Publish date:

Why Microsoft Needs Yahoo!

As Google encroaches on Office, a merger makes even more sense.

The escalating rivalry between Google (GOOG) - Get Alphabet Inc. Class C Report and Microsoft (MSFT) - Get Microsoft Corporation (MSFT) Report may have an unexpected beneficiary: Yahoo! (YHOO) .

As Google continues to encroach on Microsoft's turf -- the search giant introduced

an upgraded version of its application suite last week -- Yahoo!'s potential value as an acquisition candidate is growing for Microsoft.

And while speculation about a Microsoft acquisition of Yahoo! has been swirling since

The Wall Street Journal

reported last year that a faction within Microsoft's MSN search division was pushing for such a deal, recent developments make the case even more compelling.

For one thing, Google has continued to dominate the search space and pick up market share since May 2006 -- when reports of a possible Microsoft and Yahoo! deal first surfaced -- while Microsoft has ceded ground despite its best efforts.

Nine months ago, Google commanded 44.1% of the search market, as compared with Microsoft's 12.9%, according to research firm ComScore. As of January 2007, Google had moved up to 47.5% while Microsoft slipped to 10.6%.

A combined Yahoo! and Microsoft would garner about 38.7% of the market -- enough to present formidable competition to Google. That traffic number could also stand to benefit from Microsoft's launch of Vista, letting the software giant bundle a stronger search offering into the desktop experience that it dominates. And traffic is exactly what Microsoft needs.

Microsoft boasts conversion rates that are higher than either Yahoo!'s or Google's. (Conversion rates are the amount of advertisements that are clicked through when presented next to search queries, which is the way search engines make money.)

But advertisers complain that Microsoft's dearth of Web traffic stops it from ultimately driving as many potential customers in absolute numbers as the advertisers would like.

The stakes were raised to another level last week when Google unveiled its Google Apps Premier Edition service, a suite of hosted software that replicates many of the things that Microsoft's Office suite does. And while Google's service, which will cost $50 per user account per year, comes nowhere near the $12 billion in annual revenue Microsoft rakes in courtesy of Office, it does present Microsoft with a real reason to worry.


tech blogger Om Malik has pointed out

, Google's game plan is not so much to fill its coffers immediately as it is to put Microsoft on the defensive. "Google's strategy is to totally commoditize the market, try and take away pricing power from Microsoft, and try and put the megabillion dollar a year 'Office' business division on the defensive," he writes.

With a viable alternative to Microsoft at hand, potential customers will be in a much stronger negotiating position, and Microsoft will have a tough time justifying higher prices.

That will make the situation especially tricky for Microsoft, a company that desperately needs to show Wall Street where future growth will come from. With the lackluster launch of Vista and with its Office gravy train facing a more difficult environment ahead, the logical thing for Microsoft to do is to muscle into the rapidly growing Internet search business.

TheStreet Recommends

Yahoo!, which continues to operate some of the most-visited sites in the world and ranks a solid No. 2 in search queries, presents Microsoft with an attractive way to quickly become a player in a market where it desperately craves a bigger presence.

Although Yahoo!'s soaring stock price, which has climbed about 35% from its October lows to about $32, would make a deal more expensive for Microsoft, the stock was actually trading at around $33 when Microsoft was originally eyeing the company.

Moreover, the stock price has climbed because the outlook for Yahoo!'s Panama ad ranking system seems bullish, meaning that Microsoft would be paying for a company that seems to present fewer question marks than before.

While skeptics would argue that Microsoft is hesitant to make large acquisitions, the company had given serious thought to acquiring software marker


. With a market cap of $56 billion, SAP is 25% bigger than the $44 billion of Yahoo!. Yahoo! would certainly be within reach if Microsoft wanted the deal.

Google's latest encroachment puts Microsoft under more pressure to make big moves that strike back at Google's home base. But acquiring other significant players in the search space would be tough., which commands 5.4% of the market, is owned by



. Buying it from IAC would be nearly impossible, however, because Barry Diller has reiterated that Ask is the glue of his Internet conglomerate.


Time Warner's


AOL, which has a 5% market share, has already announced a number of partnerships with Google, including a $1 billion payment that would give Google a 5% stake in the company.

That leaves Yahoo!, a company with fewer strings but more to bring to the table when it comes to search. Even barring an outright acquisition by Microsoft, Google's intensifying onslaught would tip the balance more in favor of Yahoo! if any partnership were struck.

Either way, Google's digging into its new enemy will likely end up benefiting its old one.