Exclusive interview with Bill Gates on how Yahoo! takeover will challenge Google

Gates intends to step down from the day-to-day running of Microsoft in July to devote more time to his charities.

It has been three decades since Gates and co-founder Paul Allen set up Microsoft. The company's Windows software is the world's dominant operating system. But in the internet age Microsoft has been losing its edge and arch-rival Google has come to dominate the web as Microsoft dominated the computer desktop.

However, as last week's move shows, the fight is far from over. Gates told The Sunday Times: "Go back and look at the predictions every year since 1985. What you will see is only one constant. Every article predicts that the leader will be replaced, no matter who the leader is, and some day they will be right.

"Some day they will say Microsoft will be replaced, and in 10 years or 20 years from now, they will be right. So just keep going because it will be one out of 20 times. That is good enough for some people."

Not good enough for Microsoft. As Gates prepared to step out of the back door, Ballmer was kicking in the front one. LAST month Jerry Yang gave his first, and possibly last, speech as chief executive of Yahoo at the Consumer Electronics Show in Las Vegas. He opened with an apology.

"I'm guessing that a lot of you are here today to see what the new look and new face of Yahoo is all about," he told the audience. "Well, I'm sorry to disappoint you. It's still the same old face. I've been around since the beginning."

He went on to demonstrate a lot of stuff that many felt they had seen already. There was a lot of shuffling in the audience.

Yang and David Filo set up Yahoo in 1994 while studying electrical engineering at Stan-ford University.

Today Yang, 39, is a multi-bil-lionaire and founder of one of the biggest internet brands on the planet. Yahoo is visited by more than 130m people a month and had sales of close to $7 billion last year. On the surface there wouldn't seem to be much to apologise about. But Yahoo is in trouble.

Yang returned to the top job at the company last summer after a string of disappointments for shareholders. Last week they were disappointed again and Yang was issuing yet more apologies.

Blaming "headwinds" for poor results, Yang revealed Yahoo's final-quarter profits had fallen 23% to $205m. Now 1,000 jobs, 7% of its workforce, are to be cut in the company's biggest down-sizing since the collapse of the dotcom boom at the beginning of the decade.

Yang promised change and better times ahead, but some of those listening said they had heard it all before. Sandeep Aggarwal, an analyst at Oppen-heimer, wrote to investors saying "a management change or chatter of a sale are the only cat-alysts that could get the stock heading materially higher".

They didn't have to wait long. Within hours of Yang's presentation, Microsoft, advised by Blackstone and Morgan Stanley, made a cash-and-stock offer of $31 a share, a 62% premium on Yahoo's closing share price on Thursday.

Once the dominant internet search firm, Yahoo's share in the US market has dwindled to 23% compared with Google's 58%. The online advertising market is now worth $80 billion. Google dominates online ads that are tied to search results, but Yahoo still leads in display advertising - for now. However, a fundamental shift is threatening that market too.

Advertisers have keenly followed the rise of social-net-working sites like Facebook and MySpace and their money is moving with them.

Yahoo was in on/off negotiations with Facebook for months but lost out to Microsoft, which took a significant stake in the firm last October. It was not the first time that Yahoo had been left looking flat-footed.

When Google was in its infancy, Yahoo could have bought the firm for a fraction of its value today. Instead Yahoo gave Google its first big break by agreeing to use its search service. Yahoo has been playing catchup ever since and had to spend a fortune buying smaller rivals to compete.

Then came promises that, critics charge, Yahoo failed to fulfil. Project Panama, new software aimed at sharpening competition with Google, was troubled by delays. Yang said last week Panama was helping the company improve its advertising revenue. But the improvements are not coming as quickly as some investors hoped.

According to an analysis by Efficient Frontier, a search-en-gine marketing company based in California, Yahoo is rapidly losing share.

Comparing 2006 and 2007, Efficient Frontier found that out of every dollar in incremental spending advertisers were putting online, Google was taking 97 cents, Microsoft was taking 6 cents and Yahoo was losing 3 cents.

"That is not a good story." said Ellen Siminoff, Efficient Frontier's chief executive and a former Yahoo woman.

The decline is not due to a failure by Yahoo to attract advertisers or a shrinking market for online ads, it's just that Google is streaking ahead. "They are clearly the winners in this category," she said.

This deal is about more than search and advertising, though. The internet has woven itself into the fabric of everyday life. Not so long ago technology sat on a desktop and software was something that came on floppy disks. Today software can be downloaded online and people are just as likely to access e-mail or other software-driven services via a mobile device as a computer.

The "digitisation" of everyday things is not something that is going to stop, said Gates. "There are things you do digitally today like organise your music collection or photos, and sharing them," said Gates.

"In the next 10 years, those things will become a lot better. When you take a photo on your phone, it will immediately go to where you want it, so you can share it with your relatives or label it. Taking photos of your kids growing up will become easier. That is very neat.

"People have a view of that to some degree. There will also be things like reading the newspaper from the screen with a tablet device. TV will not be delivered over broadcast channels but over the internet."

In order to make sure Microsoft plays its part in this new flexible, digital world, the company needs a radical overhaul. Ballmer acknowledged as much last week. The deal "really represents a transformation of our business," he said. "The Windows experience increasingly needs to embrace the internet."

So far Google has led from the front in the online revolution, but, the company's critics say, it's a one-trick pony. Admirers would counter it's one hell of a trick. Google's sales topped $16.5 billion last year, but 99% of this came from ads based on its phenomenal search system. GOOGLE has started a whole range of add-on businesses like GMail, its e-mail system, and Google Maps.

But for all their technical wizardry they don't add a penny to the bottom line. That doesn't matter at the moment but there are signs that it may, and sooner than Google might Last week the firm disappointed Wall Street after it reported fourth-quarter profit rose 17%, compared with 46% profit growth in the third quarter. Revenue rose 51% from a year earlier, but Google's shares still took a pounding.

Gates has some sympathy: "The share price can be very high or very low; that is not what we control. We control innovation, sales and profits. Those are the things that have done super well." Microsoft has been building its business away from software. XBox, its gaming system, is a serious rival to Sony. Now, if things go as planned, it has Yahoo. The combined company would be a threat to Google's dominance of search and Microsoft has big plans to change "the whole way of how you think about search and why it can be tons better than it is today", said Gates.

Hostile mergers have a nasty habit of unravelling. Yang has held out against Microsoft's advances in the past, and even if the deal does go through, competition authorities will want a look and Google will fight hard to have it blocked.

No-one today has a tighter grip on the internet than Google. But tomorrow?

"The new companies are interesting and it is exciting, but the fundamental things that advance software - digital recognition, speech recognition, security-proof, model-based development - our research labs have been working on for over a decade," said Gates.

"That is where the really big stuff comes and is what makes me confident about our future."