With the Yahoo-Microsoft deal can Google still make the steal?

The bumpy, marathon mating dance between Microsoft and Yahoo finally concluded, when the two companies announced a partnership in Internet search and advertising to take on the industry powerhouse Google.

But there was plenty of skepticism about whether the new partners could make a serious dent in Google’s dominance.

Even with the deal, the Microsoft-Yahoo search operation will be dwarfed by Google — with a 28 per cent market share in the United States, versus 65 per cent — and will face an uphill struggle to try to wean people away from Google’s simple white search page.

If Yahoo and Microsoft cannot persuade people to switch, they will not build the larger audience that will bring in more revenue from ads tied to searches.

“This battle is won or lost as the user sits at the keyboard,” said Peter S Fader, a Professor at the University of Pennsylvania and Co-director of its Interactive Media Initiative. “Google is winning for good, consumer-friendly reasons. You can’t just buy that.”

The Microsoft-Yahoo pact represents a pragmatic division of duties between the two companies, instead of the blockbuster deal Microsoft, No 3 in the search market, was shooting for last year when it bid $47.5 billion to buy Yahoo, No 2 in search. That hostile offer was ultimately withdrawn by Microsoft, and its collapse led to lots of soul-searching at Yahoo and the replacement of its co-founder Jerry Yang with an outsider, Carol Bartz, in the Chief Executive role. Under the pact, Microsoft will provide the underlying search technology on Yahoo’s popular Web sites. The deal will give a lift to Microsoft’s search engine, which it recently overhauled and renamed Bing. Its search ads will have broader reach and become more lucrative. Bing, which tries to put search results in better context than rivals, has won praise and favourable reviews, after Microsoft spent years falling farther and farther behind Google in search. For Yahoo, the move furthers the strategy under Bartz to focus the company on its strengths as a publisher of web media sites in areas like finance and sports, as a marketer and leader in online display advertising. 

“This deal allows Yahoo to invest in what we should be investing in for the future — audience properties, display advertising and the mobile Internet experience,” Bartz said in an interview. “Our vision is to be the centre of people’s lives online.”

The terms of the 10-year agreement give Microsoft access to Yahoo’s search technologies. Yahoo will receive a lucrative 88 per cent of the search-generated ad revenue from its own sites for the first five years of the deal, much higher than is standard in the industry.

After the takeover bid failed, the companies renewed talks about a partnership last summer. The talks included discussion of a large upfront payment from Microsoft. But when Bartz joined Yahoo at the start of this year, the interest on the Yahoo side shifted.

Bartz was more interested in steady revenue to ensure the longer-term financial health of Yahoo instead of a big payment, she said in a conference call. Shares of Yahoo fell 12 per cent, to $15.14, after the deal was announced, apparently reflecting investors’ disappointment in the lack of a payment. Shares of Microsoft rose slightly.

“It feels kind of like a stab in the chest,” said Jacob Internet Fund Co-Manager Darren Chervitz,  which owns about 100,000 shares of Yahoo. “It certainly feels like Yahoo is giving away their strong and hard-fought share of the search market for really a modest price.”

Financial fate

Now, Yahoo’s financial fate will be inextricably linked with Microsoft for years. “My sense is that Yahoo will regret making this move,” Chervitz said.

If the deal is completed next year as planned, and after the partnership is fully in place in three years, Yahoo estimates that its operating income will increase by $500 million a year, based on the anticipated higher search traffic and ad revenue, and a substantial drop in its investment in technology development.

Microsoft’s Chief Executive Steven A Ballmer said in an interview that  Bartz had driven a hard bargain. “Look,” he said, “she got 88 per cent of the revenue and none of the cost.”

Still, Ballmer added that he won something he badly wanted as well. “I got an opportunity to swing for the fences in search.”

The crucial issue for the partnership, analysts say, is its ability to stop and reverse the advance of Google, which has steadily gained in search and search ad share in the last few years while Yahoo and Microsoft have kept on fading. Reversing the trend, they say, would give the partnership newfound credibility with advertisers and publishers.   “If Microsoft and Yahoo are 30 per cent and growing in search, then the dynamics of the market can shift,” said Harvard Business School Professor  David B Yoffie. Fader of Wharton said he was not sure the partners would be able to shake up the business.

“Microsoft is buying some market share, but there is no evidence they are going to change the game in any fundamental way,” he said. “What the Microsoft-Yahoo partnership needs is real breakthroughs to deliver disruptive innovation in search.”

Advertisers and Web publishers say they will be looking to the combination to improve its search technology and service and put more pricing pressure on Google, which has turned the small text ads that appear next to search results into a multibillion-dollar business. “It could be a more competitive marketplace, but that’s not certain,” said Bob Liodice, President of the Association of National Advertisers, a trade group. “Google still holds two-thirds of the market.” Branding was one important consideration in the deal.

Yahoo will still control the look of the search features on its sites and will determine how search technology may be tailored differently for, say, entertainment and finance sites.

But Yahoo’s search will include a logo saying “Powered by Bing.”

And Yahoo will be able to tap into records of searches for its own purposes, like monitoring the online behavior of anonymous users to more efficiently place online display advertisements.

Throughout a conference call and the later interviews, Bartz and Ballmer emphasised that combining the No 2 and No 3 companies in search would not harm competition but enhance it. Google was rarely mentioned by name, but it was the subtext of the conversation and the deal itself. Bartz pointedly said the partnership would “put choice back in the hands of consumers, advertisers and publishers,” all of whom, she said, were “increasingly concerned” about the rising power of Google.  Microsoft and Yahoo said they expected resistance from Google. But Microsoft’s General Counsel, Bradford L Smith, said he looked forward to explaining the details of the planned partnership to antitrust officials in Washington and Brussels.

“There is a compelling case that this is going to increase competition,” Smith said.

The Microsoft-Yahoo stance, legal analysts noted, amounts to the assertion that Google is so dominant in Internet search and search advertising that the best way to foster competition and innovation is with a duopoly — with the Microsoft-Yahoo partnership creating a credible rival to Google.

“That is a pretty strong story, and I suspect the one they will present to the Justice Department,” said Andrew I Gavil, a Law Professor at Howard University.