AOL Time-Warner Merger A Crock From Day One?

Bloomberg has an interesting story: the SEC is suing some former AOL execs for allegedly overstating Internet advertising revenue by more than $1 billion between 2000 and 2002:

In mid-2000, before AOL completed its $124 billion takeover of Time Warner, the Internet service provider began overstating revenue by paying more for goods and services in exchange for customers' ad purchases, the SEC said. The company agreed to pay $300 million in 2005 to settle a related regulatory probe.

Interestingly, the whistleblower, called as a witness in a number of cases, is also being pursued by the SEC. Now that seems plain silly. You'd think that the SEC would want to encourage people to come forward, and it sounds as though someone needed to at the company. Now what are people going to do in other companies? Help hide anything because they don't want to be held accountable?

Microhoo: Why a Microsoft Acquisition of Yahoo Won't Change a Thing

Money can buy almost anything you want, and for Microsoft, that would be Yahoo – for something over its original bid of $44 billion. Many experts agree that the software giant will likely have its way. But getting what you want can be different from getting what you need, which may not be available at any price.

During a February 1 conference call, Microsoft CEO Steve Ballmer said that acquisition talks had occurred “off and on for the last 18 months.” Microsoft wants Yahoo badly enough to offer an amount greater than its combined net income from 2005, 2006, and 2007 because it is stuck.

Once PCs ruled supreme; now the Internet is king, Microsoft is “struggling,” says N. Venkat Venkatraman, a professor of management at Boston University. Traditional Windows and Office products – 80 percent of company revenues – are mature businesses that won’t fuel accustomed growth. For example, the newest version of Windows, Vista, has had relatively poor sales because of technical problems and a chilly user reception. According to statistics from NetApplications.com, it has a market share of only 12 percent market, versus the nearly 75 percent for XP, the older version. To avoid future financial stagnation, needs a way to grow.

Online advertising seems like the answer to a prayer. According to Kevin Johnson, Microsoft president of platforms and services, it is currently worth $40 billion a year, and may double in size over the next three years.

But Microsoft has had a problem called Google. “I can’t think of a company that has controlled the direction of an industry [to the same degree],” says William Mahnic, professor of banking & finance at Case Western Reserve University. According to Jeffrey Rayport, a partner in consulting firm Monitor Group, Google makes twice the online ad revenue as Microsoft and Yahoo put together, with half the user traffic. Furthermore, the Internet whiz is giving away software functions – such as spreadsheets, word processors, and email programs – that that directly competes with Microsoft’s cash cows.

Microsoft’s has had a roughly 6 percent share of online advertising for a few years, which is “essentially been flat,” according to Karsten Weide, program director of digital media and entertainment for market analyst IDC. But add the 11 percent share of Yahoo, and “it would give them a much better fighting chance” against Google’s 24 percent.

Johnson said that the combination would offer a number of strengths. By eliminating duplicated R&D, freed-up staff could “improve our ability to drive innovation in emerging areas such as video, mobile, and online commerce.” Yahoo and Microsoft have both proven that trying to charge users for services is literally a losing game. That’s how Google has moved ahead: by providing a lot of free content and delivering ads that tie in with someone’s interest.

So, if online advertising is the name of the financial game, why focus on R&D? Because advertising online must still draw audience the way it must in print or television. On the Internet, that means novel and clever applications and services. R&D is supposed to deliver that innovation, as well as finding ways to use data about users to effectively pair ads with people.

Plus, Microsoft management is betting that by combining forces with Yahoo, the combined online advertising revenues would be better, while cutting redundant costs would actually mean more profit to keep shareholders happy. It all sounds smart on the surface, and Weide says, “We think a merger between Microsoft and Yahoo would make a lot of sense.”

But there’s a problem. Neither Microsoft nor Yahoo has been setting records in making money from online audiences. Between 2005 and 2006, Yahoo grew revenue by about 22 percent. Microsoft grew by over 11 percent. Google grew by close to 73 percent. It’s gross profit for 2006 was bigger than its gross revenue from 2005, and it’s significantly larger than Yahoo. Expecting the simple combination of the two companies to better address Google’s market dominance and momentum is unrealistic.

To fend off Google, Microsoft doesn’t need more of the same old thing, whether its own packaged software past or Yahoo’s online business. It needs entrepreneurial spark and invention. But innovation is the result of people, and getting the employees at Yahoo and Microsoft to work effectively in this way will be incredibly difficult.

First there are practicalities. “They’ve not done an acquisition of this size before,” notes Georgia Institute of Technology finance professor Narayanan Jayaraman. The mistakes that could come from an acquisition badly done could cost Microsoft the efficiencies and focus it is counting on.

The two groups may also get along badly. “[Yahoo employees are] always making jokes about Microsoft and the evil empire,” says Mike Grishaver, now CEO of Thingfo but until last fall a director of product management at Yahoo. Rayport agrees: “You’re talking about two cultures that are not just far apart, but that have active animosity.” Should key Yahoo employees become annoyed, they can find many other opportunities in Silicon Valley.

Furthermore, neither Microsoft nor Yahoo has shown the particular type of innovation that is necessary. “[In 2005] I laid out 13 things that Microsoft should buy or start building,” says Robert Scoble, a former Microsoft developer who used to write a popular blog about the company when still an employee there. But management turned down all the ideas because they weren’t big enough at the time to warrant Microsoft’s interest. Those small potatoes included MySpace, photo sharing site Flickr (later purchased by Yahoo), and Internet phone service Skype.

As for Yahoo, its glory days of Internet innovation may also be over. “The problem that Yahoo’s facing, and the reason they’ve been going downhill, is management bloat and lack of vision from the top,” Grishaver says. “When I started at Yahoo, the teams were small and days were about getting things done. Then they started to hire management layer over management layer over management layer who just go to meetings all day.”

In other words, Microsoft’s planned purchase of Yahoo could be nothing more than an expensive “me too” strategy of trying to follow Google, without an infusion of business innovation to start leading. And in the world of the Internet, another term for following is being an also-ran. The tens of billions of dollars could come to nothing more than an expensive way for Microsoft to stay exactly where it is now.

Has AT&T Gone Daft?

I know that AT&T was taken over by new management when acquired by Cingular a few years ago. But you'd think that the people running any major telecommunications company would have some grasp on the essentials of the business, and of its legal underpinnings.

For years, telecom carriers have gone out of their way to avoid looking at traffic passing over their networks. But AT&T has decided to end that trend, as this C/NET report shows:

For the past several months, AT&T executives have said the company is testing technology to filter traffic on its network to look for copyrighted material that is being illegally distributed. James Cicconi, senior executive vice president for external and legislative affairs for AT&T, reiterated the carrier's plans last week during a panel discussion at the Consumer Electronics Show in Las Vegas.

In other words, AT&T would play Internet traffic cop for some reason or another. But why? This has to be the biggest mudhole a corporation could want to sink in.

The customer service problems are obvious. How many complaints can one organization field from outraged customers who are sure that what they are trying to send, receive, or view online is perfect legal? Many of them might even be right...

But the big problem is not even customers, but legal liability, as Tim Wu wrote in Slate. AT&T was one of the prime forces behind the Digital Millennium Copyright Act of 1998, which, among other things, shielded telecoms from liability of copyright infringement, et. al., so long as they didn't poke into the content they carried and selectively choose what they would and wouldn't allow to pass.

Once a company starts sticking its nose into the content and making transmission decisions based on it, however, the protection pretty much disappears. And that's exactly the pit AT&T is about to enter. Now the recording industry can sue not only people who download illegal copies of songs, but potentially AT&T if its networks are carrying the traffic. And as the company has perhaps the biggest single share of Internet traffic, and as technology is never perfect and always screws up, chances are that AT&T will find itself liable in this and many other situations.

What did the "new" AT&T do? Fire anyone at the old AT&T who might have had a clue about risk and liability? Or were they just people with "old fashioned" views who obviously couldn't be as smart as those that acquired the company? At least the lawyers will be happy.

Facebook Re-learns Basic Customer Lesson

I'd ask when will companies learn, but the answer is usually never. Facebook decided, again, to try and "monetize its assets" - that is, the users. It wanted to track what people did and exploit what it learned for its own ends. And, as newspapers like the Washington Post are reporting, those customers have forced the company to back down. Read the article to see how a man's surprise Christmas present for his wife (at least, I hope it was for his wife, and if it wasn't, it is now) became known to her and many others, as Facebook broadcast his purchase. Here's a quote, in the story, from a MoveOn.org rep:

"Sites like Facebook are revolutionizing how we communicate with each other and organize around issues together in a 21st century democracy," said Adam Green, a spokesman for MoveOn.org, a liberal activist group that has launched the petition drive to pressure Facebook to stop broadcasting members' purchases and using their names as endorsements without explicit permission. "The question is: Will corporate advertisers get to write the rules of the Internet or will these new social networks protect our basic rights, like privacy?"

It's not just about privacy, though. When you start dealing with customers, you are entering a contract. It's not written, but it's stronger than any piece of paper, because it involves their expectations and demands. Flub enough on your end, and you're ended, because the people who make your business possible will walk away with their money.

Unfortunately, businesspeople who damned well should know better let greed and wishful thinking get ahead of them. That's why there was a dot com blow up, and why the current credit crisis is in full bloom. And unless online companies start getting street smart and people wise, they're going to find that the market and even government step in to put bounds on what they can do. And no one should look to have those forces registered as friends that watch your every move.

More on the Radiohead "Set Your Own Price" Experiment

There's a bit more information now - of varying quality - on Radiohead's experiment in letting people set their own price for the group's new album. Anyone in the information business - and that's content of any type - has to be keeping a close on on this story. It could offer some insights into how to make the Internet work as a commercial distribution mechanism.

According to a Forbes article, many people are still pirating the new Radiohead album, even though they could go to the site and get a legitimate copy for free if they wanted to:

On the first day that Radiohead's latest became available, around 240,000 users downloaded the album from copyright-infringing peer-to-peer BitTorrent sources, according to Big Champagne, a Los-Angeles-based company that tracks illegal downloading on the Internet. Over the following days, the file was downloaded about 100,000 more times each day—adding up to more than 500,000 total illegal downloads.

That's less than the 1.2 million legitimate online sales of the album reported by the British Web site Gigwise.com. But Eric Garland, Big Champagne's chief executive, says illegal file-sharing is likely to overtake legal downloads in the coming weeks, given that many of those 1.2 million legitimate sales were pre-orders taken during the 10 days between when the band announced the album and its actual release last Thursday.

Garland suggests that the real culprit is habit - they go to their favorite BitTorrent sites and download in the way they're used to doing.

However, even with lots of pirating, consider the economics. According to a London Times article (and we'll get to the main part of the article in a minute), an Internet survey of about 3,000 people who bought the Radiohead album suggested that most paid an average of £4. Although this won't be particularly accurate, it's the best numbers possible: a rough total of £4.8 million on the album, all going to the band. Given the economics of regular record deals and distribution, I think they made a whole lot more this way.

The real test will be whether they do the same on their next album. I also wonder whether a variation on the approach might have worked even better: pay money to get the album, or pay nothing and get some audio ads thrown in, like the free online music streaming sites. That would have increased the perceived value of the paid version and also increased revenue for the group.

Cyberwar Spills Onto Business

It's good that people are paying some attention to cyberwar - the extension of conflicts onto the Internet. The New York Times even is running a story about it. But cyberwar is old business. One of the biggest motivations for hackers these days is politics of various sorts, and even the "least developed" (whatever that means) countries have access to basic computer technology that takes relatively little infrastructure to put into practice.

I remember researching one story where I was speaking with representatives of a security analyst firm as well as other experts and an Italian hacker. Politics is a major factor in hacking these days, with thousands of businesses fending off attacks and trying to recover from web site defacements of political slogans. There are active political hacking groups in various parts of the Middle East and in China, for example. And companies that are associated with particular countries can find themselves targets of sophaisticated people who have little else to do. Digital security has to become a strategic issue, which is still an unusual approach among corporations.

Microsoft Yodels Yahoo

(The following is a story of mine running translated right now in Newsweek Japan)

It only took one initial report a little over a week ago about potential merger talks between Microsoft and Yahoo to generate some of the biggest buzz the online industry has seen. Even as further stories suggested that the two companies were actually considering a strategic online partnership, interest was still intense because of one word: Google.

The search engine company has competed online with Yahoo and Microsoft and thrashed them both, becoming the premier destination for finding information and delivering ads. And so Yahoo and Microsoft hope that somehow the combination of the former’s audience – the top ranking web destination according to site ranking service Alexa.com, with visits from more than 25 percent of all global Internet users – and the latter’s technology leadership might let them compete more effectively.

Were this any other industry, the combined forces would be powerful: almost $51 billion in 2006 revenue and well over 80,000 employees. However, on the Internet, size isn’t enough. Customers must identify a company and its site as the preferred spot to get something done, whether to keep in contact with friends, share video, get news, or look for some piece of information. Lack that connection with people, and your business is bound for bad times. Microsoft and Yahoo is just one example in the online industry of how companies are trying to use alliances to gain a spot in the hearts of customers – though it’s not clear that the approach will often work.

Finding examples of corporations that are using acquisitions for greater customer contact is easy. For example, Yahoo bought the popular photo sharing site Flickr (recently closing its own service, Yahoo Photos, because so few people used it). News Corp acquired personal networking destination MySpace as part of Fox Interactive Media, the Internet division the company created in 2005. “That’s working out quite well,” says a top venture capitalist Todd Dagres of Spark Capital. “MySpace already had presence in the online world that Fox didn’t.”

The difference between these acquisitions and a possible Microsoft-Yahoo marriage is that they were targeted at popular but still niche properties that had enthusiastic customer bases. Amalgamating more broadly based companies, however, is too unfocused. Unless companies can catch the eye of the public, they will remain stuck where they are as their competitors blow past them.

Google is a danger to Microsoft and Yahoo because it competes with them in the vital areas of search engine services and online advertising, being far more successful at both. According to NielsenNetRatings, Google’s share of U.S. searches in March was 53.7 percent, while Yahoo had 21.8 percent, and Microsoft, 10.1 percent. So Google brings more people in who want information.

Then it delivers small ads whose content matches the search terms that users choose. The result is advertisements that people often actually want to read – and many advertisers willing to pay lots of money to Google. According to Karsten Weide, program director of digital media and entertainment at market researcher IDC, Yahoo was the online advertising leader until 2005, when Google blew past them. Last year, according to research firm eMarketer, Yahoo had 15% of U.S. paid search advertising, compared to Google’s 58.7%, and next year it projects Google as taking over three-quarters. “It’s dominant already and growing so fast that it will be difficult for the other players to catch up,” he says.

That spells trouble for the other two. According to Yahoo’s 2006 annual report, 88 percent of the company’s revenue came from advertisers. And while 80 percent of Microsoft’s income is from selling copies of Windows and Office product families, the company sees its economic future elsewhere because the old software lines are now mature businesses that are unlikely to offer high rates of business growth. Before becoming vice president of media development at PodTech.net, Robert Scoble was a Microsoft developer who also wrote a popular blog about the company. He remembers upper management stressing two years ago “that the growth of the company will come from advertising, not from selling another copy of Windows or another copy of Office.”

Yet Microsoft’s online advertising revenues have been flat at about $2.3 billion for the last four years while the industry has grown at an annual rate of over 30 percent, according to Weide. That means the company has faced a constantly declining market share. “I’m at a loss,” he says. “How do you pull zero percent in a growth climate like that? It’s an accomplishment in itself.”

The problem is that bigger is not necessarily better on the Internet. The attitude comes from an old strategy of traditional industries. By acquiring other businesses, a company could create economies of scale, driving down manufacturing and distribution costs and pressuring competitors. On the Internet, though, a small and reasonably funded company can quickly reach millions of consumers: look at MySpace or YouTube.

Microsoft’s difficulty is that it understands selling packaged software, not the media world of online, so it tries to copy someone else’s success. According to Scoble, Microsoft is preoccupied with FOG – fear of Google. “Microsoft has some technologies that are really good, but they’re in clone world right now,” Scoble says. “They’re trying to clone everything that Google is doing.” For example, Microsoft is emphasizing online ad sales and even giving away use of software business applications on its Live.com site. Unfortunately the drive to copy another means that the company remains reactive to the Internet and not developing the new services that will catapult it to the lead among consumers.

Yahoo has a grasp of media, but can’t force how consumers will react. Look at its acquisition of photo sharing service Flickr. That step was necessary because Yahoo’s own photo sharing service, Yahoo Photos, simply never caught on with users. “Now you’re going to bring that together with a behemoth like Microsoft and be able to operate in a nimble and innovate way in an industry that really thrives on rapid [change]?” asks Willan Johnson, formerly a vice president at Yahoo and now general manager of SupplyFrame.com. “Many have speculated that if that deal went through, you’d want to buy Google stock.”

In the view of Kim Caughey, a senior investment analyst at Fort Pitt Capital Group, the combined entity would have a hard time hiring the “cool people … to continually create new products to drive people to your web sites and capture eyeballs.” They would find a large-scale company a bad fit. “If they have a really great idea, venture capital will give them money,” she says.

Smaller entrepreneurial divisions might do the trick, but large companies typically don’t have interest in such endeavors because the returns are too small. Scoble found this when he worked at Microsoft and in 2005 urged management to consider purchasing such companies as MySpace, Flickr, or Internet phone service Skype when they were much smaller and less expensive to acquire. “I was telling them to pay attention to something that hadn’t yet sold for $20 million,” he remembers. “I asked, ‘Why aren’t you doing things in this market?’ and the answer was, ‘We’re too busy … running multi-billion dollar businesses.’” By the time large companies see the value, it’s often too late to acquire the truly innovative businesses that are now literally worth billions of dollars.

There still might be sense in a close alliance between Microsoft and Yahoo, even if not for an online consumer market. Caughey says there might be natural synergy for corporate customers – an integration of Microsoft’s commanding presence on desktops with Yahoo’s search technology. The two could become a way to pull together data scattered throughout a large company in the form of word processing documents, spreadsheets, and other files – an area that has caught Google’s eye. Or Yahoo and Microsoft could develop software and systems that would allow others to create the next big thing for consumers. Maybe even Google developers could give the products a test. They probably wouldn’t have to search too hard to find them.

Internet Insecurity

As Network World reported, a homeless man accidentally knocked out service on the Internet2 network between Boston and New York by unintentionally starting a fire.

Many people in this country worry about security, particularly in relation to terrorism, but they forget how vulnerable much of the infrastructure is. I remember talking to one expert a few years ago who said that until shortly before our conversation, he knew of a major Internet switching point that was essentially unguarded. One car bomb could have taken out a whole lot of traffic all around the country, and even the world.

When Copyright Protection Meets Users, Guess Who Wins?

Today's New York Times story about Internet users spreading a key anti-piracy code from Blu-ray and HD-DVD disks offers a number of business lessons. First, the quick background: people have been relentless posting - in some ingenious ways - a secret code found on high definition video disks since it was unearthed in February. An industry group - the Advanced Access Content System Licensing Administrator, which has such members as IBM, Intel, Microsoft, Sony, Disney, and Warner Brothers - decided to stop things in their tracks and began sending cease and desist letters, claiming that publishing the code was a violation of the Digital Millennium Copyright Act of 1998.

That was about as effective as putting out a fire with jet fuel. People put the code up everything and in forms including lyrics of a song and hidden within the information of a digital photograph. Even though such actions are against the law, there are so many people doing it that the industry hasn't a practical prayer of going after anyone legally. This is the nature of the Internet hydra: for each user you legally smite, dozens more pop up.

Now to the lessons. One is that if command and control attitudes didn't ultimately work with employees, what made anyone think that it would with customers? Another is that companies really out to learn from experience, as the same thing happened when hackers broke the copy protection on DVDs. Third is that when you try to maximize your profits and customers perceive that it's at their expense, they will be unhappy and find ways to make you unhappy.

The Internet has changed business, but not in the way most managers understand. The real difference isn't speed or global distribution, but rather a leveling of the communication playing field and the ascendancy of ideas that the communications can transmit. Company value is in intellectual property (ideas), though few act as though it is. Customers can talk to each other using an electronic megaphone that is largely out of the control of corporations, and the ideas they express can have demonstrable impact on companies. Treat the customers with respect and you may get it returned. Try strong arming them, and the attempt is likely to blow up in your face.