Microsoft and Yahoo: Deal or no deal?

NEW YORK (Fortune) -- It is conventional wisdom in tech circles that Microsoft and Yahoo will resuscitate talks about combining at least some parts of their businesses now that Yahoo has a new CEO, Carol Bartz.

"I think there's a 100% chance they'll have meaningful conversations," says Tom Wilde, CEO of video search company Everyzing. "In terms of something meaningful actually happening, I would put that at about 70%."

Microsoft, you'll recall, a year ago offered to buy Yahoo outright for $45 billion or $31 a share, a staggering 62% premium to Yahoo's stock price at the time. Yahoo's shares today trade at about $11 a share. Yahoo (YHOO, Fortune 500), to the surprise and consternation of many shareholders, spurned the Microsoft bid. Microsoft (MSFT, Fortune 500) later sought to acquire Yahoo's search business, to no avail.

But does a Microsoft-Yahoo tie-up still make sense? A lot has changed in the year since Microsoft CEO Steve Ballmer released his letter to Yahoo's then-CEO Jerry Yang, suggesting that "together, Microsoft and Yahoo! can offer a credible alternative for consumers, advertisers, and publishers." Here's a quick look at some of the reasons the companies sought to get together back then, and whether the rationales still make sense.

Reason No. 1: A chance to catch a growth wave

In announcing its buyout offer, Microsoft spent a lot of time talking about the potential growth of the online advertising market, and at the company's annual investor meeting in July, CEO Ballmer also hammered home the online ad opportunity, says Citigroup analyst Mark Mahaney.

In the months since Ballmer made his remarks, online advertising has taken a big hit. The Wall Street Journal, citing statistic from ad firm Efficient Frontier, recently reported that spending on search advertising spending fell 8% in the fourth quarter of 2008 from the same period in 2007.

Clearly the recession isn't helping any media outlets. But when the economy bounces back, will online advertising continue to take share from traditional media? "I know the recession has blown all estimates out of the water, but I don't think the secular growth thesis has changed, and I don't think the thesis would have changed for Microsoft," Mahaney says. If Microsoft still believes in the growth of the online ad market, it seems likely the company would look to strike a deal.

Reason No. 2: Google envy

Microsoft and Yahoo both are insanely jealous of Google (GOOG, Fortune 500), which came from behind to dominate the search ad business (it has about 75% market share compared to Yahoo's 20% and Microsoft's 5%). It also has done a good job of garnering consumer mindshare in some other businesses that Microsoft and Yahoo consider core, such as e-mail.

Google continues to give Microsoft and Yahoo agita. Microsoft last week reported flat online revenue and a loss of $471 million for the unit - and said it would lay off some 5,000 people. Yahoo is set to announce earnings this week, and analysts expect ad revenue from big marketers such as auto makers to hurt its results. Google, meanwhile, keeps rolling along, posting an 18% gain in fourth-quarter revenue last week. (Profits fell because it had to write down bad investments.)

Yahoo, of course, tried the if-you-can't-beat-'em approach last year when it attempted to forge an advertising partnership with Google. Antitrust concerns scuttled the deal, and left Yahoo without a turnaround strategy- and, having rebuffed Microsoft, without a partner.

Is Google unstoppable? Of course not. Online marketers actually want Google to have strong competition. Thus far, neither Microsoft nor Yahoo have been able to put up much of a fight in search advertising on their own, and skeptics question whether putting these two wounded players together would result in a venture strong enough to take on Google. But if Microsoft and Yahoo are filled with enough Google envy, they might just be able to come up with a strong enough product to compete with their rival.

Reason No. 3: Leadership vacuum

A few people close to Yahoo have suggested that the company should have taken Microsoft's original offer because it would have solved Yahoo's management problems. And these folks weren't just talking about Yahoo co-founder and former CEO Jerry Yang, who didn't exactly endear himself to outside shareholders. Yahoo has always struggled to find ways to make employees and executives accountable for their projects; Yahoo could probably have learned a thing or two about execution from Microsoft.

Now, of course, Yahoo has new management. Former Autodesk Chairman Carol Bartz earlier this month accepted the CEO post, and she's widely expected to bring discipline to Yahoo. She ultimately may decide to enter talks with Microsoft, but presumably it will be for strategic reasons - not because she thinks she can't lead Yahoo.

No matter what Bartz decides to do, there is one wild card in Yahoo's deck, and that's Yang. Though he announced his departure in mid-November, clearing the way for the board to find his replacement, Yang remains a very large shareholder of the company, and also sits on the board of directors.

If Yahoo decides to pursue some sort of deal with Microsoft, management will still have to sell Yang on the idea. He didn't seem to like the idea very much the last go around. If Yang has in any way warmed (or acquiesced) to the idea of a deal, that may be the biggest change to occur since Microsoft approached Yahoo a year ago.

Microsoft aiming to recover lost ground in mobile

Microsoft has made some stumbles in the mobile world, but a strategy shift made more than a year ago will soon pay dividends, the company's top Windows Mobile executive said in an interview with CNET News.

Andy Lees, the executive brought over from the server unit a year ago, said that Microsoft's efforts to make sure that its mobile software could run on a wide range of phones resulted in an operating system that failed to take advantage of advances in hardware.

"We aimed to go for a lower common denominator," Lees said. Microsoft was also limited by the origins of Windows Mobile, which was developed to power handheld computers that neither connected to a network nor handled voice.

"We started out when we were in PDAs (personal digital assistants) and then a phone got strapped to the back of the PDA," Lees said. The company also failed to recognize that phones--even those that were used for business--were still as much personal as they were professional.

Meanwhile, Apple and Google have joined the fray with operating systems designed from the ground up to take advantage of the latest in phone technology.

But Lees said that Microsoft embarked on a new strategy some time ago that will come to fruition over the next 18 months. The first steps in that strategy, he said, will be announced at the Mobile World Congress conference that takes place in Barcelona in the middle of next month.

"You are going to see a bunch of announcements at Mobile World Congress but also it is going to be the beginning of a 12-, 18-month period where you are going to see a whole bunch of different stuff," Lees said.

Part of Microsoft's new strategy, Lees said, is not relying on operating system upgrades to improve its products. The new approach, while still making money by selling a mobile operating system, places considerable focus on services that help connect the phone to the PC and Web as well as devices such as the Xbox.

Microsoft has two separate teams at work on the services piece. One is Microsoft's Windows Live group, while the other is a rather secretive group headed by former Mac unit head Roz Ho--a group that also includes the team Microsoft acquired when it bought Danger. Lees declined to say specifically what Ho is up to, however.

But Lees acknowledged the company also needs to improve that core operating system, which is widely seen as lagging that of most of its rivals.

For some time now, Microsoft has been working on a significant overhaul of its operating system, known as Windows Mobile 7. However, that project has hit delays, prompting Microsoft to push forward with an interim update, Windows Mobile 6.5, which the company is widely expected to detail next month. Lees declined to comment specifically on either version of the operating system, but promised the company would have more to say on the OS front in Barcelona.

Lees also promised that Microsoft would start working more closely with hardware makers. He pointed to deals late last year with LG and Samsung.

He noted that the power of the kinds of phones that come out next year will be incredible, well beyond even today's devices. Phones next year will have dual-core processors, super-fast data connections, and graphics power rivaling that of the original Xbox.

"That's a phenomenal thing on a phone," he said. The phones of the future will also have location information beyond just GPS sensors. "It will know where it is pointing, it will know which angle it is being held at."

Web browsing has been another weak spot for Microsoft. The company made up some ground late last year with a pocket browser that essentially crams the desktop Internet Explorer 6 into a Windows Mobile phone. But it lacks the kind of easy zooming and gesture recognition present on the iPhone or in Palm's Pre. Lees promised that Microsoft would surpass those interfaces by the end of the year.

Lees would not confirm details of a rumored rival to Apple's App Store, reportedly known as SkyMarket.

"There is some question whether we can more directly connect the developer and the end user," he said. "We're looking at that."

Apple dismissed the notion that Microsoft and others are catching up to the iPhone, however.

On a conference call with analysts last week, Apple CFO Peter Oppenheimer dismissed the growing competition from rivals saying Apple remained "years ahead" in the phone business.

"Our competitors are scrambling to try and copy our success," he said.

Intel Readies Push into Mobile Internet Devices

Apple didn't take kindly to disparaging remarks made publicly last fall by a pair of Intel (INTC) executives about the iPhone and its chips, designed by ARM Holdings. The computer maker was so incensed, in fact, that Chief Executive Steve Jobs called Intel's Chief Executive Paul Otellini to complain, people familiar with the matter say.

The jabs stopped and Intel publicly backed off its comments. But the episode is a reminder of Intel's larger ambitions for handheld computers and mobile phones, and how those plans could put it at loggerheads with some longtime partners. Intel, the world's largest chipmaker, is readying new chips and a version of the open-source Linux operating system specially designed to run a new class of "mobile Internet devices," or MIDs. Consumers could use the devices to play high-definition video, make Internet-powered phone calls, or download directions and local business listings on the go. The effort could presage an attempt by Intel to land its products in pocket-size smartphones, a category where Apple (AAPL) has sold 17.4 million units.

At the same time, as Intel tries to tap into the burgeoning market for smartphone and handheld chips, estimated by iSuppli to be worth $3 billion this year, its mobile Internet devices could also compete with the iPhone for buyers. Intel's Linux effort also poses a threat to longtime collaborator Microsoft (MSFT), which is trying to land its Windows Mobile operating system in more handheld devices. Intel is stocking up on Linux talent, partly to aid the handheld effort. "Intel is going to be entering solidly into Apple's space," says Rob Enderle, president and principal analyst at the Enderle Group. "It's going to make for an interesting next decade." Apple declined to comment.

Partnering with Device Makers

The Linux software, called Moblin 2 and expected to be in software developers' hands by March, will run new portable computers Intel calls "MIDs," set to arrive around midyear, Intel told BusinessWeek. Companies including Lenovo (LNVGY), Hitachi, and BenQ already make MIDs using previous designs, and Intel plans to announce new partners in February at a mobile technology conference in Barcelona, Spain.

By providing a free version of Linux for mobile devices that run its chips, Intel is hoping to jump-start a new breed of handheld computers, a category it's been largely shut out of. Most smartphones—including the iPhone and Palm's (PALM) new Pre, which garnered accolades at its Jan. 8 unveiling in Las Vegas—run chips designed by ARM and licensed by manufacturers including Qualcomm (QCOM), Samsung, and Texas Instruments (TXN). On Jan. 19, Qualcomm paid $65 million to Advanced Micro Devices (AMD) for technology and engineers to enhance its smartphone chips' multimedia capabilities. "Intel would like to promote the MID category at the expense of high-end smartphones," says Gordon Haff, an analyst at market researcher Illuminata.

The fight over which companies will supply the chips and software for smaller and more powerful handheld computers such as MIDs comes as the PC recedes from the center of tech industry action. Worldwide PC sales are expected to drop more than 5% this year. Waning demand has slashed Intel's fourth-quarter profit by 90%, and whacked Microsoft's second-quarter earnings as well.

Mobile Computing's Category Lines Blur

Meantime, handhelds are taking on many of the functions of full-fledged computers. Market researcher Gartner (IT) forecasts the worldwide smartphone market will grow 32% in 2009, to 190.8 million units. "The line between what's a smartphone, what's a mobile Internet device, what's an ultra mobile PC—it's all going to disappear," Dell (DELL) CEO Michael Dell said in an interview last year. Another sign of the changing times: Intel Chairman Craig Barrett, who presided as CEO over the PC boom of the late '90s, said on Jan. 23 he plans to retire in May.

Yet Intel's history in the mobile computing market has been checkered. The company sold its XScale mobile chip business to Marvell Technology (MRVL) in 2006, and some analysts are skeptical its latest run at handhelds will go better. "What Intel is trying to do with this mobile Internet device category is essentially tell people, 'The smartphone is too limited for a lot of applications…so you need this thing in between,'" says analyst Haff. "I've certainly yet to be convinced there's a market for something in between a smartphone and a netbook."

To help with the convincing, Intel is stocking up on staff skilled in the operating system that will run the devices. One of the world's most experienced Linux programmers, Alan Cox, will join Intel from Red Hat (RHT) in March and work on projects including Moblin. "They were more than happy to have him there," says Paul Cormier, an executive vice-president at Red Hat. At the beginning of January, Intel brought on board Peter Anvin, another key Linux developer.

Intel is also paying special attention to MIDs' software to try to ensure users find the devices compelling. The devices will feature new capabilities like touchscreens that recognize users' gestures and a graphical user interface that employs 3D and translucent icons. Moblin 2 will be free to hardware makers and distributed by companies including Canonical and Novell (NOVL). "What we've done in the PC space, we're driving into these smaller[-size] devices," says Doug Fisher, vice-president for Intel's software and services group. "We're doing some aggressive stuff to make sure Linux takes advantage" of MIDs, he says.

Modifying the Atom Netbook Processor

On the hardware side, Intel is adapting its Atom processor, used today mainly in low-priced portable netbook computers, for MIDs. Atom sales have been a bright spot in Intel's otherwise gloomy business; fourth-quarter sales of the chips rose 50% from the previous quarter, to $300 million. A lower-power version of Atom called Moorestown, scheduled to arrive in 2009 or 2010, will target MIDs, which need to run longer and cooler than netbooks do, and future Atom chips could target smartphones as well.

Developing free software for mobile Internet devices also gives Intel an alternative to Microsoft's Windows Mobile operating system, whose market share has been shrinking. Microsoft counters by saying it doubts the market potential for handhelds with relatively large screens that could be unwieldy to carry around. "I'm not sure there's a third category of device" between a cell phone and a netbook, says Andy Lees, a senior vice-president in Microsoft's mobile communications business. "The thing that distinguishes a phone is it goes in your pocket or purse. If you have a six-inch screen, that's no-man's land."

The fight over who'll supply the chips and software for new generations of mobile computers is straining some of the tech industry's most durable alliances. "Intel is very aggressive about developing a software platform that they can deliver on MIDs, and eventually cell phones, and deliver it with their [chips] for free," says analyst Enderle. "Apple and Microsoft are…collateral damage."