In the game of chess, a gambit is an opening in which a player can risk or sacrifice material in the hope of achieving some sort of an advantage, such as a better developed position. Microsoft had put up quite a bit of material resources (to the tune of $48 billion) in order to accelerate the profitability for its Internet business and to get an online advertising operation that would only trail its arch rival Google.

 

In its attempt to acquire Yahoo! Microsoft raised its original bid of $31 per share to $33, but later elected to walk away from the deal instead of raising its offer any further, particularly after it realized that the Yahoo Board was seeking $37 per share. The reaction in Wall Street was swift, as Yahoo’s stock plunged nearly 15% while Microsoft’s initial gain was wiped out with its stock trading down 0.5%.

 

The ticker results indicate that investors are not quite endorsing either company’s strategy. Clearly, with Microsoft ruled out at least for the near term as a potential suitor, all the eyes are on Yahoo’s CEO Jerry Yang (News - Alert). The bitterness he caused those big investors who regarded Microsoft as a great exit will eventually go away, but he clearly needs to come up with a strategy that repositions the company for growth. In the meantime, while Microsoft demonstrated some discipline by not going beyond its own valuation of Yahoo, the company needs to reconsider its long-term strategy, particularly vis-à-vis its online business.

 

An interesting twist to the story was the role that Google played in the entire story. Right after Microsoft announced its first offer for Yahoo, Google made it clear that it would challenge the merger to the point of raising anti-trust objections to the U.S. Government. But Google could have conceivably planned a more elegant countergambit to defend against the Microsoft overtures towards Yahoo. The weapon used by Google was not its threats to raise legal objections, but rather the strategic use of its own coffers: the company accepted to sell some search advertising for Yahoo. There is speculation that Google will continue to sell advertisements on some of the most often queried terms on Yahoo’s search engine, giving Yahoo the majority of the ad revenues (as is the case for sites for which the company sells ads).

 

The goal of this move is to promote a quick increase in the Yahoo valuation, as Google earns more on every search than its rivals do. Not only would this deal raise the stakes for a Microsoft takeover bid, but also deprive Redmond of being able to sell all of Yahoo’s search ads. This would make the prospects of a hostile takeover much less attractive, but this move just did not seem to be in the cards in any case, as it would undoubtedly entail a protracted process which could also induce unfavorable initiatives at Yahoo. Moreover, considering the big holdings of Yahoo insiders and the retail shareholders (typically non-voting), the arithmetic for a majority vote does not work in Microsoft’s favor.

 

In fact, from a historical perspective, there are quite a few synergies between Google and Yahoo. It was Yahoo which gave Google its first major break, using Google’s engine to perform the searches on its Yahoo.com portal. And the ties run even deeper: the founders of both companies (David Filo and Jerry Yang from Yahoo, and Sergey Brin and Larry Page from Google) all came from the same alma mater: Stanford.

 

Why would Google give the number two player in the search/advertising market such a boost? Was this just as an expression of gratitude for Yahoo’s usage of the Google search engine a few years ago or was it instead a way to stalemate Microsoft? Holding Microsoft at bay is certainly a part of the equation. After all, a Microhoo combination is certainly more fearsome than Yahoo and Microsoft in their current stand-alone modes. Perhaps the true answer lies behind Metcalfe’s Law, which states the value of a telecommunications network is proportional to the square of the number of its users. The so-called network effect in search advertising can be quite powerful, as the more ads Google handles, the higher the revenue it will make and the harder it will be for anyone else to design a contending product. In other words, the more searches Google manages, the higher the number of advertising dollars that it can fetch. While Google is sacrificing some ad money in the short run, in the long run it will have an even stronger position in the search/advertising market, as this agreement can eventually undermine Yahoo’s bid to improve its search/advertising engine system. The reasoning is simple: as a result of the deal, Yahoo will have even a smaller volume of searches to attract potential customers, including ways to improve ad revenues (such as raising bids and getting data to improve its ad selection technology).

 

Much has been written about Microsoft’s inability to improve the situation of its heavily  unprofitable Internet business (which incurred a loss of $1 billion last year) and how a Yahoo acquisition could have improved the outlook. Now, in the post-mortem of the failed deal, Microsoft CEO Steve Balmer will have to make some tough choices. Reverting back to the original pre-Yahoo Internet strategy is a non-starter, as Microsoft is hampered by its ‘number three’ status in search (which is indicative of its lack of brand equity in that space) and limited ad inventory. But with the future shifting towards “cloud computing,” it is imperative for Microsoft to find a way to revamp its online strategy. Given that there are no public alternatives to Yahoo, many pundits believe that there is still a chance for both Microsoft and Yahoo to reconcile their differences on price and join forces in the long term. If Jerry Yang is not successful in his bid to revitalize the Yahoo portal, Microsoft might yet get another opportunity to make a play for Yahoo. Other alternatives for Microsoft are to continue to focus on next-gen applications (in both the Web 2.0 world via mashups and the telco 2.0 world with its Connected Services Framework product). The key areas for such software development include video and mobility. Video will be another vehicle for future advertising that will give Microsoft the ability to leverage its applications in the fight for such ad revenues.

 

As for Yahoo, in the short term, the promise of a big check each quarter from Google should appease enough shareholders to head off a revolt over its decision to turn down Microsoft’s offer. But in the meantime, Jerry Yang has to find other ways to add value. Thus far, his blog post does not offer that much insight. The company’s stated plan is to take those checks and use them to fund the development of its own search advertising system that is expected to eventually rival Google’s. Once Yahoo’s technology is proven to be good enough, it could start selling its own ads on its own terms, and compete more intensively with Google. There have been some rumors that Yahoo has been in talks with Time Warner about its AOL unit, and with News Corp., which owns MySpace (News - Alert). These transactions would entail Yahoo taking control of the Internet assets in return for a cash infusion. In return, Yahoo would give up control of roughly 20 percent of the company.

 

It is surprising that in the end game, no solution to bridge the gap between both companies could be found. Microsoft outbid itself, raising its Bid price from $31 to $33. While Yahoo showed some flexibility lowering its Ask price from $40 to $37, the $2 delta to the $35 midpoint between both prices is equivalent to roughly $3 billion, which is about seven percent of the first $45 billion bid. Despite the setback, one possible scenario could be a repeat of the Oracle/BEA storyline, with Microsoft coming back with another bid. Whether or not that bid is higher or lower depends on how Yahoo will execute its strategy in the upcoming months. The relationship with AOL and possible search outsourcing to Google are two strategies currently being talked about. Another possibility is that a new bidder (such as News Corp (News - Alert).) could emerge. But in the meantime, Yahoo will revert to a “business as usual” scenario in which it continues to focus on building its business organically and via M&A (e.g., Maven Networks), adding new functionality (e.g., voice-activated mobile search, video on Flickr) and improving its search advertising system.

 

No matter what the final outcome is, there are undoubtedly some key synergies of a Microsoft-Yahoo union that no other transaction could bring to either company. For instance, Microsoft UC (Unified Communications) distributed through what remains the most popular Microsoft IPTV offering (Mediaroom) would overlap very nicely with the Yahoo/AT&T (News - Alert) joint portal deal (Yahoo provides the end-to-end solution for AT&T). Another example of how a merger could be synergistic is in the community/social networking arena: Microsoft Xbox 360 could connect to Yahoo’s portal for online gaming and social gaming networking. Current estimates peg the Xbox LIVE community at about 10 million users, but access to Yahoo’s portal could substantially increase that number.

 

The end game is shaping up to be very interesting. Did Microsoft just castle its king to buy some time and position itself for another overture towards Yahoo? Will Yahoo succeed in its quest to earn a better valuation should that move happen? And in case it does not, what is next in store for each company? The next few months will decide the outcome of the match.

 
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