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Brandt: Yahoo and Microsoft a Powerful Partnership

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CNBC.com

When Microsoft and Yahoo announced their search engine and advertising sharing deal on Wednesday, Yahoo's stock dropped about 11 percent.

Although that was in a down market, Google's shares dropped just over one percent.

Investors don't seem happy with the deal, at least for the short-term.

That's the problem with the stock market.

This deal is much better than previous proposals from Microsoft . What probably disappointed investors is that, rather than getting a big up-front payment of millions of dollars as proposed in previous negotiations, Yahoo CEO Carol Bartz made sure this deal is designed for the long term, getting 88 percent of revenues from ads Microsoft places on yahoo's sites.

Rumors of a deal had apparently driven up Yahoo's stock price. Note that the volume of trading in Yahoo's stock increased dramatically in early July, from about 15 million shares a day on July 8 to about 54 million shares on July 22. In that time frame the stock price rose from just over $14 to over $17. After the deal it dropped back to about $15.

That means traders don't necessarily think this is a bad deal, it's just not one that immediately goosed the stock. Kudos to Bartz for not taking the easy path to please the market. The question is how good the deal will be in the long run, and the 10-year time frame for the deal is and extraordinarily large one on the Internet.

Still, this is a much better deal than previous proposals to buy Yahoo or its search engine. (Ironically, the big reversal here is that it now appears that Microsoft has decided its own search technology is better than Yahoo's.) Mergers between big companies in technology rarely work because of huge culture clashes and integration problems that distract management.

With this deal Microsoft gets a big increase in use of its new Bing search engine, a feat that's extremely important to the company. It will also license some of Yahoo's search technologies, presumably taking the best features to further enhance Bing. Most important is the fact that Microsoft will use its search engine to place relevant ads from smaller advertisers to accompany search results, with most of that revenue going to Yahoo. Both companies benefit from that.

But there are still some big caveats.

The first question is whether it will pass muster with the FTC and Justice Department, which was ready to kill a similar deal between Yahoo and Google earlier this year. Microsoft is confident: General counsel Brad Smith said he was looking forward to explaining to regulators why the deal will increase competition.

The second question has not been addressed.

Google Headquarters
AP
Google Headquarters

Will a combined Microsoft and Yahoo do better in the search advertising business, where Google holds some 75% market share in the U.S.?

Superficially, yes.

With higher adoption of Bing, advertisers are more likely to try placing ads on its search results. That's something that Microsoft desperately needs.

But will the ads will be as good as those from Google, which has had several years to refine its system? In a previous post, I mentioned that Bing seems to have a lot fewer and less relevant ads than Google (although a Microsoft representative assured me in an email that it does not place advertisers in search results, a discredited technique, as I had reported.) With more search results to study and more advertisers, Microsoft's automated ad bidding system will surely get better at creating relevant ads, but it has to become great at it.

Yahoo, however, will continue to use advertising representatives to place display ads for big advertisers. That is a highly questionable tactic, as Google itself found. A few years ago, Google used ad reps to sell its premium ads. Larry Page and Sergey Brin insisted on switching to an automated bid system. CEO Eric Schmidt was so worried that ad prices would drop, he instituted a limit on spending, which became known at Google as the “crap period.” But within three weeks, it became apparent that the automated bids were pricing the ads twice as high as the ad reps, and Google never looked back. Yahoo has yet to have the courage to fully make that leap.

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Everyone also seems to be impressed that Yahoo will be free to focus on its core competency, building its own media sites. That is, however, still a risky business. Yahoo is not competing with Google there, but with the entire world. If it cannot create the best content in the world, it's easy to find sites elsewhere that do. That's a task bigger than scaling Mt. Everest. Google leads searchers to the best content on the Internet, wherever it lies. Will Bing start giving preference to Yahoo's sites, regardless of whether or not they are better?

The key to the deal is increasing ad revenue for both companies. That's tough short-term, because advertising is in recession mode. But it will recover. And when it does, the deal could increase revenues for both companies.

What they're saying about Yahoo/Microsoft:

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Richard L. Brandt is a journalist with over 20 years’ experience covering science, technology and business. He is the author of the upcoming book, INSIDE LARRY AND SERGEY's BRAIN (Portfolio, September, 2009).