Microsoft, Yahoo face many hurdles to successful merger

SEATTLE -- Launching sporadic strikes at starship Google got Microsoft and Yahoo nowhere.

So on Friday, Microsoft let loose a quantum blast across Google's bow — an unsolicited $44.6 billion bid to acquire Yahoo.

The proposed merger brims with potential. Yahoo would bring legions of loyal users of its Internet e-mail, chat, search, news, shopping and dating services. Microsoft would contribute engineering prowess and its deep presence in home PCs and corporate servers.

As allies, the tech titans could leapfrog Google to the budding sweet spot of the Internet advertising galaxy: display ads on popular websites. By joining forces, the companies would reach 86% of U.S. Internet users and control 59% of the online display ad market, according to Nielsen Online.

"If Microsoft and Yahoo join forces it will be the most important event in the Internet industry this year, without a doubt," says Ken Cassar, analyst at Nielsen Online.

Yet black holes abound.

Google remains solidly entrenched as the leader in the current sweet spot, online searches and search advertising, commanding a 78% market share, worth $11.5 billion a year, says Jeffrey Lindsay, analyst at Sanford C. Bernstein. Yahoo, by comparison, has an 11% share, worth $1.6 billion.

If the deal is consummated, Google clearly must respond. But it can afford to move methodically. Corporate mergers are intrinsically messy. And this one is rife with looming deal breakers.

Starship "YahooSoft" could be thrown off course by a clash of corporate cultures, antitrust hurdles, or the possibility that the flight plan — set primarily by forceful Microsoft CEO Steve Ballmer — is simply wrong-headed.

"Although synergies are certainly great, the merger raises the question of how effectively they'll be able to continue operating during their integration," says Andrew Frank, research vice president at Gartner.

Yahoo says its board of directors will evaluate the proposal, but offered no timetable on when it would reach a decision. The company's vice chairman and former CEO, Terry Semel, abruptly resigned late Thursday. It declined further comment Friday.

The Yahoo factor

Microsoft's bold gambit comes at a wrenching time for Yahoo, an Internet pioneer that has been unable to convert its considerable online assets into a successful business model of late.

Despite, or because of, its broad spectrum of services, Yahoo has been hammered on multiple fronts by Google (in search), Microsoft (e-mail), AOL (instant messaging), MySpace and Facebook (social networking), and others in multiple countries. All the while, its management team has been dinged by analysts for moving too cautiously.

The stress has been reflected in Yahoo's slackening display-advertising revenue and its declining share of the online search market. The slumping company reported a steep drop in fourth-quarter profits, plunging its stock to a four-year low, and announced 1,000 layoffs last week. Management also conceded its turnaround efforts would take at least a year.

In making a play for Yahoo, Microsoft is showing the steely resolve to consummate a big deal that Yahoo was reluctant to do under former CEO Semel. Tech analysts say Yahoo's inability to acquire YouTube — as Google did — and its fruitless pursuits of Facebook and MySpace deprived it of valuable properties in fledgling markets. Dalliances with eBay and Google — and even Microsoft a year ago — also went nowhere.

"You grow in Silicon Valley by taking calculated risks, not standing still," says Lindsay, who has advocated major changes at Yahoo to pull it out of its tailspin.

The convergence of technologies should improve Microsoft's Web search, and add popular and valuable properties, such as Yahoo's photo-sharing service Flickr and Yahoo Finance. The addition of YahooMail, and its 257 million users, will help, says Nick Patience, managing analyst at The 451 Group, a market research firm.

The chief motivation, however, is dominance of the $40 billion online advertising market, which Google holds sway over, analysts say.

"This deal is mainly about advertising, mainly search-based advertising," Patience says. "It combines the second (Yahoo) and third (Microsoft) players in the market to take on No. 1, Google. This brings Microsoft a profitable advertising business, something it has not managed to achieve with its own online services business."

The meshing of two distinctly different cultures could also benefit Yahoo. It lost its laser focus after it became sidetracked by a foray into creating original content as a traditional media company the past few years, says Ali Diab, former vice president of product management at Yahoo, where he oversaw local search and mobile technologies until late 2006. Prior to that, Diab was at Microsoft, where he worked on mobile and Web products.

"Microsoft is a strong traditional software development company. It can bring organizational and technology discipline to Yahoo, which was missing," says Diab, who is now CEO of RippleTV, which runs a network of interactive TV screens at coffee shops and book stores. He is not a shareholder in either company.

Yahoo failed to make talent recruitment a priority. "This caused a brain drain," says Kevin Lee, analyst at didit.com. "Superstars wanted to be where they could influence the final product."

Over the past few years, "Yahoo became less nimble," says Diab. "Yahoo tried too hard to out-Google and out-Microsoft the competition. It lost touch with its roots that made it successful — the aw-shucks persona, everyday man. In the process, it may have alienated customers, and it became a less fun place to work."

Where this leaves Jerry Yang, Yahoo's co-founder who took over as CEO last year, is unclear. He may remain as an adviser, if the deal goes through, or leave the company he co-founded in 1994.

Privacy

Meanwhile, privacy advocates are throwing up red flags. Kevin Johnson, Microsoft president of platform and services, says both companies have been "leaders in focusing on privacy."

But that hasn't allayed fears. Each company has less-than-sterling records on that score.

Yang and Yahoo general counsel Michael Callahan were chided before Congress for the company's role in the imprisonment of at least two dissidents in China. A Chinese journalist was jailed after Yahoo China, then a unit of the company, handed information about the journalist to Chinese authorities in 2004.

Microsoft earned the wrath of privacy experts when it and Yahoo turned over search-engine data on customers as part of the federal government's efforts to revive a controversial online pornography law in 2006. (Google went to federal court to fight the government.)

Jeff Chester, of the Center for Digital Democracy, worries about a duopoly controlling consumer's online data.

"Google and Microsoft will have inordinate power to shape the online communications marketplace, including journalism, entertainment and advertising," says Chester. " In an era when individuals are increasingly conducting their personal, social and political lives online, the corporations that control the digital experience will have a far-reaching influence over every aspect of society."

The merger would face tough scrutiny from U.S. antitrust enforcers, says analyst Blair Levin of Stifel Nicolaus.

But he says the deal likely would be cleared, adding that the companies will argue Google is growing so dominant that Microsoft and Yahoo need to join forces to compete more effectively.

The European Union, which already has ruled that Microsoft abused its Windows operating system monopoly, would likely take a harder look at the deal, Levin says. Regulators there could seek conditions preventing Microsoft from using Windows to make it tougher for consumers to access Google.

Acohido reported from Seattle, Swartz from San Francisco. Contributing: Paul Davidson in McLean, Va.