Forget Yahoo—Buy Palm

Why Microsoft would be foolish to get into the Web ad business.

Nearly a year ago, Microsoft made an unsolicited $44 billion bid to buy Yahoo. No good came of it: Yahoo’s executives, who appeared chronically allergic to any move that might reward shareholders, wasted a precious year fending off Microsoft rather than finding a way to beat their chief corporate rival, Google. Microsoft emerged looking no better; as it puzzled for months over whether to go all out for Yahoo or leave it alone, the company seemed to fall ever further short of developing a business strategy to compete with its main rival—yes, Google again. Do you see a pattern here? The only beneficiary of all of these chaotic merger talks has been the company that Microsoft and Yahoo are most desperate to beat.

Happily for Google, Microsoft and Yahoo may be ready to dance once more. Last week, Yahoo named Carol Bartz its new CEO. Many expect the appointment to spark a new round of talks with Microsoft; gossips were recently rewarded with the sight of Microsoft CEO Steve Ballmer and Roy Bostock, Yahoo’s chairman, meeting for lunch. This can’t end well. The past year has eroded the already tenuous rationale supporting any partnership between these two also-ran Web companies. Not only would regulatory hurdles and a clash of cultures doom Microhoo—the new company would now be forming during a declining Internet ad market.

What’s most puzzling about the possibility of renewed merger talks is that in betting on Yahoo, Microsoft would be jumping deeper into a volatile business that is outside its area of expertise. Microsoft really has no business being in the business of advertising. It is a software company, and software remains an astonishingly lucrative market. So why does it want to sell ads?

For Ballmer, beating Google in the ad game might offer a kind of redemption. The Wall Street Journal’s Robert Guth reported last week that over the past decade, Ballmer and Bill Gates missed several chances to build a Google of their own. Yet Microsoft’s early blindness to the ad business was understandable—Ballmer and Gates were more focused on the bigger riches to be had from selling operating systems, office applications, and Web servers. Does Microsoft need to be in the ad business now? Only if you believe that advertising is somehow a threat to revenue from software—in other words, that the economic future of software depends on advertising rather than paying customers. But that’s a foolish bet—and buying Yahoo will only magnify the foolishness. Instead, I’ve got a better idea for Ballmer: Abandon the Internet ad business and focus on your main market, developing and selling software. I’ve even got a great way to jump-start that strategy: Buy Palm!

As computers burrow ever more deeply into our lives, the market for good software only grows. Ten years ago, the PC was the only device that ran a recognizable operating system. Today, your cell phone, your music player, your TV’s set-top box, your camera, your GPS navigator, your video game console, and dozens of other devices require code to keep them humming—and to keep them working together. Not only that, but people are willing to pay for software that makes these devices easy to use. Look at the iPhone. Sure, it’s pretty on the outside, but its main innovations are inside: its user interface, Web browser, App Store, and seamless connection to your PC and the Internet cloud. The iPhone carries no ads; it is supported entirely by customers’ monthly contributions to Apple and AT&T—to the tune of around $2,000 over the life of a two-year contract.

The success of the iPhone and other smartphones demonstrates how the market for software is changing. Applications are no longer bound to a single device—your programs come in different flavors on different gadgets and share data across the Internet. The model by which we pay for software is also shifting. Once, we bought applications in boxed units; now, depending on your need, you may buy a subscription to an online service (see what 37 Signals does with its Web collaboration software), you may download software for free in conjunction with a gadget (sales of iPods and Macs subsidize Apple’s development of iTunes), or you might get an app in return for viewing ads (that’s how Google supports most of its Web apps for consumers).

As Henry Blodget has pointed out, free, ad-supported Web applications pose little threat to Microsoft’s most profitable business—selling software to corporations. It’s true that companies are increasingly replacing their desktop software with Internet apps—but many still want to pay for the stuff they’re using. Google charges firms $50 per employee for a suite of its online programs; in return, employees see no ads, and companies get technical support from Google., one of the most successful online software companies, also shuns the ad-supported model—and last quarter, its revenues jumped 43 percent.

You could forgive Microsoft for being slow to develop its own Google-like search advertising business—search engines weren’t its main focus. What’s less forgivable is that over the last few years, the world’s biggest software company has failed to adapt to the changing software market. Microsoft’s apps integrate poorly with the Internet—how did you share your Word documents with co-workers before you had Google Docs? Microsoft’s portable software also isn’t very good. Apple, Google, Research in Motion (Blackberry’s manufacturer), and Palm now all make stylish, easy-to-use mobile operating systems. Microsoft’s mobile OS, Windows Mobile, looks ancient in comparison and carries none of the sex appeal that’s proven so important in the sales of mobile phones.

Microsoft even failed to anticipate the next wave in PCs—its main business. Windows Vista, its current OS, doesn’t work well on netbooks, the tiny, ultraportable, cheap laptops that are becoming a big part of the notebook market. Last month, I praised Windows 7, Microsoft’s excellent successor to Windows Vista, which the company says will run well on netbooks. But many people who load up Windows 7 will still go elsewhere for most of the software they run on it—they’ll download iTunes to manage their music, Google’s Picasa to manage their pictures, and Firefox or Chrome to get online. When we think of the software that powers our most personal apps, we rarely think of Microsoft.

Buying Yahoo would solve none of Microsoft’s software woes—and could likely make them worse if Ballmer spends resources fixing what’s wrong with Yahoo rather than fixing what’s wrong with Windows Mobile. So here’s another plan: Earlier this month, Palm unveiled its fantastic new phone, the Pre. The device looks to be the most advanced competitor to the iPhone yet—in many ways, its user interface, which is much more responsive than Apple’s and features the ability to run multiple apps side by side, bests the iPhone. What it lacks, though, is distribution. The Pre will be locked to Sprint’s network, and Palm has only a fraction of the marketing muscle of Apple, RIM, and Google.

Microsoft might pay tens of billions of dollars for Yahoo; it could pick up Palm instead for just $1 billion or $2 billion and then spend several hundred million more on transforming the Pre’s user interface into a mobile OS that can run on phones made by multiple vendors. Microsoft would also gain a loyal Palm audience—and a base of developers looking to create apps for the device. And then Microsoft would have money left over to buy other software companies—startups and established firms that power the next generation of devices, or that are pioneers in the selling online software to companies. In other words, it could buy lots of companies that share its core mission—building apps—instead of one that makes its money in a completely alien business.

Over the past few months, Google, the company that Ballmer considers his main rival, has made a series of moves to cut costs and ditch parts of its business that aren’t performing. It announced plans to close down the virtual world Lively, its video search engine, the Twitter-like service Jaiku, and the scrapbook app Google Notebook, among others. Many of these projects seemed like boom-era extravagances—things that might have seemed smart when Google’s stock price was $700 but now look like deviations from the company’s main business.

Microsoft’s own boom-era delusion was that by buying Yahoo, it could succeed in both the Internet ad business and the software business. Now that the boom is over, Microsoft ought to take a page from its rival and pick a single business. In 2009, companies are expected to spend about $45 billion on Internet ads. The market for software is nearly 10 times that size—around $388 billion this year. If you were Microsoft, which would you choose?