The Evil Empire Stirs

We face significant competition from Microsoft… Microsoft recently introduced a new search engine and has announced plans to develop features that make web search a more integrated part of its Windows operating system or other desktop software products. We expect that Microsoft will increasingly use its financial and engineering resources to compete with us. In addition, advertising and other fees generated from one Google Network member, America Online, Inc…accounted for approximately 12% and 11% of our revenues in 2004 and in the six months ended June 30, 2005…—Google prospectus, 9/9/05. Demonstrating its growing concern about Google Inc., Microsoft Corp. has entered talks with Time Warner Inc. about taking a substantial stake in the media giant’s America Online unit, said people familiar with the matter. The conversations have centered on whether AOL would switch to using Microsoft’s search engine instead of Google’s, these people said, as well as other areas of potential cooperation. AOL and Google shared about $380 million in revenue last year derived from displaying ads on AOL’s search results.—Wall Street Journal, 9/16/05.

I apologize up front to those of you who, based on the title of this piece, expected commentary about Sith Lords and Master Puppeteers and other fantasies of a certain CEO who sees conspiracies to ruin his share price where others merely see what they believe to be a lousy business model and poor corporate governance.

The “Evil Empire” referred to in the title is, of course, Microsoft, whose own CEO—the brilliant and irascible and monopoly-spoiled Bill Gates—has decided to target Google after letting two Stanford grads undermine his hold on the hearts and minds of millions of Windows users around the world, and, ultimately, threaten that very monopoly by making the software underlying the search platform irrelevant to the user.

And now we see one thrust of Bill’s attack plan: pick up in a single, quick move the biggest piece of Google’s business—that portion of its revenues generated by AOL users who do Google searches from the AOL web site.

The timing couldn’t be better.

Google just priced its secondary offering of 4-plus million shares at $295 a share, after management road shows that included meetings with some of the biggest funds on the planet and a luncheon at the top of the St. Regis in New York—the main feature of which was co-founder Sergey Brin, young and scary-smart, looking for all the world like a high school sophomore dressed for his first prom in a new and very uncomfortable suit and tie.

For the record, as readers have gleaned, I own shares of Google, because I think the earnings power of the business is much higher than Wall Street thinks. But I could very well be wrong and change my mind in a minute, and I don’t recommend anyone go near the stock.

Why point out a very large potential short-term negative to Google—i.e. the Evil Empire’s courtship of a damaged AOL and the one trump card in its otherwise weak hand?

Well, because it’s right there on the front page of the Wall Street Journal, and because we all knew this day was coming.

In previous posts, I’ve argued that “you can’t under-price free”—meaning that Microsoft’s disadvantage in the search wars is that users don’t pay for search, and, therefore, Microsoft couldn’t undercut Google the way it undercut Borland and Lotus and WordPerfect and Novell and all the dozens of other software companies it destroyed by selling under-priced software subsidized by its desktop operating system monopoly.

But, here, at least, is an example of where Microsoft might be able to simply buy outright more than one-tenth of Google’s current search revenues by cutting a deal at the source—the AOL web site.

I do not know details of the AOL/Google contract, but today’s WSJ reports that “people close to AOL say the company has the option to walk away.”

If I was Bill Gates and had $40 billion of cash in the bank, my “negotiation” with Dick Parsons of Time-Warner (parent company of AOL) would go something like this: Gates: “We want to buy an equity stake in AOL in return for AOL walking away from Google and giving that business to MSN.” Parsons: “Okay. We’re willing to sell—” Gates: “Done.” Parsons: “I haven’t told you what we’re willing to sell to you, or the price.” Gates: “Sorry. Hurry up.” Parsons: “We’re willing to sell 49% of AOL for twenty—” Gates: “Done.” Parsons: “I haven’t told you the whole price.” Gates: “Sorry. Hurry up.” Parsons: “For twenty-five—” Gates: “Done.” Parsons: “I’m not finished. For twenty-five HUNDRED billion—” Gates: “Here’s the check—fill in the blanks.” But that’s just me. However this supposed deal works out, if at all, one thing is certain: Darth Vader is looking for blood. I’m rooting for Luke.

Jeff Matthews I Am Not Making This Up

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations.