Last Updated: May 5, 2008: 7:12 PM EDT
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Microsoft running out of options

Few companies can deliver Yahoo's audience, which will force the software giant to rethink its strategy.

By Jon Fortt, senior writer

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Some analysts believe that rather than try to beat Google at its own game, it should focus on out-innovating its rival.

(Fortune) -- Microsoft thought that by proposing loudly in public it could get Yahoo to agree to a marriage offer it had spurned in private.

It didn't work. After three months of meetings, pressure, and leaks to the media, Yahoo repeated the answer it had been giving Microsoft (MSFT, Fortune 500) in private for more than a year before the bid became public in February: No deal.

Now it's time for Microsoft to cobble together another plan. Sure, the fallout from the failed deal will be bad for Yahoo (YHOO, Fortune 500) - analysts on Monday seemed to agree that management will have to face a horde of angry shareholders. But in the long run, it could be just as bad for Microsoft. With Yahoo out of the picture, Microsoft will have to either give up its fight in online advertising, or find other partners to help it compete with Google (GOOG, Fortune 500). The problem is, there aren't many that could deliver an audience as big as Yahoo's.

There's one reason why a big audience is important if Microsoft is going to win online: Google draws a crowd. Because of Google's huge lead in search and its acquisition of display advertising firm DoubleClick, it just has a larger pool of people viewing its ads than Microsoft does. That advantage allows Google to more efficiently match ads with people who might be interested, and to make more money at the same time.

Google's crowd also helps the company to steadily pull further ahead of Yahoo and Microsoft, as a source close to Microsoft's legal and strategic thinking told Fortune soon after the deal was announced.

That's part of the reason why Microsoft wanted to get the Yahoo deal done quickly. "The fact that this deal would have made even more sense a year ago suggests that the longer you wait, the steeper the hill that the companies are going to have to climb together" to catch Google, the source said. "So you want to start climbing it as soon as you can."

Three months later, Microsoft is still staring up the same hill. So whom will Microsoft court as a climbing partner? It will have to be someone with a large online audience. Yahoo's 140 million-user monthly audience would have offered Microsoft billions of chances to link advertisers with potential customers through its ad network. There aren't many other companies that can deliver those kinds of numbers. Media companies offer some possibilities - Yahoo for instance has been courting newspaper publishers to build up a base of ad inventory.

Another option might be to forget trying to compete with Google's size, and instead try to out-innovate its rival.

"Frankly, I think Microsoft was playing Google's game, and clearly they can't win at that game," said Forrester Research analyst Charlene Li. "Microsoft has more than 400 million users and a very strong advertising base on the display side. I think instead of trying to chase the tail that Google's wagging at them, they should think about how they can really be innovative in display and search advertising."

Even if Microsoft could out-scale or out-innovate Google, that wouldn't solve all of its problems. When he announced the Yahoo bid, Microsoft CEO Steve Ballmer mentioned that Microsoft would want access to Yahoo's data centers, and to its web-savvy software engineers. Wall Street analysts are eager for Microsoft to explain how it will get all of the assets it needs without Yahoo, and they'd like to hear details during the company's July 24 analyst day, at the latest.

"We believe that it is imperative that in relatively short order, Microsoft's management articulates a viable and credible new strategy" for online operations, Bernstein Research analyst Charles Di Bona wrote in a note Monday. "Investors are now unlikely to be satisfied with a return to Microsoft's 'Plan A.' " To top of page

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