Tuesday, August 24, 2010

Issue XX - Microsoft/Yahoo

Dear Readers,

One of the major business storylines throughout the first half of 2008 was the possibility of Microsoft Corp. (MSFT) acquiring Yahoo Inc (YHOO). The deal had been in the works for several months before the formal offer was announced on January 31, 2008. After the initial offer, several rounds of negotiations commenced, ending in the early summer and eventually fading away from the news as the faltering economy overtook the headlines. I have spent the past month studying the circumstances surrounding the merger. The questions I sought to answer were simple. First, what were the causes, and motivations, behind this proposition? Second, could it have been consummated, and if so, would it have worked? My findings are contained in this two-part newsletter (Part 2 will come out next week).

The origins of MSFT and YHOO’s courtship, as is the case with most mergers, were not due to events solely involving the two companies. In particular, it was due to the new behemoth in all areas of the internet business during this decade: Google (GOOG). YHOO had spent the first ten years of its existence as one of the companies on the forefront of wide-scale internet use. As a result, even with the emergence of GOOG this decade, YHOO still enjoyed the luxury of a broader, more widespread audience. For example, despite the emergence of university and workplace-based e-mail systems after 1998-2000, and the debut of GOOG’s Gmail, millions of individuals still use their original @yahoo.com e-mail address after all these years.

GOOG was established by Larry Page and Sergey Brin in 1998. Unlike early sites such as YHOO and Lycos.com, which sought to be hubs of everyone’s internet activity, GOOG was originally conceived as a superior search engine, and has grown out of that in the years since. By the middle of the 2000s, GOOG had emerged in less than five years to dominate the online search market. It had its initial public offering in 2004, and by 2005 the company was diversifying into e-mail, maps, and many other businesses. By 2006, GOOG’s share of the search market was well over 60% and growing. (For an idea of how fast this was happening, GOOG’s market share in search was reaching above 70% by the time MSFT made its bid for YHOO.)

YHOO management was aware of these problems long before the unsolicited offer was announced in January 2008. In 2006, reports surfaced of growing tensions within YHOO about the company’s direction and strategy. A prominent YHOO manager, Brad Garlinghouse, issued an internal memo that has become known as the “peanut butter manifesto,” available here. It was leaked to the press in the middle of November of that year. The point of the metaphor was that YHOO had become spread too thin, like peanut butter on a sandwich. In other words, it was engaged in many different sectors of the internet business, and not doing any of them particularly well. Garlinghouse's recommendation was to hunker down, eliminate the many redundancies at the company, and focus on the few core sectors in which it could do well.

Similar dilemmas have been seen countless times in American business history. A quick example: Procter & Gamble (PG). Having long been one of the most comprehensive consumer-products companies, by the mid-to-late 1990s the strategy of the company’s management was increasingly skewed toward growth via innovation and introducing new brands. While a few of these brands were hits and are company staples today (e.g., Swiffer), the failure of a number of new brands and the slowing of the economy combined to produce an earnings miss in February 2000. As PG was one of the first companies to miss earnings during the early 2000s slowdown, the market was not expecting it, and the stock was cut in half in a matter of weeks. After a change in management, new CEO A.G. Lafley refocused the company’s strategy on what had long been its core businesses of personal care and household cleaning items. High-growth sectors like hair coloring and shaving were also included in this strategy, thereby leading to the acquisition of Gillette in January 2005, among others. Historic, yet stagnant brands (e.g. Folgers Coffee, a $1 billion brand that was profitable but low-growth), were spun off or sold. Like PG, GOOG has achieved success by focusing on its core business of internet search. Recognizing this, Garlinghouse put forth his vision for YHOO.

In the search advertising market, the business model is simpler than it may initially seem. Briefly, when an ad gets clicked, GOOG, MSFT, YHOO, or whichever other search engine displays the ad gets paid, and the advertiser gets a potential customer. While this might not seem like much at first glance, millions of clicks add up. Since Americans are spending more time online every year, the potential market is worth billions and growing exponentially. By 2007, GOOG dominated this market with 70% market share, while YHOO and MSFT were fighting over the scraps at 18% and 9%, respectively.

With regard to search advertising, the main issue for YHOO was that while it had a larger audience amongst its many features due to its legacy as one of the oldest internet firms, it did not effectively monetize its search engine. This was, of course, GOOG’s forte. While YHOO was a very proud brand with a long-established brand name, the fact that GOOG was conceived and focused on search and monetizing that business is what made the difference. In short, YHOO had the audience, but GOOG did a better job making money in their core business. Therefore, in late 2006 YHOO management began to explore ways to combine YHOO’s superior audience with GOOG-style monetization. The success of MSFT’s Bing search engine thus far is evidence that a better-executed initiative at YHOO may have been successful. Bing will have nearly 30% of the market when fully integrated, although long-term growth concerns are currently surfacing.

To highlight the wide difference in monetization success, at the time of MSFT’s offer, analysts estimated that GOOG got approximately 20 cents for each click, compared to less than a dime at YHOO. As mentioned, YHOO’s management was well aware of this and launched several initiatives throughout 2007 to improve this; the most prominent became known as the “Panama Project” with tepid results. While YHOO made progress with regard to monetizing the searches, GOOG’s market share continued to increase throughout the year, effectively nullifying the gains in monetization.

Meanwhile, 800 miles north of Silicon Valley in Redmond, MSFT management was debating about how to best increase the market share of their MSN.com services. Knowing of YHOO’s internal squabbles, and knowing that YHOO had a large, broad audience that they did not have on the internet, MSFT saw the potential synergies in doing a deal. Therefore, while YHOO was making its efforts to improve its search monetization throughout 2007, MSFT began making subtle hints in the press and opened up formal discussions with YHOO. MSFT’s management team recognized that YHOO had many areas of redundancy and felt they could better diagnose and solve YHOO’s underlying issues.
At the time, many questioned why MSFT would want to expand into the internet when its specialty is software. Simply, any well-seasoned businessman knows that you can’t rest on your laurels; you need to be expanding, improving, or both. In the 2000s, MSFT had expanded into video games (Xbox), and a larger internet presence was a natural next step via an internal initiative to overhaul their MSN.com properties or an acquisition. Seeing YHOO in a vulnerable position beginning in mid-2006 made this more of a possibility.

Thus, on January 31, 2008, MSFT made an offer of $31 per share for YHOO. Less than two weeks later, YHOO rejected the offer, saying that it substantially undervalued the company. In early March, formal talks took place between the two companies’ leaders, followed by similar summits over the next two months. In May, YHOO co-founders Jerry Yang and David Filo rebuffed MSFT CEO Steve Ballmer’s raised offer of $33, announcing their price as $37 per share. At this point, Ballmer publicly announced that he had “had enough” with YHOO. Several weeks later, YHOO retracted and reopened the ongoing discussions, now willing to sell for $33 or $34 per share. After a few more meetings, YHOO cut off talks and signed an agreement with GOOG.

Not surprisingly, there was intense media interest in the prospects of the deal from the very beginning. Since GOOG already held more than 70% of the search advertising market, antitrust concerns made for the fact that MSFT was one of the only, if not the only, viable suitors. $45 billion deals are few in number to begin with, and on a worldwide basis the proposed YHOO/MSFT merger would have been one of the 30 biggest deals of all time. After the deal collapsed, YHOO tried to outsource its search engine to GOOG. The Department of Justice immediately stepped in and voiced its concerns, because GOOG would have had more than 90% market share in the sector. Among these regulatory concerns and an increasing divide over pricing between YHOO and GOOG, the deal was called off in late 2008. MSFT and YHOO re-initiated talks, and in 2009 YHOO outsourced its search engine to MSFT’s new Bing search platform, which is the current arrangement today.

Leading those opposed to the deal were, not surprisingly, those who built the company and the board of directors. Many commentators at the time pointed out the fact that YHOO was still a company run by its founders who were extremely proud of their brand. Jerry Yang was still CEO, and co-founder David Filo was still involved with company management as well. They had already initiated their turnaround strategy, and were confident that it would work. Their optimism can be seen in their overly optimistic projections for the company going forward from early 2008. Clearly, Yang and the rest of the management team were determined to see through their own redemption with the YHOO shareholders. When this did not come to pass, Yang stepped down as CEO in
the wake of the tumult to be replaced in January 2009 by Carol Bartz.

In conclusion, with an offer of $31 per share, MSFT could make its offer appear to be a very good deal to shareholders and not overpay for YHOO, if at all. As mentioned, YHOO’s board was well aware of this and did not want to sell out so easily. However, the lesson here is what ultimately matters is the opinion of shareholders. By early 2008, the Panama initiatives had yet to bear fruit, and shareholders were not yet confident in YHOO management’s turnaround strategy. Additionally, 2006 and 2007 had been especially brutal on the share price, at a time that the “Four Horsemen” tech stocks of Amazon (AMZN), Research in Motion (RIMM), Apple (AAPL), and GOOG were leading the market upward (See Charts 1 and 2). This was fresh on the minds of YHOO shareholders in January 2008, as the market was still relatively high at the time and their stock had lots of ground to make up. For this reason, the initial refusal of YHOO management to accept the deal and subsequent dragging out of the negotiations did not bode well for the deal from the outset.

Next week, I will be running through what a combined MSFT/YHOO would have looked like and what challenges would have existed for the company’s integration.

Respectfully Yours,

Matthew R. Green

August 24, 2010

Chart 1: YHOO Share Price 2004-Present

Chart 2: YHOO (Blue) compared to AMZN, RIMM, GOOG and AAPL 2004-Present