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Simple Math = Big Challenge: MSFT & YHOO

I have only a few sections of Beyond Search to wrap up. Instead of being able to think about my updating my description of Access Innovations’ MAIstro, I am distracted by jibber jabber about the Microsoft (NSDQ:MSFT) Yahoo (NSDQ:YHOO) tie up.

Where We Are

First, it’s an offer, isn’t it? Maybe a trial balloon? No cash and stock have changed hands as I write this in the wee hours of Monday, February 4, 2008. Yet, many are in a frenzy over a hostile take over. Think about this word “hostile.” It means antagonistic, unfriendly, enemy. The reason for the bold move? Google, a company that has out foxed Microserfs and Yahooligans for almost a decade.

The number of articles in my various alerts, RSS feeds, and emails is remarkable. Worldwide a Microsoft – Yahoo marriage (even it is helped along with a shotgun) ignites folks’ imagination. Neither Microsoft nor Yahoo will be able to recruit tech wizards, one pundit asserts. Innovation in Silicon Valley will be forever changed, posits another. Sigh.

Sorry. I’m not that excited. I’m interested, but I’m too old, too pragmatic, and too familiar with the vagaries of acquisitions to jump up and down.

Judging from some grousing from Yahooligans, some Yahoo professionals aren’t too keen about working for Microsoft. I have had a hint that some Microsoft wizards aren’t too excited about fiddling with Yahoo’s mind-numbing array of products, services, technologies, search systems, partnerships, and research initiatives.

I think the root concern is trying to figure out how to fit two large operations together, a 1 + 1 = 3 problem. For example, there’s Yahoo Mail and Hotmail Live; Yahoo Panama and Microsoft Ad Center; and Yahoo News and Microsoft’s new services, etc., etc. One little-considered consequence is that Microsoft may end up owning more search systems than any other company. That’s a technology can of worms worthy of a separate essay.

I will tell you who is excited, and, please, keep in mind that this is my opinion. And, once I express my view, I want to offer another very simple (probably too simple for an MBA wizard) math problem. I will end this essay with my now familiar observations. Let’s begin.

Who Benefits?

This is an easy question to answer, and you will probably think that I am stating the obvious. Bear with me because the answer explains why some at Microsoft may not be able to get the right prescription for their deal bifocals. Without the right eye glasses, it’s tough to discern some smaller environmental factors obscured in the billion dollar fusillade fired at Yahoo’s board of directors’ meeting.

1. Shareholders who can make some money with the Microsoft offer. When there’s money to be made, concerns about technology, culture, and market opportunity are going to finish last. Most shareholders don’t think too much other than the answer to two questions: “How much did I make?” and “What are the tax implications?”
2. Investment bankers who earn money three ways on a deal of this magnitude. There are, of course, other ways for those in the financial loop to make money, but I’m going to focus on the ones that keep these professionals in blue suits, not orange jump suits. [a] Commissions. Where the is churn, there is a commission. For many investment advisors, buying and selling equals a bigger payday. [b] Bonuses. The mechanics of an investment banker’s bonus are complex. After all, it is a banker dealing with a fellow banker. Mere mortals should steer clear. The idea is simple. Generate churn or a fee, and you get more bonus money. The first three months of a calendar year is bonus and job hopping time on Wall Street. Anyone who can get a piece of the action for a big deal gets cash. [c] Involvement in a big deal acts like a huge electro magnet for more deals. Once Microsoft “thought” of the acquisition, significant positive input about the upside of the deal pours into the potential acquirer.
3. Consultants. Once a big deal is announced, the consultants [delete apostrophe here] leap into action. The buyer needs analyses, advice, and strategic counsel. The buyer’s minions need tactical advice to answer such questions as “How can we maximize our tax benefits?” and “How can we pay for this with cheap money?” The buyer becomes hungry for advisors of every species. Blue-chip outfits like Bain, Booz, Allen & Hamilton, Boston Consulting Group, and McKinsey & Co. drool in eagerness to provide guidance on lofty strategy matters such as answering the question, “How can I maximize my pay-out?” And “What are the tax consequences of my windfall profit?” Tactical advisors from these firms can provide support on human resource issues and real estate leases, among other matters. In short, buyers throw money at “the problem” in order to be prepared to negotiate or find a better deal.

These three constituencies want the deal to go through. If Microsoft is the buyer, that’s fine. If another outfit with cash shows, that’s okay too. The deal now has a life of its own. Money talks. To get the money, these constituencies have no desire to help Microsoft “see” some of the gaps and canyons that must be traversed. Let’s turn to one practical matter and the aforementioned simple math. Testosterone and money — these are two ways to cloud perception and jazz logic.

More Simple Math

Let’s do a thought experiment, what some German philosophers call Gedankenexperiment. I am not talking about the proposed Microsoft – Yahoo deal, gentle attorneys.

Accordingly, We have two companies, Company Alpha and Company Beta; hereinafter, Company A(lpha) and Company B(eta), neither of which is a real company and should not be construed as having any similarity with any company now in existence.

Company Alpha has a dominant position in a market and wants to gain a larger share of a newer, tangential market. Company A has a proven, well-tuned, aging business model. That business model is a variation on selling subscriptions and generating annuity income from renewals. Company A’s business model works this way. Company A offers a product and then, on a periodic basis, Company A makes a change to an existing product, assessing a fee for customers to get the “new” or “enhanced” version of the product (service).

The idea is that once a subscription base is in place, Company A can predict a certain amount of revenue from standing orders and new orders. Company A has an excellent, stable, cash flow based on this well-crafted business model and periodic fee increases. Although there are environmental factors that put pressure on the proven business model, the customer base is large, and the business model continues to work in Company A’s traditional markets. Company A, aware of exogenous factors — for instance, the emergence of cloud computing and other non-subscription business models — has learned through trial and error that its subscription-based business model does not work in certain new markets. These new markets are potentially lucrative, representing “new” revenue and a threat to Company’s existing revenue stream. Company A wants to acquire a company to increase its chances for success in the new and emerging markets. Company A’s goal is to [a] protect its existing revenue, [b] generate new revenue, and [c] prevent other companies from dominating the new market(s).

Company A has performed a rational, market analysis. Company A’s management has determined that one company only — our Company B — represents a mechanism for achieving Company A’s goals. Company A, by definition, has performed its analyses through Company A’s “eye glasses”; that is, Company A’s proven business model and business culture. “Walking in another person’s moccasins” is easy to say and difficult, if not impossible, to do. Everyone views the world through his own experiential frame. Hence, Company A “sees” Company B as having characteristics, attributes, and capabilities that are, despite some acceptable risks, significant benefits to Company A. Having made this decision about the upside from buying Company B, the management of Company A becomes less able to accept alternative inputs, facts, information, perceptions, and opinions. Company A’s reasoning in its decision space is closed. Company A vivifies what William James called “a certain blindness.” The idea is that each person is “blind” in some way to reality that others can perceive.

The implications of “a certain blindness” in this hypothetical acquisition warrant further discussion:

Culture

Company A has a culture built around a business model that allows incremental product enhancements so that subscription revenue is generated. Company B has a business model built around acquisitions. Company A has a more or less homogeneous atmosphere engendered by the business model or what Company A calls the agenda. Company B is more like a loose federation of separate companies — what some MBAs might call a Ling Temco Vought framework. Each entity within Company B retains its own identity, enjoys wide scope of action, and preserves its own culture. “We do our own thing” characterizes these units of Company B. Company A, therefore, has several options to consider:

• Company A can leave Company B as it is. The plus is that not much will change Company B’s operations in the short term. The downside is that the technical problems will not be resolved.
• Company A can impose its culture on Company B. You don’t need me to tell you that this will go over like the former Soviet Union’s intervention in Poland in the late 1950s.
• Company A can try to make changes gradually. (This is a variation of the option in bullet 2 and will simply postpone rebellion. )

Technology

Company A has a different and relatively homogeneous technology base. Company B has a heterogeneous technology base. Maintaining multiple systems is more costly in general than homogeneous systems. Upon inspection, the technical staff needed to maintain these different systems have specialized to deal with particular technical problems in the heterogeneous environment. Technical people can learn new skills, but this takes time and adds cost. Company A has to find a way to streamline technical operations, reduce costs, and not waste time achieving rationalization. There are at least two ways to do this:

• Shift to a single platform, ideally Company A’s
• Retrain existing staff to have broader technical skills. With Company B’s staff able to perform more generalized work, Company A can reduce headcount at Company B, thus streamlining work processes and reducing cost.

Competitive Arena

The desirable new market for Company A has taking on the characteristics of what I call a “natural monopoly.” When I reflect on notable events in American business history, I note monopolistic behavior. Some monopolies were spawned by force of will; for example, JP Morgan and finance (this guy bailed out the US Treasury) and Andrew Carnegie and steel (this fellow thought of libraries for little people after pistol-whipping his competitors and antagonists).

Other monopolies — like Bell Telephone and your local electric company — came into being because some functions are more appropriately delivered by one organization. Water and Internet search / advertising, for instance, are subject to such economies of scale, quality of service, and standardization. In short, these may be “natural monopolies” due to numerous demand and cost force.

In our hypothetical example, Company A wants to enter a market which is coalescing and beginning now, based on my research, appears to be forming into a “natural monopoly”. This nameless competitor seems to be following a trajectory similar to that of the original Bell Telephone – AT&T life cycle.

Company A’s race, then, is against time and money. Untoward delay at any point going forward with regard to leveraging Company B means coming in second, maybe a distant second or losing out on the new market.

Instead of owning Park Place (a desirable property in the Parker Brothers’ game Monopoly), Company A ends up with Baltic and Mediterranean Avenues (really lousy properties in the Parker Brothers’ game). If Company A doesn’t get Company B, Company A is trapped in its old, deteriorating business model.

If Company A does acquire Company B, Company A has to challenge the competitor. Company B already has a five-year track record of being a day late and a dollar short. Company A, therefore, has to do everything in its power to make the Company B deal work, which appears to be an all-or-nothing proposition.

Now the math: Action by Company A = unknown, variable, escalating costs.

I told you math geeks would not like this analysis. Company A is betting the farm against long odds. Here’s why:

First, the cultures are not amenable to staff reductions or technological efficiencies; that is, use software and automation, not people, while increasing revenues. Company A, regardless of the money invested, cannot be certain of success. Company B’s culture – business model duality is investment insensitive. In short, money won’t close this gap. Company A’s resistance to cannibalizing its old, though still functioning, business model will be significant. Company A’s own employees will resist watching their money and jobs sacrificed to a great good.

Second, the competitive space is now being captured by the increasingly monopolistic competitor. Unchallenged for some period of time, the monopolistic competitor enjoys momentum and a significant lead in refining its own business model.

In the lingo of Wall Street, Company A can’t get enough “oxygen”; that is, revenue despite its best efforts to reign in the market leader.

Observations

If we assume a kernel of truth in my hypothetical analysis, we can now apply this hypothetical discussion to the Microsoft – Yahoo deal.

First, Microsoft’s business mode (not its technology) is the company’s strength. The business model is also its Achilles’ heel. Just as IBM’s mainframe-centric view of the world make its executives blind to Microsoft, now Microsoft can’t perceive today’s world from outside the Microsoft business model. The Microsoft business model is perhaps the most efficient subscription-based revenue generator in history. But that business model has not worked in the new markets Microsoft’s covets, so the Yahoo deal becomes the “obvious” play to Microsoft’s management. Its obviousness makes it difficult for Microsoft to see other options.

Second, the Microsoft business model is woven into the company’s culture. Cultures are ethnocentric. Ethnocentricity often manifests itself in conflict. Microsoft will have to make prescient, correct cultural decisions quickly and repeatedly. Microsoft’s culture, however, does not typically evidence excellent, rapid-fire decision-making.

Microsoft seems to be putting the company in a situation guaranteed to spark conflict within its own walls, between itself and Yahoo, and between Microsoft and Google. This is a three-front war. Even those with little exposure to military history can see that the costs and risks of a three-front conflict will be high, open-ended, and difficult to estimate.

The hostile bid itself is suggestive that Microsoft could not catch Google without Google, the notion that Microsoft can catch Google with the acquisition requires tremendous confidence in Microsoft’s management. I think Microsoft can make the deal work, but I think that execution must be flawless and that favorable winds push Microsoft along.

If Google continues to race forward, Microsoft has to spend more money to implement efficiencies more quickly. The calculus of catching a moving target can trigger a cost crisis. If costs go up too quickly, Microsoft must fall back on its proven business model. Taking a step backward when resolving the calculus of catching Google is not a net positive.

As you read this essay, you are wondering, “How can this doom and gloom be real?” The buzz about the deal is mostly positive. If you don’t believe me, call your broker and ask him how much your mutual fund will benefit from the MSFT – YHOO tie up.

I’ve spent some time around money types, and I can tell you making money is akin to blood in the water for sharks.

I’ve also been acquired and done the acquiring. Regardless of being the buyer or being the bought, ties ups are tricky. The larger the stakes, the more tricky the tie ups become. When the tie up is designed to halt the Google juggernaut, the calculus of time – cost is hard.

Please, recall, that I’m not saying that stopping Google is impossible for a Microsoft – Yahoo tie up to deliver. Making the tie up work will be difficult.

Don’t agree? That’s okay. Use the comments to set me straight. I’m willing to listen and learn. Just don’t overlook my core points; namely, business models, cultures, and technologies. One final thought: don’t factor out the Google (NSDQ:GOOG).
Stephen Arnold, February 4, 2008

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