MSN-Yahoo: Watch out Google

Maybe Yahoo! has cold feet now. But if Bill Gates and Terry Semel join forces, Google will have a tougher time dominating the online advertising business.

By Paul R. La Monica, CNNMoney.com editor at large

NEW YORK (CNNMoney.com) -- Microsoft, the world's largest software company, is reportedly in preliminary talks to buy online search company Yahoo!. And if the two companies do decide to merge, they could create an Internet advertising powerhouse that would rival industry leader Google, analysts said.

According to reports in both The New York Post and The Wall Street Journal Friday, Microsoft (Charts, Fortune 500) is said to have approached Yahoo (Charts, Fortune 500) to discuss a possible combination. But one source close to the situation told CNNMoney.com that Yahoo may not be interested in a deal. And late Friday afternoon, The Wall Street Journal also reported that talks between Microsoft and Yahoo are no longer active.

microsoft_yahoo2.03.jpg
According to reports, Microsoft's Bill Gates and Yahoo's Terry Semel may be discussing a merger. A combination would be a much tougher competitor to Google
Gunning for Google
MSN-hoo? Ya-soft? Whatever you'd name a possible merger of Microsoft and Yahoo!, the combined entity would still trail Google.
March U.S. Search Market Share
comScore Nielsen//NetRatings
Google 48.3% 53.7%
Yahoo-MSN 38.4% 31.9%
Ask.com 5.2% 1.8%
AOL 5.0% 5.8%
Source:comScore, Nielsen//NetRatings

Spokespeople from Yahoo and Microsoft both declined to comment on the reports, citing company policy that they don't discuss market speculation.

Shares of Yahoo surged 10 percent in regular-hours trading on Nasdaq Friday, but lost 1 percent after the report that talks had ended. The stock was up as much as 19 percent Friday morning.

Microsoft's stock slumped more than 1 percent. Google's stock dipped slightly.

According to the reports, Microsoft is said to be considering an offer of as much as $50 billion for Yahoo. That would value Yahoo at about $36.75 a share. The stock was trading at around $32.75 following Friday's spike.

David Garrity, director of research with Dinosaur Securities in New York, said a deal makes a lot of sense since it would allow the two companies to pool their resources in order to take on a common enemy -- Google (Charts, Fortune 500) -- as opposed to wasting money by competing against each other.

"There is a great deal of competitive logic here. Why not just set their sights on Google and go at it?" he said.

If Microsoft and Yahoo merged, their market share in search would still trail Google's but not by a wide amount.

According to figures from Web traffic tracking firm comScore, Yahoo-MSN combined had 38.4 percent of the search market in the U.S. in March. Google led the market with a 48.3 percent share.

Microsoft has struggled to make inroads in the rapidly growing online advertising business. The company's MSN division ranks a distant third to Google and Yahoo in the online search market.

Last week, Microsoft reported in its latest quarterly earnings report that revenues at its online division grew only 10 percent, below the industry average, and that the unit posted an operating loss of $200 million.

To that end, one executive who works in the search business said that Microsoft does face a sense of urgency and that a deal for Yahoo would be the one thing that could finally make Google nervous.

"Google likes to be arrogant but if this deal happened, they would have to sit up and take notice. Microsoft hasn't shown much so far in online advertising but an acquisition of Yahoo would be a very good combination," said Samir Patel, founder and CEO of SearchForce, a privately held software firm that lets advertisers manage keyword purchases on Google, Yahoo and MSN.

Patel added, however, that Microsoft needs Yahoo more than Yahoo needs Microsoft.

Yahoo has fared better than Microsoft but has also found it difficult to compete with Google. Yahoo recently upgraded its search technology platform in order to make keyword search results more relevant for advertisers and users.

Analysts had hoped that the new system, dubbed Project Panama, would lead to market share gains and improved revenue and profits for Yahoo. But Yahoo released disappointing first quarter results last month and also issued tepid sales guidance for the second quarter.

Google, on the other hand, has continued to click, so to speak. The company posted first quarter results last month that far exceeded analysts' consensus estimates.

What's more, Google announced in April that it was buying online ad placement firm DoubleClick for $3.1 billion, a deal that analysts think will bolster Google's prospects in the so-called branded advertising market, which include banners, videos and other online graphical ads.

Google's purchase of online video sharing site YouTube last year also is seen as a way for Google to extend its market lead beyond search.

The DoubleClick purchase was seen as a blow to Microsoft, which was also said to be considering an acquisition of DoubleClick and has prompted speculation that Microsoft could scoop up a DoubleClick rival such as 24/7 Real Media (Charts), ValueClick (Charts) or aQuantive (Charts).

But Ryan Jacob, a portfolio manager with the Jacob Internet fund, which owns shares of Yahoo, said it makes more sense for Microsoft to target Yahoo instead of a smaller online ad company. He also thinks that Yahoo would be better off hitching its wagon to Microsoft.

"Microsoft is at a crossroads. For them, rather than spend just hundreds of millions in the hopes of being more competitive with Google, buying Yahoo evens the playing field in one fell swoop," Jacob said. "And for Yahoo, over time they will have an even more difficult time competing against both Google and Microsoft and I think that's becoming more clear to them."

Yahoo currently is considered the leader in branded advertising and the company is also bulking up in this area. Earlier this week, Yahoo announced it was purchasing the 80 percent in online ad exchange Right Media that it didn't already own for $680 million.

Marianne Wolk, an analyst with Susquehanna Financial Group, said a Microsoft-Yahoo deal merger would quickly trump Google's deal for DoubleClick.

She said a combination of Microsoft and Yahoo would give them a clear leg up on Google in the branded advertising business, a market that should see heady growth over the next few years as more marketers look to online video as an advertising option.

"A deal would create a behemoth in online branded display advertising and in my mind it would make Yahoo's Right Media exchange the standard for ad marketplaces," she said. "This is about the race to be the leader in branded advertising as video takes off."

And Dinosaur's Garrity said a marriage of Yahoo and Microsoft makes a formidable pair since it would match Microsoft's tech savvy, something Garrity feels Yahoo lacks, with Yahoo's media expertise.

Semel, after all, is more of a mainstream media guy, having worked for Warner Bros., which like CNNMoney.com is owned by Time Warner (Charts, Fortune 500), Walt Disney (Charts, Fortune 500) and CBS (Charts, Fortune 500) before joining Yahoo.

"Yahoo, relative to Google has not been seen as a technology firm per se and were a merger to take place between Microsoft and Yahoo, the combined entity's claims for technology leadership would be equal to if not better than Google," Garrity said. "Semel, coming out of Hollywood, may be cast as a technologist but he's not. He just plays one on TV."

Nonetheless, Wolk cautioned that there was no indication that Microsoft and Yahoo would definitely merge. She said Yahoo might want to hold out for an even bigger deal and suggested that the company could wind up fetching as much as $42 a share in a takeover.

Wolk estimated chances of a deal at about 50/50 and said that instead of an acquisition, the two companies might wind up just forming a deeper strategic partnership.

Wolk also said that if Microsoft and Yahoo are unable to work out a deal, Yahoo could also consider partnering, although probably not merging, with Barry Diller's IAC (Charts, Fortune 500), which owns Ask.com, or News Corp (Charts, Fortune 500)., which is increasing its presence online through its Fox Interactive Media unit, which owns MySpace. (MySpace already has an ad sharing agreement with Google, however.)

Charlene Li, an analyst with Forrester Research who covers trends in online advertising, is also doubtful that a merger will actually take place.

Li wrote in a Forrester blog Friday that "on paper, the deal makes sense ...but in the end it's going to be so hard that I don't think it will happen."

She added that a merger would bring a "limited benefit" to Yahoo and that a partnership that could be a prelude for an eventual merger down the road for the two companies was a wiser action to take.

"Tentative first steps to a merger would make a lot more sense, giving both companies the ability to "test the waters" before jumping into the deep end. But if I'm wrong and a merger does get announced, I wish the two companies good luck -- they are going to need a lot of it to pull it off." Top of page

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Most stock quote data provided by BATS. Market indices are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer.

Morningstar: © 2014 Morningstar, Inc. All Rights Reserved.

Factset: FactSet Research Systems Inc. 2014. All rights reserved.

Chicago Mercantile Association: Certain market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved.

Dow Jones: The Dow Jones branded indices are proprietary to and are calculated, distributed and marketed by DJI Opco, a subsidiary of S&P Dow Jones Indices LLC and have been licensed for use to S&P Opco, LLC and CNN. Standard & Poor's and S&P are registered trademarks of Standard & Poor’s Financial Services LLC and Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC. All content of the Dow Jones branded indices © S&P Dow Jones Indices LLC 2014 and/or its affiliates.