http://www.nytimes.com/2005/09/16/technology/16aol.html?dlbk=&pagewanted=print
September 16, 2005 Microsoft Said to Be in Talks on Forming Link to AOL By Saul Hansell Microsoft and Time Warner have explored a variety of possible combinations of the MSN Internet portal with the America Online operation of Time Warner, including a merger of the two into a new company that would be jointly owned, according to several people involved in the talks. The discussions were initiated by Microsoft, which has Google, its new archrival, clearly in its sights. Microsoft is trying to focus its Internet operations on its developing Web search product rather than its Web portal and Internet access business, which it no longer sees as strategically important. Microsoft offered to sell its MSN Internet portal and dial-up subscriber business both to America Online and to Yahoo, according to several people with knowledge of the talks. While Yahoo considered and quickly rejected the proposal, Time Warner, the parent of America Online, expressed interest. Top executives at the companies discussed a variety of potential transactions as recently as three weeks ago. Those talks, however, are in suspension as Microsoft considers its strategic position, people involved in the discussions said. Representatives of Time Warner, Microsoft and Yahoo declined to comment. The most elaborate proposal being discussed would involve combining America Online with the MSN Internet portal and dial-up Internet business, creating the world's largest Internet company. The venture's Web search would be provided by Microsoft. That combination would be a significant blow to Google, which provides the Web search on AOL's services. This year, 11 percent of Google revenue came from advertising it placed on AOL sites. A combination of AOL and MSN would have 18 percent of the search market in the United States, according to Nielsen NetRatings, making it third after Google, with 46 percent, and Yahoo, with 23 percent. Indeed, much of Microsoft's motivation to do such a deal is to head off a threat it sees from Google. Microsoft's worry is not so much Google's Web search business. Microsoft sees in Google the potential to offer a variety of Internet services, using Google's vast network of servers, making it less necessary for people to buy Microsoft software or even computers with the Microsoft Windows operating system. Moreover, Google could offer free desktop software as well, supported by its network of advertisers. "Ultimately Microsoft knows that the software landscape will shift from the desktop to the hybrid of the Internet and the desktop," said Gene Munster, an analyst with Piper Jaffray. "Google has thrown out warning shots that they will be players in many of the significant areas of software." Time Warner, meanwhile, has been trying to figure out if AOL fits into its amalgamation of companies, especially because AOL's core dial-up Internet access business, while profitable, is shrinking as customers shift to high-speed service provided by telephone and cable companies. AOL has been trying to build a free, advertiser-supported portal business. Combining that effort with Microsoft's large MSN portal, along with Microsoft's popular Hotmail e-mail service, could accelerate AOL's progress toward its goals. The merged company would leap past Yahoo as the biggest Internet portal and have a more credible case to make to advertisers. Another advantage of a deal is that MSN is strong in many countries while AOL has focused mainly on the United States and a few European countries. Being able to describe AOL as a leader and bring in the backing of Microsoft, Time Warner executives hope, may reverse investors' negative perception of AOL, which they believe has been dragging down Time Warner stock. If such a deal were successful, the venture might eventually issue shares to the public. AOL's management has long wanted the flexibility of making acquisitions with a separate stock as well as independence from Time Warner, where many executives still resent the terms of the 2000 merger of the two companies. Michael Nathanson, an analyst with Sanford C. Bernstein, said such a deal would probably help Time Warner's stock. "The deal will be trumpeted so much that the stock will go up," he said. The discussions of potential deals are said to have begun early this year, when Microsoft approached AOL in hopes of persuading it to drop Google and use MSN's new Web search service. (Microsoft has been having similar talks with nearly every major company that offers Internet search.) Talks progressed and explored many options, from a combination of ad sales staff to a full merger of AOL and MSN. The possibility of a deal by Microsoft and AOL was first reported by The New York Post. A deal with AOL could provide widespread distribution for Microsoft's search system and a platform for developing Microsoft's own Internet-based services. An AOL merger would also provide a graceful exit from MSN's stagnant dial-up Internet service business, which still has several million subscribers. But Microsoft would also have to give up some control over the future of technology that could be strategically important to its future. Bill Gates, Microsoft's chairman, is not known for giving up control of anything. Indeed, MSNBC, Microsoft's 50-50 joint news venture with NBC, has been a source of friction, because Microsoft executives believe it has limited their ability to make decisions on their own. Indeed, disentangling Microsoft's contract with NBC may well be one of the most difficult parts of pursuing a deal with Time Warner, which owns the rival CNN network. Some important issues in the talks remain undecided. For example, both AOL and Microsoft want to control a combined instant messaging system, which each company sees as strategically important technology. Another question is how much traffic Microsoft would direct to the combined venture. Until recently Microsoft was able to use its browser and other software to direct people to MSN by default. But a combination of legal settlements and contract changes have allowed computer makers to set their own default home pages for browsers. The next version of Windows is designed to be even more neutral about Internet services, thus providing less of a boost for MSN. Indeed, that is one reason Microsoft is now interested in getting out of the Internet portal business. The financial terms of a transaction have not been fully explored because they depend on which assets would be combined. Because AOL is bigger and more profitable than MSN, Time Warner would own a majority of a combined operation, unless Microsoft put up cash to increase its stake. Analysts value AOL at $10 billion and $20 billion. Mr. Nathanson said he hoped the companies do not create a venture in which the owners have equal control because such arrangements typically become bogged down in wrangling. "There has to be the lead dog," he said, "and someone has to give up control to make it work." Richard Siklos and Andrew Ross Sorkin contributed reporting for this article. Copyright 2005 The New York Times Company Ray T. Mahorney WA4WGA
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