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Microsoft may feel urge to merge

Feb 19, 2001  •  Post A Comment

On the rebound from its lingering legal debacle with the U.S. government, Microsoft Corp.’s biggest challenge is getting back in the interactive TV and mass media game. But it’s nothing a multibillion-dollar merger with the right media company won’t cure.
Although Microsoft is the only player that approaches the scale, depth and focus of the newly formed AOL Time Warner, the house that Bill Gates built needs to link to mainstream content and distribution. But how and with whom?
Next to Time Warner, The Walt Disney Co. has one of the largest stables of animated characters, films and cable program franchises; one that could bring branded pizazz to the Microsoft Network (MSN), the family of Web sites and services. Disney’s television stations and cable presence would give Microsoft leverage in TV interactivity and commerce. Having failed at its latest Internet strategy, Disney could use a savvy Internet partner.
Tom Wolzien, analyst at Sanford Bernstein, says a stock deal that works for both companies could include the spinoff of Disney’s theme parks and sale of other noncore assets.
Another possible alliance could involve Microsoft and NBC, as long as it would allow NBC corporate parent General Electric to maintain a majority stake. Mr. Wolzien also mentioned Dow Jones and the Tribune Co. as other possible alliances for NBC.
Competing with AOL TW
Of course, Microsoft is not alone in its need to develop more of a hybrid base through mergers, acquisitions and strategic investments, although none of these companies will talk openly about the prospects.
The AOL Time Warner deal has redrawn the media map, Mr. Wolzien says, pressuring other media concerns to accelerate their plans for multiple revenue options and multimedia platforms through deals-big deals.
Another deal just waiting to happen, Mr. Wolzien said, is a three-way alliance or merger with Viacom, Yahoo! and EarthLink that would give the resulting entity an Internet profile more like that of AOL Time Warner.
Ironically, Microsoft Chief Financial Officer John Connors said last week during a Robertson Stephens technology conference that the company would not rule out the acquisition of an Internet service provider at the right price. Speculation persists that Microsoft and EarthLink are in negotiations. But even tallied together, EarthLink’s 4.7 million subscribers and MSN’s 4 million still fall far short of AOL’s 27 million members.
However, Viacom’s content and traditional distribution vehicles, coupled with the Yahoo! mass advertising-based Internet platform and EarthLink’s ISP capabilities would immediately put the combined entity on a par with AOL Time Warner.
In the past 18 months, Disney and Rupert Murdoch’s News Corp. also have expressed interest in aligning with Yahoo!, sources say. The fiercely independent Yahoo! is trying to avoid such a move at all cost.
For now, the biggest players still have the best options.
“Market capitalization is a proxy for the relative ranking across all the businesses represented by a media conglomerate … the industry runs on the basis of balance, or mutually assured destruction,” Mr. Wolzien said.
“Companies do deals simultaneously in multiple businesses and at multiple levels. Unless it has market dominance, a smaller company probably won’t get as good a deal as a large competitor that can negotiate across several businesses at once. The loss of the level playing field will be an impetus for even more media companies to merge,” he said.
How to be a player
Because it lacks the mainstream connections and content to be a true media force, Microsoft clearly must do something to reduce its PC dependence and become a player in mainstream digital interactive media.
To date, Microsoft has attempted to buy a seat at the mass media table by taking significant stakes in major concerns.
It is expected to invest at least $4 billion for a less than 5 percent stake in the new powerhouse that will be created by the merger of News Corp.’s satellite operations with Hughes Electronics’ DirecTV. Its other investments in the cable industry have included a $1 million stake in Comcast Corp. and a $10 million stake in AT&T Corp. There has been a bevy of smaller strategic investments elsewhere.
Seattle sag
But Microsoft has yet to make a major break into proprietary content for consumers, despite its ownership of MSNBC.
While it was unveiling a more Internet-friendly version of its Windows operating system and naming Rick Belluzzo as its new president last week, antitrust enforcers were opening up new investigations into the company’s investments and practices.
Internet guru Henry Blodget of Merrill Lynch contends Microsoft has lost significant ground on the all-important interactive television front in its effort to develop markets outside of personal computers.
Microsoft is now as much an Internet company as a software maker, and much of its growth will shift to “converting its software into Internet software and services,” he said.
All that was underscored in spades by Mr. Blodget’s recent assumption of the coverage of Microsoft at Merrill Lynch, where Senior Software Analyst Chris Shilakes had been tracking the company. Indeed, other high-profile Internet analysts, such as Mary Meeker at Morgan Stanley Dean Witter, also cover Microsoft.
Mr. Blodget immediately downgraded the $65 stock from “buy” to “accumulate,” explaining, “We don’t find Microsoft’s potential upside particularly compelling at this price.”
“Dependence on the desktop will make sustainable earnings-per-share growth of faster than 10 percent a year very difficult,” Mr. Blodget said, which is why it is so important for Microsoft to make strides in the interactive space.
Mr. Blodget estimates that more than 95 percent of Microsoft’s operating profit is generated from desktop personal computers, and that is slated to grow only at 5 percent to 7 percent this year.
Gaining successful entry and, eventually, dominance of new enterprise and consumer businesses such as its new Xbox video game is critical for Microsoft to achieve earnings growth at a sustainable 8 percent to 20 percent annually, Mr. Blodget said.
At best, 2001 will be a year of transition for Microsoft, which will concentrate on enhanced TV, Xbox and other new consumer services as it moves to stem losses on its e-commerce investments. Together, consumer and e-commerce contribute about 13 percent of the company’s revenues.
Excluding new businesses, revenue growth in this area will slow to 19 percent from 28 percent annually. The largest business, Internet access, which was worth $900 million last year, will be retarded by the end of rebate incentives.
Internet advertising, the second-biggest business, worth $600 million in revenues last year, should be flat.
Microsoft has incurred losses from its Internet-related businesses, which are dominated by MSN but also includes WebTV. Worse, it appears its overall Internet strategy is falling short of expectations.
Mr. Blodget estimates that Microsoft has a $1 billion profit opportunity in the enterprise areas of enhanced TV, video games and consumer wireless software. But the bulk, or about 60 percent, will come from video games alone, Mr. Blodget said.
The Ultimate opportunity
However, the Xbox, for instance, is a very expensive bet, projected to generate as much as $500 million in operating losses in 2001 on more than $700 million in expenses and about $300 million in revenues. Because the video-game market is so large and competitive, Mr. Blodget said in a recent report, Microsoft will be lucky to generate $400 million in operating profits from Xbox by 2005, having budgeted $500 million for its rollout this year and investing $200 million in the product already.
In the enhanced TV area, the Microsoft TV software platform, which enables network operators such as cable companies to provide enhanced TV services, represents the company’s single-largest opportunity.
Ultimate TV, which launched in January as the first consumer service in the United States powered by the Microsoft
TV platform, exists primarily as a showcase for Microsoft TV. For $9.95 a month, Ultimate TV offers digital video recording, interactive television, Internet access and DirecTV programming.