technological underpinnings, in part because of Yahoo Open Strategy, and begun steering new sign-ups to it. Perhaps a migration tool would be released, or at least under way, for those who want to change manually.

With Yahoo part of Microsoft, one big project would look very different: the cloud-computing version of Microsoft Office, accessed via a browser. The combination of Microsoft's existing Office customer base and Yahoo's online customer base would have provided a much better rival to Google Docs, especially when it comes to attracting business customers who are more likely to actually pay for a reliable, supported service.

Not everything would have gone well for Yahoo projects, though. The same scrutiny that Yahoo properties are undergoing now, under the Bartz administration, would have begun months earlier and likely with less sympathetic eyes. With new bean counters in charge, Yahoo sites that didn't pass muster would have been axed with less hesitation.

Merging in an ugly economy
And that cold calculation likely would have gotten colder because of the economy.

By the time the acquisition closed, signs of the economic troubles would be apparent. Microsoft shareholders, seeing their stake diluted and their cash reserves depleted by the acquisition, could have become a significant issue. Microsoft's flexibility to acquire other companies, lavishly fund research with cash, or pursue other big-picture changes would have been significantly decreased.

Yahoo's deteriorating ad revenue would have become apparent, likely spawning a collection of Monday morning quarterbacks. After all, a better time for companies to consolidate is by snapping up weaker companies more vulnerable to economic swings. Microsoft wouldn't have been buying Yahoo at its peak, but the accountants in Redmond likely would be worrying about goodwill impairment charges.

Yahoo employees, spooked by the bad economy and Google's continued dominance despite it, might have been happy about having a more stable employer and a better shot at taking on Google, cultural clashes notwithstanding. But the reality of layoffs would likely have swept away many feelings of security.

Yahoo and Microsoft each announced significant cuts in the real world--1,520 for Yahoo and up to 5,000 for Microsoft--because of the economy. Combined with the inevitable redundancies from the merger, the job cuts probably would have come earlier for Microhoo and might well have been followed by more, increasing the total.

Worse, that unpleasantness would have taken place before any of the fruits of the integration were visible, deepening morale issues.

So by this time in our alternate history, there would be plenty of unpleasant news. Google wouldn't be put in its place, the benefits of the Microhoo merger wouldn't be apparent, and the world would look very similar to today's, minus a YHOO ticker symbol on Nasdaq. But the seeds of the merger's fruit would be planted, and if Microsoft played its cards right, Google would be reckoning with a more formidable competitor.

A major Yahoo shareholder is reportedly pushing for the company to renew discussion with Microsoft for a deal over its search business, CNBC reported Wednesday.

Ivory Investment Management, a hedge fund based in Los Angeles that owns 1.5 percent of Yahoo, is expected to release a letter Wednesday outlining its plan, which could result in as much as $15 billion from Microsoft, CNBC said.

Officials from Ivory could not immediately be reached for comment.

The Microsoft-Yahoo saga has been a long one. Last month, Microsoft CEO Steve Ballmer finally said that the company was "done with all acquisition discussions with Yahoo," though rumors of a search deal continued.

Earlier this year, Yahoo and Google announced a search deal, but that was later called off. The whole debacle was widely considered to have cost Yahoo CEO Jerry Yang his job.