Michael Nutley: Microsoft-Yahoo! merger no answer to social networking

It’s hard to overstate the symbolic importance of Microsoft’s $44.6bn (£22.6bn) bid for its rival Yahoo!

Microsoft, despite Bill Gates’ protestations to the contrary, is a company that was always slow to “get” the Web. Yahoo!, on the other hand, was the Web – or at least, in its heyday, the best way of navigating it. Back in 1995, when David Filo and Jerry Yang were graduate students turning their Guide to the World Wide Web into Yahoo!, Microsoft was trying to decide whether MSN should be part of the internet, or an entirely separate network.

But, for the past three years, Microsoft has been attempting to establish itself as an online media company. Faced with an overwhelmingly dominant position in the software industry, suddenly under threat from an entirely new distribution model, the company has been casting covetous eyes at the global advertising market – a potential vehicle for its next stage of growth.

Its initial attempts to break into that market were based on the idea that thetraffic to its online properties – MSN, e-mail and instant messaging services – was enough to qualify it as a media owner. Last year’s unsuccessful offer for Yahoo! was an admission that this was not enough. Last week’s bid simply shows how far Yahoo! has fallen.

Since its hierarchical approach to navigating the Web was superseded by the algorithmic search pioneered by Google, Yahoo! too has been attempting to turn itself into a full-blown media company. However, it has lost out on crucial acquisitions to richer rivals. Meanwhile, the companies that it has bought, such as photo-sharing site Flickr, have gathered more critical acclaim than revenue. At the same time, it was hit by delays to its pay-per-click search offering Panama, while Google cemented its dominance of the search market. Two-thirds of the world’s searches now go through Google.

Microsoft, too, has been spending furiously in a bid to overtake Google in search. Its engine, and the associated pay-per-click service AdCentre, are now regarded by search experts as being just as good, if not slightly better than, those of its bitter rival. But when Google was beginning its rise to dominance of the search market, it was widely believed that there was no brand loyalty in search; that users would rapidly switch to a superior service. If that’s still true, the billions that Microsoft has spent on its search have either failed to deliver a sufficiently differentiated product, or the company has failed to generate sufficient user trials to precipitate a shift.
This is one of the reasons Microsoft is so interested in Yahoo!. For all its problems, Yahoo! still generates huge amounts of traffic to its portal. It’s the prospect of combining that traffic with Microsoft’s technology that is at the heart of the company’s claim that the deal will create “a more credible alternative in search and advertising”.

But the big question this raises is of integration. Not only would it be by far the biggest acquisition that Microsoft has made, but there is doubt that the technologies behind AdCentre and Panama can easily be merged. In the time taken for the combined company to resolve these issues, Google could easily move further ahead. This, in turn, would postpone the promised increase in competition that the ad industry has already welcomed.

Of course, the deal is not just about search, even though search still accounts for over 50% of all online ad spend and looks likely to do so for the foreseeable future. Google’s swoop on DoubleClick and Microsoft’s purchase of aQuantive last year opened another front in the war, this time in online display advertising. Yahoo! missed out in that flurry of deals, but its traffic and expertise makes it valuable to Microsoft, particularly with an influx of display-oriented packaged goods brands predicted for the next few years.

Beyond all this, however, is another big question. Part of Yahoo!’s problems stem from its failure to capitalise on the social media boom. While it has bought leading Web 2.0 companies such as Flickr and Delicious, its own social networking site stumbled (although it does handle the advertising on Bebo). Microsoft too has not made much impact in the sector with its own MSN Spaces. Its purchase last year of a 1.6% stake in Facebook for $240m (£121m) was again seen as an admission that the software giant was unable to cope with the recent changes in online behaviour.

But Google is also struggling in this area. Last month’s results announcement showed slower than expected growth in revenue and profits, which the company attributed to the difficulty with getting users of social networks to accept its advertising products, despite its tie-up with MySpace. If these sites and their successors continue to play a massive role in online behaviour, while proving difficult to monetise in traditional ways, any Microsoft-Yahoo! merger might look like an expensive way of running fast to stand still.