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Why Microsoft will win Yahoo

To understand Microsoft's pursuit of Yahoo, you have to take a clear-eyed look at Google. It's not the greatest tech company after all.

By David Kirkpatrick, senior editor
Last Updated: July 7, 2008: 2:56 PM EDT

NEW YORK (Fortune) -- In the end, Microsoft is almost surely going to end up owning Yahoo's search business. That's the only conclusion I can come up with, having spent months talking to Microsoft's senior leadership for a recent story on the company. And even what does seem like erratic behavior on the part of Microsoft CEO Steve Ballmer et al points toward that inevitable conclusion.

To understand why Microsoft (MSFT, Fortune 500) so desperately wants Yahoo's search business - which even in its earlier pursuit of the whole company was its primary target - you have to understand how Microsoft sees Google.

Google (GOOG, Fortune 500) drives Microsoft crazy for two fundamental reasons. One, Google has developed the fastest-growing new pool of profit in technology with its ad-supported search business. And secondly, it has taken the mantle of "greatest and most powerful tech company" away from Microsoft, with all the associated benefits that go along with that, most notably a very high stock-market valuation.

But Microsoft does not accept that Google is the best tech company. And neither do I. It is a fundamental misreading of Google's market success to describe it as the industry's technology leader. It has one very good business which it has managed superbly well, and it lucked into a uniquely powerful business model to support that business with search advertising.

No, what Google has done is not to have created the world's best tech company but to have created the world's most powerful and profitable marketplace. The development of that marketplace flowed from having superior search technology in the company's earlier days. But today Google is not unequivocally the best place to search for information.

Microsoft owns a site called Live.com that offers search results that in many cases are just as good as Google's, and sometimes are better. But nobody knows Live.com exists, and there's little likelihood that will change.

Microsoft knows it must create not comparable search but a comparable marketplace. Both in my most recent magazine opus on Microsoft and in an earlier story I wrote about online chief Kevin Johnson, I explained the Microsoft view - the more searches that take place on a site, the more advertisers who are likely to come there. And the more advertisers who are there, the more bidders there are in competition for slots adjacent to the searches. Thus, the larger a search company's scale, the more money it can charge per search. Not only is Google larger, but it is more profitable per search.

Think of it the way you think of eBay (EBAY, Fortune 500) - you probably wouldn't want to sell your stuff anyplace else because there just aren't many buyers elsewhere. Google has acquired that kind of position in search advertising. If it were to succeed in the recently-announced deal to combine some or all of Yahoo's searches with Google's, the problem for Microsoft would become even more severe.

So even though Microsoft has with painstaking and expensive effort come near to par with Google on search technology, it still shows little likelihood of competing successfully with it as a search business. In fact, despite Microsoft's recent gains in search quality, its market share has been declining dramatically in recent months - down over a full point in market share to an anemic 8.5% of searches, according to comScore. Yahoo (YHOO, Fortune 500), meanwhile, still commands 21%, to Google's 62%.

The only way Microsoft can compete with what the business of Google really is - a large marketplace for advertising and searches - is to somehow achieve much greater scale. No method of creating dramatically greater scale seems available other than combining with Yahoo's search.

It's a chicken and egg argument - only with scale can Microsoft compete with Google, but Microsoft cannot get scale without successfully competing with Google. Unless, that is, it combines with Yahoo. It doesn't want or need Yahoo's people or its search technology, though it would probably take them on happily. What it wants is the search volume, and the Yahoo brand that would seem to be required to continue attracting it.

Microsoft doesn't see any other large business that it could conceivably enter that compares with search-related advertising for its profit potential. So it bid $47.5 billion to buy Yahoo a couple months ago, and now it is engaged in a fitful effort to find another way to get its hands on Yahoo's search. It cannot afford not to compete with Google and cannot compete with Google without Yahoo's search.

Reports have Microsoft toying with all kinds of methods to get its hands on that search business. Most of them reportedly involve teaming up with either Time Warner's (TWX, Fortune 500) AOL or News Corp.'s (NWS, Fortune 500) MySpace, which would somehow take on the remainder of Yahoo that Microsoft less desperately wants. There are also reports of Yahoo talking to AOL about a combination. Everybody wants to compete with Google, though MySpace and AOL - whose only tools are sheer traffic and a display advertising business - will likely have very little success against Google.

Microsoft and Yahoo both seem to have been inept and flatfooted during the last few months' negotiations. Yet now the market seems to think something could still happen - Yahoo's stock is up slightly in recent days.

Mark my words - Microsoft is not giving up. To top of page

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