What Microsoft's bid for Yahoo! means for the economy and for Google.

Commentary about business and finance.
Feb. 1 2008 12:52 PM

Web 2.Over

What Microsoft's bid for Yahoo! means for the economy and for Google.

Also in Slate, Chris Wilson explains why Microsoft's play to purchase Yahoo! isn't about search,and Henry Blodget writes that Yahoo! won't be able to say no to Microsoft.

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Two huge potential deals in the online space in the last 24 hours. First, Amazon.com announced it was buying Audible. And now Microsoft has made a $44 billion bid to acquire Yahoo!. Such aggressive takeovers generally occur either close to a top—when buyers are really optimistic—or after a bust, when survivors pounce on opportunities to pick up companies on the cheap. But coupled with yesterday's disappointing earnings report from Google, the deal-making points to a new phenomenon: the first economic slowdown of the Web 2.0 era. After a few quarters of defying the broader economic decline, even the best-of-breed technology companies are showing themselves to be subject to the business cycle. The slowdown is gutting margins, causing executives to revise their PowerPoint presentations on growth, and depressing stocks. As a result, the hot young singles of the NASDAQ are seeking to cut costs and ride out the storm by shacking up together.

Audible is a new-media company that old-media types like to root for. Its founder and chief executive officer is the excellent magazine journalist and author Donald Katz, and its services provided a potential new revenue stream for long-form journalists. Audible survived the dotcom meltdown in 2000 and quietly built a significant business. (Projected 2007 revenues: $106-$108 million.) But as shown by its third-quarter earnings, impressive revenue growth of about 30 percent has been unable to overcome persistent spending on technology, marketing, and operations. The upshot: Audible is still losing money.

Enter Amazon.com, which, though it continues to put up excellent numbers, remains a retail stock. And when the end of a business cycle approaches, retail growth frequently comes at the expense of margins. Amazon.com's fourth-quarter earnings release, which came out on Wednesday, showed sales rose an impressive 42 percent from the 2006 fourth quarter, to $5.67 billion (with an assist from foreign exchange translations). But operating income grew only 38 percent, and operating margins fell in the core North American market. (Translation: Amazon had to discount, or throw in free shipping, more than it did last year to help goose sales.) For 2008, Amazon is expecting revenue growth to slow to between 26 percent and 33 percent. So, why get hitched? Amazon's huge infrastructure investments and distribution capabilities may make it possible for it to run Audible profitably, even if sales growth is muted. And Audible represents a significant revenue stream that it can acquire without spending too much. The agreed-upon price is $11.50 a share. While that's a small premium to Audible's Jan. 30 closing price, $9.33, it's below where Audible traded for much of the past year. At the end of October, Audible's stock traded at about $13.75.

Economic slowdowns are also bad news for media companies, as marketers cut back on advertising spending. And it stands to reason that while online advertising is still growing at a much more rapid pace than overall ad spending, reduced budgets may take a bite out of interactive marketing. The darkening outlook for online advertising and e-commerce, as well as the continuing challenge of competing against Google, is likely behind Microsoft's bold bid for Yahoo!.

Both Yahoo! and Microsoft are struggling online. Yahoo!'s fourth-quarter earnings, released earlier this week, showed that in the 2007 fourth quarter, revenues rose a meager 8 percent from 2006, while operating income fell 38 percent. In Microsoft's bright quarterly earnings report, the one dark spot was the online division, which lost money, despite rising revenues. In the six months ended December 2007, losses increased from $236 million to $510 million over the same period in 2006, even as revenues rose from $1.16 billion to $1.53 billion. Google has been eating its lunch competitively, and the overall market isn't growing rapidly enough to allow all the major players to prosper. The stock of Yahoo!, which is in the midst of a long-running (and so far unsuccessful) turnaround plan, closed yesterday at $20, its lowest level since the fall of 2003. That has given Microsoft, which has invested billions in its own efforts to compete against Google in search and advertising, the opportunity to acquire Yahoo! for a decent price. Yahoo! said it would evaluate the offer. (So did the Justice Department.) By sharing development and infrastructure costs, Microsoft and Yahoo! will likely have a better shot of going head to head against Google.

But even Google is showing signs of challenge. The company announced its fourth-quarter results yesterday (Thursday). Revenues grew 50 percent from the year-before quarter. That's an impressive gain off a large base, but Google's rate of year-over-year revenue growth is slumping, from 57 percent in the third quarter. Operating income as percentage of revenues fell from about 33 percent to about 30 percent. The stock fell sharply on the news and is off by nearly 30 percent since its peak in November.

To different degrees, all three events—the Audible-Amazon.com friendly merger, Microsoft's apparently hostile bid for Yahoo!, and Google's disappointing earnings result—can be pegged in part to broader economic trends. Investors (and executives) are worrying that the secular trend of rapid growth and rising profitability for Web 2.0 companies is running into the brick wall of the business cycle. Over the past year, the slowing consumer has dragged down a chain of sectors—from the homebuilders to department store retailers. Now it's the turn of technology companies. During Google's conference call, CEO Eric Schmidt said that "we have not yet seen any negative impact from the rumors of future recessions." He must not be looking in the right place.

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