In an economy that many see as tightening, the potential for organic growth often becomes limited. In these circumstances companies seek growth opportunities through M&A.
First is Microsoft's desire to improve its presence in the search and advertising market. Microsoft has ranked third, behind Google and Yahoo - with Google having a substantial and clear lead. The combined Microsoft and Yahoo business is will be a much smaller player than Google, but they will have substantially improved their ability to compete.
The addition of Microsoft engineering capability into Yahoo should allow the combined entity to bring new products and services to market more quickly, something that Yahoo has notably struggled with. The additional volume of subscribers that Yahoo brings to Microsoft will allow increased scale and distribution volumes to be delivered.
However, Google still represents a formidable opponent for even the combined Microsoft-Yahoo entity to tackle. Make no mistake - Microsoft still has huge challenges. However, one should also remember the example of Alta Vista. This early stage search company was once felt to be in an insurmountable market position - inviolate from all attacks. Where are they now on the global scale‾
Second, is the Microsoft's desire to protect the solid revenue and margin contributions coming from Microsoft Office. Although Google Applications has yet to make a dent in the Microsoft Office giant, it poses a long-term threat. Over time the functionality of Google Applications will become progressively richer and more complete, to the point that they will represent a real alternative.
As a defense against this position, Microsoft needs to accelerate its own move into online services. The online engineering capabilities that Yahoo has will undoubtedly offer Microsoft the potential to bring new services to market as a counter Google's own products.
The valuation of $44.6 billion is based on a $31 per share offer. An argument could be made that this is a low offer, based on the share price decline since October 2007 - acknowledging that the 52-week market high is $34.08. A counter is the market today is very different from the market as it was at that peak.
The global credit crisis has changed so many market dynamics that the valuation cannot assume the last three months have been a temporary blip from which Yahoo would gleefully rebound to re-establish its previous share price. 62% is a good premium on Thursday's market close, and that's really the only price point that is truly valid as a comparison. Of course, if the Yahoo executives choose to negotiate on price, they will present a different argument.
To make the deal work for Microsoft there are two pre-conditions: first is that the price remains controlled. The $44.6 billion price is "full, rather than silly". If a negotiation does ensue from the bid, Microsoft needs to ensure it does not overpay in the lust for the deal.
Second, there needs to be a strong plan in place to achieve cost reduction synergies. Microsoft has not traditionally made acquisitions of this magnitude so it needs to demonstrate to the market that it has the vision and appetite to deliver the savings through focused cost reduction.
Combining the engineering and operations functions of both organizations should enable significant cost reductions on a pure headcount reduction basis. A second area where cost reductions will be able to be driven out is in the data center operations that both organizations have been building out. Data centers typically run at low levels of asset utilization, with 20% asset utilization being typical. Bringing together data center estate and improving efficiency together have the potential to generate tens of millions of dollars in savings.
Whether the deal goes ahead or not will become clearer over the next hours and days. The market has become used to negotiations being held through proxy posturing in the press, and it is likely that a lot of decisive words will be exchanged through the press while a form of realpolitik carries on behind the scenes.
David Mitchell, SVP IT research at Ovum