A $45 billion bet

Microsoft's bid for Yahoo!

IT IS a potential deal that has been talked about for years, but has suddenly become a real possibility. On Friday February 1st Microsoft, the world’s biggest software company, made a $44.6 billion offer for Yahoo!, an ailing internet giant. The proposed deal, which would transform the software and internet-services industries, values Yahoo! at $31 a share, a 62% premium over the closing price on Thursday.

In a letter to the board of Yahoo!, Microsoft’s chief executive, Steve Ballmer, referred to previous discussions between the two companies in 2006 and 2007 about a possible partnership or merger. At the time, Yahoo! was hopeful that Panama, a new system it had developed to place advertisements next to the results of internet searches, would improve its fortunes and help it to catch up with Google, the leader in both internet search and advertising. Panama failed to live up to expectations, however, prompting Yahoo!’s chief executive, Terry Semel, to resign in June 2007.

His place was taken by Jerry Yang, one of Yahoo!’s co-founders, who promised to put things right at the sprawling internet conglomerate. But Yahoo!’s latest results, released on January 30th, were disappointing, and its share price fell to a four-year low. Mr Yang said that the company faced “headwinds”, as Yahoo! announced plans to cut 1,000 jobs, some 7% of its workforce. Microsoft saw its chance. “While a commercial partnership may have made sense at one time, Microsoft believes that the only alternative now is the combination of Microsoft and Yahoo! that we are proposing,” wrote Mr Ballmer.

Google is not mentioned anywhere in Mr Ballmer’s letter, but its increasing clout in the online-advertising market, as a result of its leadership in search, is what has motivated the deal. “Today, the market is increasingly dominated by one player who is consolidating its dominance through acquisition,” he wrote. Combining Yahoo!, the number two in search and advertising, with Microsoft, the number three, would provide a stronger competitor in an industry where scale provides a huge advantage.

Google currently handles 66% of searches on the internet in America, compared with 21% for Yahoo and a mere 7% for Microsoft (through MSN and its new search engine, live.com). Strikingly, over the past year both Microsoft and Yahoo have seen their share of searches decline while Google's has gained.

The more people use your search engine, the more advertisers you can attract; and the more advertisers you can attract, the more likely you are to be able to serve up relevant advertisements that people will actually click on. As Mr Ballmer puts it: “While online advertising growth continues, there are significant benefits of scale in advertising platform economics, in capital costs for search index build-out, and in research and development, making this a time of industry consolidation and convergence.”

Microsoft is desperate to grab a bigger share of the online-advertising market because many of its software products are being challenged by free, advertising-supported services offered by Google. The company is also worried that Google’s dominance in search and advertising allows it to dictate terms to advertisers, and gives it an unfair advantage over its smaller rivals. This is a bit rich coming from Microsoft, a convicted monopolist in operating-system software, which has also been known to squeeze out smaller competitors, but its anger that it has had to endure years of scrutiny by regulators, while Google has been left alone, is genuine.

As well as creating a stronger rival to Google, the deal would also have other merits, Microsoft claims. The two companies could combine their research-and-development efforts into search, advertising and other areas; they could save money by consolidating the huge warehouses full of computers, known as “server farms”, that both firms operate; and they would be better placed to compete in new areas such as online video, social networking and online commerce. But it is clear that the real prize is greater clout in search and advertising.

Whatever Yahoo!’s management makes of the offer, the firm’s shareholders will be delighted at the news. Microsoft shareholders are likely to be less enthusiastic: integrating the two companies would be a mammoth task, and Microsoft has never made an acquisition on anything approaching this scale before. Some sceptics say that this is too much to pay for a troubled company, even if it is, by some measures, the world’s biggest internet firm. Microsoft says it is confident that regulators will approve the deal, which could be completed by the end of the year.