Microsoft v Google | When clouds collide | Economist.com

Microsoft v Google | When clouds collide | Economist.com

THE collision of two clouds is a gentle affair—except, that is, in the digital skies of the technology industry. But such a virtual collision is the best image to keep in mind when trying to understand why Microsoft, the world's largest software company, has bid a whopping $44.6 billion for Yahoo!, an ailing online giant. As computing moves online, the sources of power and money will increasingly be enormous “computing clouds”, as the cognoscenti call them, hosted on the internet. The Yahoo! deal is mainly about inflating Microsoft's cloud so that it can at last match that of its most dangerous rival, Google.

To be sure, the merger, which would be the internet industry's biggest since the ill-fated union of AOL and Time Warner in 2000, is far from a done deal. As The Economist went to press, Yahoo! had yet to reply formally to the offer, other than to say that it was considering it. Indeed, its management, which has spurned previous overtures from Microsoft, is said to have been looking into alternatives to the takeover, including selling off some units and even considering an alliance with Google. A rival bid is possible, but so far no one appears inclined to enter into a bidding war with deep-pocketed Microsoft; its offer values Yahoo! at $31 a share, a 62% premium over its closing price before Microsoft's bid was made public. And then there is the inevitable antitrust review, which promises to be lengthy, particularly in Europe.
If Microsoft does manage to swallow Yahoo!, it risks a severe bout of post-merger indigestion, as happened with AOL and Time Warner. (This week Time Warner's new boss, Jeff Bewkes, said he planned to spin off AOL's shrinking internet-access business.) Microsoft will have to combine or eliminate overlapping products and services. There will be cultural problems to overcome, too. Yahoo! is an online-media company that prides itself on its fun-loving ethos and has built its business on open-source technology, whereas Microsoft attracts hard-charging geeks and makes its money from proprietary software. So combining the two firms' technology infrastructures to make further savings will also be tricky.

Since Microsoft must know all this, the fact that it still wants to buy Yahoo! is nothing less than an admission that it needs help to catch up with Google. The latter is best known for its search engine, but it was also the first company to build a huge computing cloud—a nexus of hardware, software, data and people which provides online services. In Google's vast data centres, the computing equivalents of power stations, hundreds of thousands of machines are cleverly linked to act as one. Google collects vast amounts of data from its users and from the web. And it has hired an army of bright engineers to devise new services that make use of these resources.

Most importantly, Google has figured out a way to make money from its cloud. By giving away its services, the firm creates plenty of space for targeted advertising, mostly in the form of small text-boxes related to users' search queries. These are auctioned, and buyers pay only if users click on their advertisements. Google has thus created a virtuous cycle. As the largest search engine, Google attracts more advertisers and can serve up more relevant advertisements. This in turn attracts more users and advertisers, and so on.

In recent years Microsoft has tried to create a comparable cloud of its own. It is investing heavily in infrastructure and has built data centres around the world. It is also trying hard to catch up with Google's services, notably internet search. It recently strengthened its position in display advertising, a subset of the online-ad market that is smaller than search-based advertising, but is expected to grow quickly. In May Microsoft bought aQuantive, an online-ad agency, after Google agreed to buy DoubleClick, a leader in display.

Yet it has little to show for its efforts. In search, for instance, Microsoft's worldwide market share in December 2007 was 2.9%, according to comScore, a market-research firm, compared with 62.4% for Google (and 12.8% for Yahoo!). Microsoft's online business has yet to turn a profit. Yet what worries the firm's management most is that Google is pulling ahead in online advertising and may soon corner this crucial market, particularly once its acquisition of DoubleClick is completed. Despite fierce lobbying by Microsoft, American regulators have approved the deal, and their European counterparts are expected to follow suit soon.

Ironically, Microsoft argues that Google will benefit from the same advantage that has long made it almost impossible for any other firm to compete with its own Windows operating system, and which played an important role in successful antitrust cases against the software giant. Since so much software is written to run on Windows, it is difficult for competing operating systems to enter the market. Similarly, if too many publishers and advertisers adopt Google's online-advertising platform, rivals will not be able “to mount a credible competitive challenge”, as an internal Microsoft document puts it.

Having failed to keep DoubleClick out of Google's clutches, Microsoft now hopes that Yahoo! will keep it from being left in the dust. If it succeeds, the takeover would expand Microsoft's cloud, though not to the size of Google's. The combined firm's websites would attract over 290m unique visitors per month in America—slightly more than Google, according to Nielsen Online, another market-research firm. Yet Microsoft-Yahoo! would have a market share of only 18% in search advertising and 30% in display, according to Oppenheimer, an investment bank.

Still, the takeover would give Microsoft greater clout in other areas. One is web-based e-mail, where the merged entity would have 80% of the American market. It would be equally dominant in instant messaging. Since Yahoo! also offers many other services, such as Flickr, a photo-sharing site, Microsoft would control the world's biggest directory of registered internet users—a valuable asset as it develops new cloud-based services.

Nonetheless, the transaction could be good news for Google, at least in the short term. Google will most certainly try to lure away Yahoo!'s best staff. The integration effort will distract Microsoft's management and take time. Google has already launched a lobbying campaign to block the merger, arguing that it could undermine innovation on the internet—though neither Microsoft nor Yahoo! has done anything terribly innovative online lately. Indeed, the more Google complains about threats to innovation, instead of just getting on with doing it, the more it sounds like Microsoft used to.