Microsoft's Thirty Percent Solution

(MoneyWatch)  Most observers have dismissed the Microsoft-Yahoo alliance as a non-starter for both companies. Yahoo looks like the 50-year-old schnook who took a second mortgage on his house to buy himself a Corvette, while Microsoft seems to be buying an illusory bump in the ComScore ratings game.

My colleague Erik Sherman argues that the deal really hurts Microsoft by raising false hopes that it will ever catch up to Google (which is the underlying justification for this deal), thus diverting corporate energies towards a strategic dead end.

False hope and distraction are bad enough when things aren't critical. But when a company such as Microsoft or Yahoo is now facing declining revenue and profit, no matter what the rationale, every moment spent strolling down the wrong path takes away from the time needed to craft a solution. Eventually they get the temporal equivalent of credit card poverty, where interest on the debt becomes so high that it's virtually impossible to catch up and get ahead.

I would tend to agree with him, certainly where Yahoo is concerned, but Steve Ballmer's remarks during yesterday's analyst conference indicate that Microsoft at least has a coherent strategy. It might not work, but it's a plan.

In a nutshell, the deal gets Microsoft to around 30 percent market share in the search ad business, which is enough for it to generate the kind of economies of scale that will matter in the long run, kind of like annual compounding actually works if you start early enough and live long enough to see it play out. In search, this compounding creates a positive feedback loop where the more information you gather about customer behaviors, the more relevant ads you can serve them, the more revenue you generate and the more likely those customers are to return to your search engine. And just look at the number of times Ballmer mentioned "scale" in reference to this deal:

We get a chance by putting together our scale and Yahoo!'s scale in the United States and in some other countries where Yahoo! has scale. You have to understand that in Western Europe neither one of us has much scale, Google has got about 92 percent paid search market share in Europe, so this gives us a little bit more scale, but not a lot more there. But scale is actually a tool for product improvement. I'm not talking about money improvement. I will get there in a minute. It's a tool for product improvement. The more queries you see, the more you can tune your product. The more you scale you have, the more advertisers advertise on your system and the more relevant they make their ads for your users. It is not about money. It is actually about relevance because the advertising is part of the actual user experience.

Later, Ballmer told Steve Lohr of the New York Times that "scale is more important in this business than any other technology business I know."

The trouble is, annual compounding only works if you live long enough to reap the reward of patience. Search revenue might not matter to Microsoft ten years from now unless it manages to overcome serious looming challenges to its critical businesses, like Office and servers and tools.