Yahoo-Google: An Alliance That Could Work

The hubbub over the ongoing Micro-Hoo saga and the anticompetitive overtones of Yahoo's pending search service pact with Google eclipses one of the more savvy value creation maneuvers of recent times.

If the Yahoo-Google alliance passes regulatory muster, it will significantly close the monetization gap between the two companies and eventually generate at least $2 billion of new annual revenue. That's not bad for a deal that occurs as a result--and in spite of--Microsoft's exasperated pursuit of Yahoo, while skirting the hassles of a merger or acquisition.

The partnership will erase about two-thirds of the monetization gap between the two leading search engines by tapping both their strengths. Yahoo provides stronger pricing and advertiser draw in lead and brand search results. Google provides long-tail searches that reach far beyond Yahoo's top three best positions, according to a new RBC/Searchignite study. The research squashes the notion that the deal is mostly about Google rescuing Yahoo from the clutches of an unwanted Microsoft union.



The study concludes that advertisers' costs for keyword searches on Yahoo generally will rise about 22% if Google is facilitating the ad sale. By inserting Google ads where appropriate, the deal could potentially generate between $250 million and $450 million in the first year, and up to $800 million in net revenues once fully implemented. Google also immediately gains from assuming Yahoo's owned and affiliated searches, and generally adding a massive volume of higher-quality clicks for a total of more than $1 billion in additional net revenues, according to RBC Capital Markets analyst Ross Sandler.

Creating new value for Google and Yahoo at the expense of advertisers without leaving much competitive price resource in the marketplace is core to the study, as well as to ongoing Senate hearings and a Justice Department review. Searchignite, a search advertising software provider, analyzed six-month data of 12 million paid clicks for 15,000 different keywords, comparing only clicks that were positioned the same on Web pages and noting the difference in word choices.

Comparing the two search engines' pricing at various search positions reveals how the partnership will work. Yahoo is most likely to outsource long-tail searches for which Google charges 20% more for the third search result, 35% more after the fifth search finding and more than 50% more beyond. Advertisers seeking the top-three search positions would pay 5% to 16% more per click for the position on Yahoo than on Google. An advertiser bidding for the top position for their brand name on Yahoo would pay almost 38% more per click on Yahoo than on Google.

The "open platform" created by the Google-Yahoo partnership provides each of the companies with comparable flexibility and financial benefit, despite the relative difference in the players' sizes. In other words, even in a universe where Google is king, other players matter. However, the deal doesn't solve all their problems.

In addition to the Microsoft distraction factor, Yahoo's Achilles' heel is its declining search business. Yahoo's value with the Google partnership is estimated at about $27 per share. The economics of Microsoft's five-year offer--that includes acquiring its search business, covering $2.8 billion of debt, and generating nearly $14 billion in guaranteed revenues--gives Yahoo a total value of $33 per share, according to Bernstein Research. Establishing a joint venture with Time Warner's AOL is one of the options that could conceivably be worth more to Yahoo. Another is the off chance that dissident shareholders win the Aug. 1 proxy fight and force Yahoo to pursue a paid search deal with Microsoft.

Even Google is not without risks to its stock price, although it shares many of those potentially threatening factors with Yahoo. They include competition from key competitors, unforeseen disruptive technologies and new entrants, and failure to reach agreements with key media, access and advertising partners. Even in an Internet universe seemingly dominated by Google, technology, business fundamentals and competitive prospects are still new enough to make just about anything possible.

Falling short of analyst expectations in many key second-quarter metrics is proof that Google is not immune to the economic slowdown. Some of Google's other pressing issues include monetizing YouTube as an advertising platform (having generated only about $63 million in the second quarter), delivering its long-promised Android mobile device and a 3G wireless spectrum play, and more aggressively addressing cost containment and margin improvement.

Even as its share of worldwide search reaches 64%, Google could be bolstered by indirect exposure to Yahoo's Alibaba and other equity-ownership stakes in search engines abroad. Yahoo's core user base also could help to support the growth of interactive video advertising on YouTube. The same quality of video clips on YouTube that exists on Yahoo or AOL has the considerable added advantage of Google search and navigation providing more effective targeted ad opportunities.

Anti-competitive arguments aside, the ways in which Google and Yahoo can help each other to almost immediately begin to create value run very deep. And that begs a contrarian point of view. Defending and creating a clear path to that new value--rather getting mired in arguing what is lost to advertisers or to Microsoft in the process--will likely win the day. So much for the checks and balances in online advertising consolidation.

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