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Daniel Hung
Articles (5983)  | Author's Website |

Microsoft vs. Yahoo: Long term merger arbitrage?

August 05, 2009 | About:

The market (and internet) is buzzing with talk of the Yahoo!-Microsoft search deal. The deals are pretty simple and somewhat more beneficial than the deal which AOL signed with Google a few years back. Basically, Microsoft will power Yahoo’s search and Yahoo will become the ad platform across both search properties. Yahoo is granting Microsoft a 10-year license on its search technologies and transferring much of their search development team to Microsoft. What becomes of Microsoft AdCenter seems hazy, but without access to a legitimate search destination, it will likely be phased out as advertisers prefer to deal with ad networks that have broader reach.

Implications for Yahoo!

Yahoo is finally embracing the fact that it is not a true tech firm or development shop. The Company started as a web directory when the internet was in its nascence. It’s only innovation was that prior to Yahoo, no one had created a comprehensive listing of interesting sites online. Dave Filo was just skilled enough to develop a file server which could scale the website as it became popular and then what? It expanded into various content verticals – finance, games, e-mail. But, name for me a real innovation that it provided. It’s search was the “best” simply by virtue of having a human-vetted directory to pull from. Once crawlers and search algorithms gained popularity, it fell behind the curve and, in fact, was powered by Inktomi (which Yahoo later acquired and ostensibly turned into its search group) and Google.

The question becomes, can an internet content destination without differentiated tech IP – i.e. search, social networking, etc. – be any more successful than an AOL or some other blog network. Search is the #1 online advertising market. Giving up search, necessarily gives up value in Yahoo’s ad network. As users realize Yahoo is no longer providing the search service, will they migrate to Microsoft’s portals? It will be interesting to watch how Yahoo’s revenue “sources” change as time progresses. At some point in the future, one could imagine that a plurality of their ad revenue will be Microsoft property generated. As Yahoo is basically purging its search developers, making a move back will be difficult especially since Microsoft will have a claim on any new technologies developed on top of Yahoo’s IP.

Implications for Microsoft

Apparently, there’s some sort of secret sauce in Yahoo’s search IP that Microsoft believes can help them win the battle with Google over “best search product”. (Most popular conspiracy theory is that they want to go after Google for IP infringement.) But, as Facebook will tell you, a great product does not always make money. Microsoft needs to be able to monetize search and search advertising seems to be the current route of choice (no one would pay for search so I can’t think of any other revenue model, but if you can maybe you can shake up this industry).

In order to monetize effectively, one needs scale. Advertisers want to reach the most people for their ad dollars. Google offers this by virtue of 60% search market share (higher in some localities around the globe) as well as a broad and diverse publisher network (AdSense). Microsoft’s move here seems impatient. Strategically, they seem to be more interested in chipping away at Google than profiting for themselves. Instead of developing and nurturing an in-house ad solution, it’s signing a pricy deal to license Yahoo’s search IP and as well as pay Yahoo a premium to serve ads on its search results. The two companies immediately achieve scale which could win advertisers away from Google, but it’s a disincentive to Microsoft’s in-house Ad Center group. Will it survive this partnership? If at the end of 10-years, Yahoo decides to back away, how will Microsoft effectively monetize its internet properties?

My Wild Speculation

Ultimately, it would seem that this deal is more just the groundwork for a potential acquisition of Yahoo. I’m not sure why Microsoft won’t just outright do it. Does Microsoft intend to continue to run MSN? As far as I’ve read, Yahoo’s ad deal does not cover Microsoft’s content properties. How will Microsoft monetize MSN now that its clear that its own Ad Center will not have reach into a much better trafficked search destination? Does Yahoo have what it takes to truly embrace its place as a media company? Can it provide investors the returns that it expects simply through content and advertising? Both Company’s are giving up an integral portion of what is the only proven sustainable internet business model – search AND search advertising. It would seem the mutual reliance can only point to one thing – a merger.

Full Disclosure: Long shares of GOOG at the time of writing.

Dan Hung


About the author:

Daniel Hung
StreetAuthority, LLC is a research-intensive financial publishing firm that aims to level the playing field for small investors by giving them access to the ideas and insights of some of the country's top investment researchers, analysts and writers. Although we specialize in income and international investment research, we publish a wide variety of newsletters that are geared towards helping EVERY kind of investor profit from today's volatile marketplace. Visit StreetAuthority.

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