• by Diane Mermigas , July 31, 2009

Can Yahoo improve advertising sales and create innovative content and services enough to make its new search pact with Microsoft profitable? The jury is still out on whether Yahoo will sell better than it could search.

Yahoo will handle the global ad sales for the companies' combined premium search platforms, which Microsoft will power. Their economics of scale does not assure that Yahoo will sell, follow through and match the "right" ad for the "right" search user. The advertising sales component is a complex process on which the success of this new partnership depends. Microsoft CEO Steve Ballmer says the alliance is all about "relevance."

In that context, it is worth noting Yahoo's ongoing transition to improve its advertising, content and service. Company executives outlined their ambitious plan during Yahoo's second-quarter earnings call, a week before it announced its pact with Microsoft.

Like most makeovers, it will require time and money. Initially, Yahoo is eliminating $75 million in low-quality, high-frequency ads to concentrate on more lucrative targeted ads with an increased investment in engineering, sales and marketing. While Yahoo maintains complete control of its leading display ad business, overall display revenues are expected to decline 8% this year, which it could make back in 2010 in an economic recovery.

Even supportive analysts say they are uncertain about the outcome and cost of such enterprising initiatives, complicated by the integration and execution risks of interfacing the two companies' very different advertising operations.

Although Yahoo's new home page design includes intriguing social and engagement elements (including live updates from YouTube and Facebook), its rivals -- including Microsoft and AOL -- are aggressively enhancing their content and services. In fact, the partnership with Microsoft just makes Yahoo more like AOL -- media content companies selling their own advertising.

If the proposed search deal with Microsoft fails to secure regulatory approval, Yahoo could potentially emerge a weaker stand-alone, vulnerable to takeover. If the 10-year deal conditionally proceeds, Microsoft will poach the core search technology Yahoo has spent a decade growing just to remain a distant second to Google.

In the two years it takes to approve and fully implement the new arrangement, Yahoo will need a growth strategy that does not depend on the projected savings of $650 million in operating costs and $200 million in capital expenses it will not realize until 2012. Even then, Yahoo will sustain a $150 million negative impact on annual revenues and gross profits as a result of sharing 12% of ad revenues with Microsoft, according to Credit Suisse analyst Spencer Wang.

Yahoo's primary value from the proposed alliance is cost savings. It is going to find out the hard way how difficult it is to expand and grow advertising sales, content and services now that it "has effectively decoupled the value of its audience from its search engine and monetization platform," Wang says.

Yahoo's future -- with or without Microsoft -- depends on how well it meets a "boatload" of challenges, borrowing the word used by Yahoo CEO Carol Bartz to describe the revenue windfall she assured investors would come from this deal:

*Without complete control of its search platform, it is unclear Yahoo can continue to build innovative new search/display programs like its rich ads in search launched earlier this year, Barclays Capital analyst Douglas Anmuth said.

*Yahoo brings about 500,000 advertisers and Microsoft contributes about 200,000 search advertisers, compared with more than 1 million at Google. But Yahoo ad sales will not be explicitly compensated for selling Microsoft search queries, and Microsoft is not contributing any major new ad sales technology to better go up against Google.

*Although Yahoo executives say they are cautiously optimistic that "less fear" by advertisers will prompt an uptick in spending later this year, the company will likely see a -14% decline in net revenues and earnings in 2009, and only a 7% gain in earnings on a 3% gain in revenues in 2010 with an improving economy, analysts say.

*The new pact does not include any revenue guarantees or upfront payments -- only 88% of search revenues to cover Yahoo's traffic acquisition costs during the first five years. Yahoo's rising costs will include adding sales staff who are familiar with Microsoft's logistics and able to integrate both companies' ad sales cultures with the least amount of friction. Yahoo has no financial safety net through this transition, which is why its stock plummeted more than 15% following the announced agreement.

*Yahoo is left to develop an all-important mobile strategy on its own.

*There is no guarantee that Microsoft can change the competitive dynamics even after buying itself 30% search market share against Google's 65%. If Bing takes share from Yahoo search, Yahoo "will not participate in Bing's success beyond potentially a more robust bidding platform and higher overall RPS," Anmuth observes.

*Microsoft will be expected to be as aggressive selling ad impressions against Yahoo Finance, Yahoo News and other branded content even though it competes with its own content. Unlike Google, Microsoft's Bing organizes content by search relevance, not algorithms, and promotes itself on delivering "answers" instead of Web pages. There are some early concerns that Yahoo may not be allowed legally to share relevant user data with its new partner to assure an effective search and ad sale interface.

*Although Yahoo retains full control of its leading display ad business, it is under more intense competition from fragmentation and a growing share of non-premium inventory, both resulting in lower CPMs, Anmuth said.

*The new pact does nothing to assist Yahoo in coping with the core issue of the declining relevancy of portals compared with search engine home pages, Wang observes.