Will Microsoft's acquisition of Yahoo backfire?

Microsoft's US$44.6bn bid to buy Yahoo could backfire if not executed properly, according to analysts -- but the phenomenal price may be worth paying to fend off the challenge from Google.

Microsoft announced on Friday that it was making a further attempt to acquire Yahoo after approaching the company's board in February 2007. If the deal goes through -- and many think it will -- it could go some way to closing the gap Microsoft and Yahoo have endured between themselves and Web-ad leader Google.

"Microsoft needs to beef up its content capabilities," said analyst Andy Buss of Canalys. "Google is becoming a behemoth and Microsoft has been feeling left out." As well as chipping away at Google's 75 percent share of the online-advertising market, Microsoft also wants to use Yahoo's online users to drive a move to subscription services, he said.

"Yahoo used to be a leader, but it has been struggling under the onslaught of Google's development of Internet-based services," said Buss. Combining forces removes one competitor and could build an online presence that might finally reverse Google's rise, he added.

Microsoft is making no secret of the fact that it wants Yahoo not so much for its technology but its members. The online-advertising business relies on scale, pointed out Chris Liddell, chief financial officer for Microsoft, on a conference call on Friday to discuss the proposed deal.

"Microsoft's consistent belief has been that the combination of Microsoft and Yahoo clearly represents the best way to deliver maximum value to our respective shareholders, as well as create a more efficient and competitive company that would provide greater value and service to our customers," wrote Microsoft chief executive Steve Ballmer in his letter to the Yahoo board.

The two companies combined can get better economies of scale, said Ballmer, to compete with Google, and "offer a credible alternative for consumers, advertisers and publishers". Microsoft is expected to use Yahoo's research and development arms to augment its own software-as-a service offerings, and combine the two user bases of Yahoo and MSN/Windows Live into one.

Microsoft's offer, a 62 percent premium on Yahoo's share price, has raised eyebrows, given the latter's recent lacklustre performance. "Yahoo lost 30 percent of its share price over the past year," pointed out analyst Jon Collins of Freeform Dynamics. "But that is all short-term stuff, against the backdrop of the world market."

"This deal will break even or better in the second financial year," said Microsoft's Liddell. Buss agreed. "It won't take too long to pay this off," said the analyst, adding that Microsoft is currently so profitable, it needs to spend money to avoid piling up too much cash.

Microsoft, Yahoo and Google are all attempting to move, with limited success, to a subscription-based business, where users pay for software-as-a-service, said Collins. "Yahoo's done a reasonably good job and [so has] Microsoft... but Google has been less successful than it hoped," he said, pointing out that Google relies on advertising, while Microsoft lives off licence fees.

"It is difficult to believe there are enough advertisers or eyeballs out there to make all companies mathematically viable," said Collins. "Google is trying to wean people off the Microsoft desktop platform into software-as-a-service, while Microsoft's opportunity is to take the same people, who no longer want to use their tools on the desktop, and allow them to carry on working in a subscription-based Microsoft framework," he said.

"It's a bet-the-company move," said Canalys's Buss. "Microsoft has to move this way; if they don't compete, they will lose out."

"Microsoft has already made the bet, and is consolidating it," added Collins. "Microsoft has the ability to do things in both online and offline worlds, while Google is working only in the online world and is overly reliant on the advertising model. It could be argued that Microsoft's traditional approach is overly reliant on licensing, but it is easier to go from licensing to subscriptions than to go from advertising to subscriptions. People are quite familiar with paying money to Microsoft -- put it that way."

"Google will find it difficult to move to paid applications," agreed Buss. "It doesn't have the resources to do what Microsoft can do with Office, and Google doesn't have strength in the enterprise."

"This combination, long rumoured, comes a day after Google's first sign of a financial mis-step, after it missed fourth-quarter estimates," said Nick Patience, managing analyst at The 451 Group. "Google dominates web search, and this would combine the number-two and number-three players in [the market]; Microsoft sees Google encroaching on its desktop productivity business and neither Microsoft nor Yahoo have done much to counter that yet; plus both are battling Google for leadership of the online-advertising business."