Analyst changes tune on a Microsoft-Yahoo deal

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."

[slecalvez]

No deal will be done between these two until "Kumo" goes out live... That's my opinion. Kumo will give leverage, or at least more leverage than live, to Microsoft.

[t8]

More leverage for the fist 2 weeks, then it is back to googling.

[shawnlin]

Well.. if my understanding is correct, the OSB would be responsible for the MSN portal and the Live services. The MSN portal shouldn't be expensive to run as the 4 most expensive to run services, Hotmail, Search, Toolbar (due to promotion costs) and Ads management, are now part of the Live service platform. But the Live service platform is a very important part of Microsoft's cloud computing and hosted applications strategy. Google has clearly already won the search engine and context ad wars, and now matter now hard Microsoft tries, it will not change this reality. However, the battle for the next generation cloud computing and hosted applications platform is just beginning, and if Microsoft has to lose billions each year to get a ticket into the game, then so be it. Exchanging Live.com for a minority stake in Yahoo -- no way, exchanging or outsourcing MSN -- maybe.

[naterandrews]

Yahoo! is quickly turning into the modern day Excite (or Lycos, take your pick). Once a leading web pioneer, Yahoo! is losing its' grip on the market and mindshare of internet users. Microsoft does not need this aging property in the slightest to wage their war on Google.

While I agree with shawnlin, the war for market share in search and contextual ads is all but over, I also can't help but think- what if Microsoft pushed hard enough to sway confidence in Google? Offering enough incentives and creative partnership roles (MSN content sponsors, Hotmail sponsors, etc.), Microsoft could in essence leverage their massive visitor and user base to directly lead in ads, at cut-throat prices. This could help to gain a little market share, but watching Google scramble to protect their top tier advertisers from being poached, while cutting down ad rates and essentially slitting their own throat would be strategically worthwhile enough for Microsoft to try.

As the war for cloud computing begins to shape itself and the battle lines are drawn, Microsoft has little to worry about with Google Apps online. They are feature-deprived, and do not have the luxury of the Office brand equity. Microsoft, in a simple service pack or patch, could launch Microsoft WebOffice to all existing Office users, for free. Or, they could push it as a premium product while still having enormous support from the millions of users out there. Google stands little to no chance in beating Microsoft at it's own game. Again, this is a great chance for Microsoft to cut Google down at the knees; while they attempt to directly attack the Office crown jewel, Googles' only lifeblood- advertising will be vulnerable.

With Yahoo! saddled to the side of MSN and Live, Microsoft will not be able to deftly maneuver to compete with Google, while wasting resources that could be spent on direct assaults for the ad dollars.
Yahoo! has little growth in ads and search, while Microsoft has monopolies it can leverage intelligently- while avoiding antitrust suits. Go ahead Microsoft, show the world your true strength...

[t8]

Go ahead Microsoft and screw everyone all over again.
I don't think so.

It was stupid to let that happen once, but twice is ridiculous.