Microsoft's $2 billion online problem

July 30, 2009: 10:34 AM ET

Even with Yahoo deal Microsoft will continue to struggle -- and lose money -- online.

The anti-climactic deal of the year is now out.  Long after the sizzle faded from Microsoft's (MSFT) failed $40-billion-plus bid for  Yahoo (YHOO), the two companies announced Wednesday they'll do what sympathetic observers urged them to do two years ago. They'll stop competing on search and search-advertising technology, enabling them to combine forces against Google. (GOOG)

Critics frowned on Yahoo (where's the "boatloads" of upfront cash Yahoo CEO Carol Bartz promised she'd extract from Steve Ballmer?) and praised Microsoft, The Wall Street Journal going so far as suggesting the tide may turning in the tired monopolist's favor. Perhaps. Beyond the something-must-be-said-because-they-called-a-press-conference chatter, however, a few points to consider:

  • Yahoo is a sideshow now. Sure, it's an afterthought that's still worth $21 billion, even after being hammered by investors Wednesday. But this is a battle of giants now, and only giants. Consider in comparison the market capitalizations of Microsoft ($212 billion), Apple (AAPL) ($143 billion), Google ($138 billion), Cisco (CSCO) ($125 billion), Oracle (ORCL) ($110 billion) and Hewlett-Packard (HP) ($101 billion). These are the titans that are clashing. Their strategic feints and jabs at each other are the ones that matter now.
  • This deal won't become reality quickly. What happens next between Microsoft and Yahoo is, well, nothing. The two must convince Washington and Brussels that their combination isn't anti-competitive. It's sort of laughable. Of course they won't be anti-competitive. They'll be lucky to get Google even to notice them. But the way things work they won't even get to start trying until next year. (A contrary thought: Several times during the course of writing this post I decided to use Bing, Microsoft's renamed search engine. I actually liked its look, feel and, importantly, results. I doubt I'll stop using Google any more than I'm likely to give up on Microsoft Outlook. The behavior is too ingrained. But still, it makes you wonder and ought to worry Google just a little.)
  • Microsoft will have to make many more clever deals. One of Google's strongest suits in search is the toolbar arrangements it has negotiated along the way that place the Google search box at the top of the page of many user's screens. These cost money in the form of revenue sharing agreements, and Microsoft is in this game too. Staying in it is expensive and sometimes futile. Microsoft made a big deal, for example, of a November, 2008, agreement with Sun Microsystems to include what was then Live Search, now Bing, with a key version of Sun's important Java software. One can envision Sun's new owner, Oracle, beating a hasty retreat from that deal, given Oracle's lack of affection for Microsoft.
  • Microsoft loses gobs of money online -- and seems resigned to losing more. Overlooked in the hoopla over Microsoft's first-ever year-over-year revenue decline that it reported last week is that its online division continues to bleed red ink. I focused on this last year in a piece that asked Why Can't Microsoft Make Money Online? The short version: Catching Google is costly in terms of personnel, marketing and capital expenditures; Microsoft's people have software on the brain, not the Internet; and online advertising is a scale business. With the Yahoo deal Microsoft is addressing the last issue. As for the first two, Microsoft CEO acknowledged Wednesday that the benefit of the deal to  Yahoo is that it won't have to keep spending heavily on search technology. Microsoft will. By the way, the two billion figure in the headline of this piece? That refers to the $2.3 billion Microsoft's online business services division lost in its just-reported 2009 fiscal year on declining revenues of $3.1 billion. Think about that, Google remains a cash machine, Yahoo itself is profitable and getting more so, but Microsoft's online business, the one that will spend heavily and give Yahoo most of the revenue from combined search-ad sales, is oozing more than half a billion dollars each quarter.

Microsoft has said repeatedly that online mastery is critical to its future. Maybe it is. For now, it's a cash sinkhole that is years from providing a return on Microsoft's investment.

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About This Author
Adam Lashinsky
Adam Lashinsky
Senior Editor at Large, Fortune

Adam Lashinsky is a San Francisco-based editor-at-large for FORTUNE, covering Wall Street and Silicon Valley. Lashinsky joined FORTUNE in 2001, after two years as a contributing columnist. Prior to joining FORTUNE, Lashinsky covered Silicon Valley for and The San Jose Mercury News. A Chicago native, Lashinsky holds a B.A. in history and political science from the University of Illinois at Urbana-Champaign.

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