So when Microsoft on February 1 announced its proposed $31-a-share, $44.6-billion, cash-and-stock acquisition of Yahoo, we promptly sold nearly all of our Microsoft holdings. And we don’t own Yahoo; we sold it in January 2006, when the company’s earnings began to falter. As we see it, a Microsoft-Yahoo combination may very well be a case where one plus one equals something less than two. We anticipate that the acquisition of Yahoo may pose two short-term difficulties for Microsoft: it could dilute the company’s earnings power, and it could result in a dysfunctional integration of two distinctly different corporate cultures.

To us, this kind of acquisition calls to mind the old wisecrack about the mating of elephants: it’s a cumbersome act that is conducted at a high level, involves a great deal of noise, and requires about two years to get results (if any). Various Wall Street analysts have articulated these three reservations about a consummation of the Microsoft-Yahoo deal:

• Microsoft is offering more for Yahoo than the company is worth. (We don’t share that opinion; we think Microsoft’s price is fair.)
  
  
• Microsoft would be better off to focus on its core desktop-operating-system/software business. (We disagree; Microsoft may jeopardize its future if it chooses to cling solely to that business.)
  
  
• The acquisition won’t clear antitrust regulatory hurdles in the U.S. and Europe. (Again, we beg to differ; the merger is likely to eventually be approved by both the Justice Department and the European Union, our contacts tell us.)

So why is Microsoft interested in Yahoo anyway?

The future is online

The rationale is that the Yahoo acquisition would expand Microsoft’s online businesses -- advertising, search, and e-mail -- and thus make the company a more formidable competitor to Google. For at least the past three years Microsoft has coveted a greater share of the online market, which Google dominates in much the same way that the Beatles held sway over the pop-music charts in the mid Sixties.

As we see it, there’s ample evidence that online businesses are worth coveting. For instance, take Internet advertising, which despite a recent cyclical softening of revenue, has been a great growth business -- and should remain one for some time to come, in our view. We expect the Internet advertising business to grow at least 25% annually over the next three years. Even in the currently weak shopping environment, consumer visits to retail Web sites from Google.com have increased 11% for the year-to-date versus the same period last year, according to a research unit of the Experian credit-reporting firm.

But Internet advertising isn’t an easy business to crack. As our colleague Jason Schrotberger of the consumer-sector team points out, in 2005 Microsoft held a 7% share of the Internet advertising market. Since then, in an effort to become a bigger player in that market, Microsoft nearly doubled its capital spending, to $1.8 billion annually. The result has been something less than heartening: Microsoft’s share today has shrunk to 6.8%.

What the bid means

Basically, Microsoft’s attempt to acquire Yahoo tells us two things:

One, Microsoft is a once great growth company whose core business has matured and needs to enter a faster-growing business to revitalize itself.

Two, Microsoft believes -- rightly so, in our opinion -- that it must do something to fortify its core software business against the competitive threat of Google. Or more to the point, Microsoft in its business model must come to terms with what Google represents: the rise of the "computing cloud." For those of you who aren’t tech geeks, a computing cloud is an enormous, Internet-based centralized repository of hardware, software, data, and digital services that businesses and consumers can tap economically or for free. And it threatens to render obsolete much of the traditional software business, which of course has long been Microsoft’s hugely profitable domain.

In essence, the computing cloud is the means by which the Internet is beginning to usurp most of the functions now performed by computer systems and software. We agree with this characterization of the cloud’s potential significance by the Financial Times: the cloud may be the most paradigm-altering development in the tech sector since the invention of the personal computer in the 1970s.

Google was the first company to build a computing cloud. Its cloud extends from Silicon Valley to Ireland and contains, according to conservative estimates, more than 450,000 servers that offer prodigious computing power. Google’s cloud can handle a computing task for only 10% of what it costs a typical company, the Financial Times notes. If, as we suspect, companies and consumers rely increasingly on clouds to meet their computing needs, Microsoft and other tech giants whose businesses revolve around traditional computer-based technologies may end up as cooked as reheated lasagna.

Critical to the advent of the computing cloud has been the rapid evolution of "on-demand software," or low-cost, Internet-based software that enables businesses and consumers to obtain the benefits that more expensive, traditional, commercially licensed software now provides. In fact, on-demand software and the computing cloud share these characteristics:

• They offer access to computing networks and functions via the Internet.
  
  
• They are managed from central locations (as opposed to customers’ sites), thus permitting customers to obtain computing functions remotely and updates of those functions more easily, without the bother and expense of applying downloaded patches.
  
  
• They deliver broadly commercial applications to many users instead of customized applications to a single user.

As we see it, the computing cloud may largely explain why Microsoft has begun to reveal key details of its software programs and to encourage others to create additions to those programs without having to pay the usual licensing fees. In effect, Microsoft is somewhat grudgingly acknowledging that the Internet is making possible the mixing and matching of Microsoft software with other free or low-cost software for new applications. How well Microsoft adapts to this new reality should largely determine its future, in our judgment.

As for the likelihood of Yahoo being acquired, we estimate there’s a 65% chance that Microsoft will ultimately prevail, in spite of Yahoo’s initial resistance to the bid. The Wall Street Journal has reported that Yahoo wants an offer of at least $40 per share. But the members of Yahoo’s board of directors, wary of shareholder lawsuits accusing them of a breach of fiduciary responsibility, may have to settle for less money; as a practical matter the board has little leverage to rebuff Microsoft’s bid without having another offer in hand.

And unfortunately for Yahoo, there’s no other offer in hand, which we think says something about the marketplace’s perception of Yahoo’s prospects. In our judgment, the lack of interest can be attributed to Yahoo’s failure in recent years to develop many notable new products or make inroads in Internet advertising or improve profitability.

Some analysts and investors, however, believe other offers for Yahoo may be forthcoming, BusinessWeek notes.

It’s been speculated, for instance, that Yahoo might become partners with Google. Reportedly, after talks between the two companies in February, Google executives are lukewarm about the idea, according to The Wall Street Journal, among others. The plain truth is that Google doesn’t need Yahoo; Google should be able to perform nicely on its own. For instance, it’s conceivable to us that Google could gain a 75% share of the U.S. Internet search market over the next five years, up from a conservative estimate of 55% today. As a result we assign just a 20% probability to a Google-Yahoo partnership.

It’s also been suggested that Yahoo could swap assets with News Corporation, whereby Yahoo would acquire Fox Interactive Media, the online business that includes the popular MySpace social-network site. We put the odds at 15% of that happening, or of Yahoo attracting another suitor (Viacom, Vodafone, Nokia, AT&T, private equity firms, and sovereign wealth funds from Asia have been among those mentioned).

Finally, there’s a lot of buzz about Microsoft sweetening its offer for Yahoo. After all, Microsoft has in fact paid a higher multiple of EBITDA (earnings before interest, taxes, depreciation, and amortization) previously for acquisitions. But Microsoft may not want to -- or have to -- raise its price. It would be cheaper for Microsoft to simply nominate its own slate of 10 Yahoo directors and initiate a hostile takeover for the company. Microsoft has never gone medieval in acquisitions before . . . but then never say never.

BusinessWeek calculates that if Microsoft were to offer even $1 per share more for Yahoo, the cost would be steep: about $1.4 billion. In contrast, a hostile takeover would set Microsoft back about $30 million, mainly for legal and shareholder-solicitation fees -- an expenditure that amounts to chump change in relative terms.

Whether friendly or unfriendly, the acquisition of Yahoo seems Microsoft’s best opportunity at the moment to raise its competitiveness in a sector that’s being roiled by a potentially big technological discontinuity, the computing cloud. If nothing else, Yahoo would provide Microsoft with the world’s biggest directory of registered Internet users, which would at least be a start in devising new cloud-based services. We aren’t ready to count Microsoft out just yet, but we will have to see definite progress by the company in remaking itself before we again have sufficient conviction to buy its shares.