What Microsoft Should Do

Yes, it's fun to piss and moan, but once in a while, you have to put yourself in the CEO's shoes.  So here's a response to reader Bruce Hamm's question of two days ago: What SHOULD Microsoft do?

(First, I should clarify my position regarding Microsoft:  My position is not that Microsoft's web business sucks.  It doesn't.  Microsoft is either the third or fourth strongest web company on the planet.  My position is that the common idea that Microsoft is going to do what it has done in many software businesses--come from behind, bury Google and Yahoo!, and rule the web--is ludicrous.  Microsoft has been trying to come from behind on the web for a decade, and it is almost as far behind now as when it started.  A few more years--or Microsoft Live, or AdCenter--is not going to change this.)

So what should Microsoft do?

1) Merge MSN with AOL in the complex transaction described below.  Do NOT enter into a "partnership" with Time Warner.  Time Warner has had enough trouble managing AOL by itself; don't make things worse with a joint venture (a.k.a., a "joint agreement to take no responsibility" and/or "joint headache").  As part of the deal, give the combined company a right of first refusal on Time Warner content and Microsoft software and insist on a good distribution deal with Time Warner Cable.  Pay for the purchase with stock in the new company, called, for the sake of this post, AOL-MSN (see No. 3 below), with Microsoft and Time Warner each keeping a major chunk of the equity.

2) Eliminate duplication: development teams, VOIP efforts, content platforms, network operation centers, bandwidth deals, sales forces, call centers, etc.  Make the two IM systems interoperable.  Make AOL mail work with Outlook.  Put both companies on the same search and advertising platform. Unify the mission.  Take the best of both management teams and hire new blood.  Etc. 

3) Spin the combined entity off as a separately traded public company, with Microsoft and Time Warner together owning about 70%-80% (but neither having a controlling interest) and the public and other strategic partners owning the rest.  Make sure the company has at least $5 billion in cash. 

4) Cut broadband distribution deals with cable companies, telecom companies, and wireless companies.  Start with Comcast, which wants access to the AOL subscriber base so badly that it's talking to Time Warner on its own.  Focus efforts on trying to migrate dial-up subscribers that want to quit AOL to broadband partners, thus retaining some revenue.  (In each market, at least two broadband distributors compete with each other, and they would both love to attract AOL dial-up subs.)  Consider buying Earthlink, United Online, etc., to gain more leverage in these partnerships.

5) Combine the portal infrastructures of AOL and MSN and gradually migrate toward a single brand in each geography in which one is weak.  Integrate the portal with Windows (Microsoft will still be a strategic parner).  Leverage Time Warner content (Time Warner will still be a strategic partner). Consider partnering with News Corp., which should have a stake in a major portal.  Partner with News Corp's MySpace, and provide technology and content to MySpace's users.

Why merge?  Because MSN and AOL are currently fighting it out for No. 3 in the web wars, and neither has a realistic shot of gaining market share by itself (let alone becoming No. 1).  Merging will create a stronger No. 3, with about $2 billion of annual cash flow, the world's leading online communications services, strong positions in the U.S. and internationally, strategic partnerships with the world's leading media and software companies, etc.  And also merge because most markets only support three major generalists, not four, so the future for either company alone looks bleak.

Why spin the combined company off?  Because the immense personalities and talents needed to pull off a merger like this probably won't want to work for massive conglomerates for whom the Internet is a sideline business (Microsoft or Time Warner), especially when they get paid in the conglomerate's stock options.  Because the conflicts and infighting at Time Warner and Microsoft are stifling the growth of the web businesses.  Because being a stand-along company will increase focus and pressure on management.  Because Microsoft and Time Warner shareholders will benefit as much, if not more, from owning equity in a strong No. 3 web company (AOL-MSN) than from owning a controlling interest--and consolidated cash flows--of same.  Because the combined company will be able to develop its own personality and identity, which it needs to be able to compete with ubiquitous global Internet brands like Google and Yahoo!

(For more, please see a recent Cherry Hill Research publication, The Web War is Over...and Microsoft Lost, which I linked to in this post.  It includes a snapshot of what the combined P&L of AOL-MSN would look like, pre- cost cuts).

Comments

[Bruce Hamm]

Henry, what assets are you assuming would be in this new entity? Is your concept based on Microsoft and AOL both contribute their communications, advertising, access and content assets? Why would Microsoft, who has just made it clear that advertising is a huge opportunity for the company, place such strategic assets outside of their control? This is a long-term game (with online advertising reveneus growing for the next 10-15 years), and the AOL deal appears to be a short-term play stuffed with complexities than would challenge even the most adept management team. More importantly, this all seems premised on the attractiveness of such an entity and success in the capital markets, would investors really want a piece of a 'hey we're #3 story (the Avis-1 approach)? And, you would know this well, if the executive team at an AOL-MSN is acting in its shareholder base's best interests, what precludes them long-term from just doing a rich deal with Google for the search portion of the concern? How do you walk the balance between broad shareholder interests and strategic shareholder concerns?

[Henry Blodget]

I still think there is a difference between software and services--a difference that Ray Ozzie seemed to acknowledge in yesterday's memo, when he suggested that Microsoft's services would be able to plug into Windows but would not be made a part of Windows. And that's where I think Microsoft's business should be separated.

Part of the trouble I have with Microsoft's current strategy is that I just can't envision a company so vast and broad that it can compete successfully with Oracle, SAP, Sun, and IBM on one end and Google, Yahoo!, Time Warner, News Corp, eBay, and telecom companies on the other. I think the web services business and the software business should be separate, with cooperation encouraged but not forced, and I don't think Microsoft's shareholders would lose from this (Microsoft EGOS would lose, but so it goes).

As for whether the capital markets would support a No. 3, yes--especially if the company had the strategic backing of big media and Microsoft. The market would not support it indefinitely--the company would have to deliver, of course--but there would certainly be interest. And more important than the capital markets, I think, would be Madison Avenue, which would embrace the company, if only as a means of undermining the Google near-monopoly.

What goes into the entity? All of AOL and all of MSN. Full stop.

[dmart]

MSN is an also-ran, AOL is a listing barge! Reality is, they just can't muscle this one around ala the browser race of yesteryear. Google is in the business of building better mousetraps. If they can build a better literary index then they will take away from Amazon, if they can build a better garage-sale index, then they will take away from eBay and similarly from the instant messengers and the VoIP services and the news portals and the list goes on.

The most telling example of what's awaiting Microsoft is how easy it was for Google to launch an assault on Hotmail and show that it can be done easier, faster and better. Best of all, it was just an experiment, a warning salvo across the bow, courtesy the Google Labs.

The biggest advantage that Google has over Microsoft and all other players for that matter, is the ease with which this company moves. No drumbeats, no strategy cookbooks, no infinite-delays, just a steady stream of fluid motion.

Borrowing a page from Apple's new-found paradigm and buying a next-frontier-platform-provider like say Nokia, makes a great deal more sense than getting in bed with AOL. Fighting a come-from-behind battle is getting old and tired, they need to create some magic and fast, otherwise they would be well advised to transform the company into an Income Trust. Maybe then, they might start coming back to life on the capital markets' radar screens.

[Jack Miller]

Thank you for the post. I think your ideas are as good as it gets for holding third place and third place will see large revenues as the internet grows into TV, phone, etc.

The question I would love to have answered is "Will the major content owners be able to control the way the content is ultimately distributed?" I am not ready to pay .99 cents for a TV rerun but it seems that there will be a lot of low or zero cost content available from thousands of sources; some of it will turn out to be excitingly good stuff. The dream of all on demand content is powerful. I expect subscription fees for "prime" shows and events. "Will the producers be able to keep the "prime" shows piping through the cable and phone companies or will Google have so many eyes searching that the producers would be foolish not to take the plunge and offer internet downloads to all comers for reasonable prices?

[Matty Dread]

You may be right about what Microsoft should do, but here's what they're trying to do.

They want to keep the newly rebranded "Windows Live" services--Web-based e-mail, Messenger, VoIP,nad so on. These services are defense: they need to ensure that GOOG and YHOO don't get so far ahead that they can suddenly present a threat to the crown jewels. But the talk of ad dollars is a distraction, sure, a nice new revenue stream, but one of many.

Then they'll spin the parts they couldn't care less about--the dial-up ISP and content businesses--off into a JV with AOL. Then sell the ads provided via adCenter to this new JV.

What does Time Warner get out of it? Hmm...good question. And probably why the negotiations are taking so long.

[Anders Kargaard Jensen]

Great insight Henry - I love reading your blog - fantastic input to my investment strategy! Thanks! Only I don't understand why you don't personnaly own shares or options in Google? Any specific reason?

[NeoKen]

I agree that as currently constituted Microsoft will not kill or significanly harm Google. However, I cannot agree that merging with AOL would worry Google either.

Upon reading your post, I visited MSN.com for the first time in a long time. I see a zillion different business there. I see traffic reports. Weather. Searching. Shopping. Merging with AOL isn't the answer. Setting these mini-businesses loose with MSFT resources sounds better. If I were Google I would worry about a search only outfit with MSFT bucks but not MSFT baggage behind it.

Moving around the internet is so easy that portals with mediocre applets can't win against specialized "perfect for what I want" sites. So I search with Google. Price with NextTag. Check weather with weather.com. So on.

Anyway, as a long time MSFT shareholder I hope they don't follow your plan. It offers just merger confusion to an already confused business model.

Set free and spin out is what MSFT needs to do with it web businesses.

[Neal Lachman]

I don't agree at all with you on what MSFT should do. I have tried to give a point by point response to the points you raised.

http://nealsperspective.com/blogs/?p=23
Reality Check: Google vs Microsoft (part 2)