With Yahoo deal's collapse, stymied Microsoft must find new online strategy

With its three-month pursuit of Yahoo at an end, Microsoft is back where it started: far behind Google, the undisputed online-advertising leader.

For several years, Microsoft has been striving for a bigger share of the billions of advertising dollars migrating online. Buying Yahoo would have gone a long way to making that happen, the company reasoned.

Now, after the companies could not agree on a purchase price, Microsoft has to chart a different course.

Chief Executive Steve Ballmer, in an e-mail to employees Saturday explaining his decision to withdraw the offer to buy Yahoo, said Microsoft has a strategy in place.

"Although the acquisition of Yahoo would have accelerated our ability to deliver on our strategy in advertising and online services, I remain confident that we can achieve our goals without Yahoo," Ballmer wrote.

But some analysts are looking for something new.

"It's not OK to say, 'We're going back to Plan A,' " said Charlie Di Bona, a securities analyst with Sanford C. Bernstein. "They need to say something that's credible and different. That's not Plan B, since they just gave up on Plan B. So what's Plan C?"

While Microsoft may be back where it started, the landscape has shifted since it offered to empty its bank accounts to buy Yahoo for as much as $47.5 billion.

Microsoft's pursuit of the one-time Internet champion may have chased Yahoo into Google's arms for an online-advertising partnership.

Media giants Time Warner and News Corp. also saw their online properties, AOL and MySpace, respectively, raised in partnership and acquisition discussions.

Microsoft's main reason for buying Yahoo was, in essence, a shortcut to catch up with Google.

That's still the goal, Ballmer told employees.

"Ultimately, our goal is to build the industry-leading business in search, online advertising, media and social networking," he added. "We are absolutely committed to being the leader in each of these areas."

Right now, the dominant form of online advertising is text ads displayed next to search results. They are powerful because they are naturally targeted.

Targeting audience

If you're searching for information on dogs, the search-engine results display text ads for dog food. When you click on one of those ads, the search-engine company gets paid by the advertiser.

Many observers see Google's lead in Internet-search advertising as insurmountable, despite the billions of dollars and years of effort Microsoft has poured into its own search engine.

"Up until this point, they were just trying to catch up to be as good as Google," said Kip Kniskern, a contributor to LiveSide.net, which tracks Microsoft's online-services efforts. "They're probably still not quite there yet but they've certainly closed that gap tremendously."

But Google has become the verb people use to talk about Internet search, while Microsoft's brand, Live Search, is not nearly as well known. Even if Microsoft's product is on par with Google's, there's no compelling reason for someone to switch, Kniskern said.

"Can Microsoft come out with a product that just blows Google's product away?" he added. "That's what they would need to do in order to take share away."

Although it's the top online-ad medium now, search advertising was nothing a decade ago. In fact, it was the lack of a viable ad-funded business model that contributed to the collapse of the dot-com bubble in 2001.

The end goal

"Internet search is a means to an end. It's not an end in itself," said Rob Enderle, a technology analyst based in San Jose, Calif.

The end goal is gaining a piece of online-advertising revenue predicted to be worth $80 billion by 2010.

Companies are already betting other forms of online advertising will come to the fore.

Google's acquisition of DoubleClick strengthened its position in display advertising, a less-targeted and less profitable online category than search. Yahoo is the leader in this business, and Microsoft's highly trafficked online services and content sites put it in strong position, too.

Other new forms of digital advertising, including ads on mobile phones and online video, are still up for grabs.

Scale matters

The challenge for Google, Yahoo, Microsoft and other online companies is gathering an audience so large — whether it be people searching the Web, checking e-mail, watching videos or reading celebrity gossip — that advertisers can't ignore it.

All the major companies are building competing technology to present ads to the audience and track their performance.

Microsoft would have quickly gained scale through Yahoo. Its acquisition last year of Seattle-based aQuantive added to its advertising-technology portfolio.

Growing through acquisitions and partnerships is still part of the strategy Ballmer outlined in his e-mail to employees.

In an interview with The Wall Street Journal last week, he said there are only "seven or eight" Internet companies of significant size.

"You have MySpace, Facebook, MSN, Yahoo, Google, Baidu, AOL," Ballmer said. "But then — boom — it really falls dramatically after that."

MySpace and AOL, involved in negotiations with Yahoo, could still be in play as Microsoft considers a next step.

Time Warner reportedly was the closest to a deal with Yahoo for AOL. To Microsoft, AOL would be the online property on Ballmer's list most similar to Yahoo, but much smaller.

Google owns 5 percent of AOL and provides its Internet search, further complicating any transaction with Yahoo or Microsoft.

With Facebook, Microsoft paid $240 million for 1.6 percent of the Palo Alto, Calif.-based social-network site. That put the young company's total worth in the range of $15 billion.

Potential there

Social networking has yet to develop into a new, lucrative form of advertising like search, but the sites do lots of display-advertising business. According to comScore, Fox Interactive Media, the News Corp. unit that includes MySpace, had 16.3 percent of U.S. display ads in November, second only to Yahoo.

Microsoft could always make another pass at Yahoo.

"Yahoo didn't want to be acquired outright, but in six months, it might be more interested in a business partnership or other deal short of a straight acquisition," said Matt Rosoff, analyst with Kirkland-based Directions on Microsoft.

Microsoft also regularly makes smaller acquisitions, and it could seek to beat Google by finding a startup with promising, innovative technology, or by snapping up leading online businesses in other parts of the world.

"The strategy should not be to move against Google's strength but to catch the next wave — move around Google like Google is moving around Microsoft," Enderle said. "Google was just an idea coming out of Stanford a few short years ago."

While looking for growth externally, Microsoft will continue pouring money into its own online projects.

Part of the strategy is to "expand investments in engineering" as Microsoft continues to improve its search engine and expand its advertising platform, Ballmer told employees.

Di Bona said that with the Yahoo acquisition off the table, Wall Street may be more willing to accept greater investment in Microsoft's money-losing online-services business.

But the company needs to try something different and be ready to defend any dramatic spending increases, he said.

"Plan A on steroids is not credible," Di Bona said.

Benjamin J. Romano: 206-464-2149 or bromano@seattletimes.com