How Google Could Keep Yahoo From Microsoft

Eric Schmidt, the chief executive of Google, is offering Yahoo — and, it seems, anyone else — whatever help he can to make sure Yahoo isn’t swallowed by Microsoft.

What sort of help could that be? Lots of money for the right to sell ads on Yahoo’s search results, most likely. Google would have a very hard time buying Yahoo outright, for antitrust reasons. But if Google offered a long-term guarantee for advertising revenue on Yahoo’s search pages, there would be a pot of money that could help finance a bid for Yahoo by a private equity firm or a media company. Yahoo also could try to stay independent by cutting such a deal and giving part of the money from Google back to shareholders in the form of a share buyback or special dividend.

There is a lot of money at stake. Since Google earns more for every search than Yahoo does, such a deal would immediately add money to Yahoo’s bottom line.

Here is a back-of-the-envelope way to look at how much is involved. Google agreed to pay a reported $3.5 billion to sell advertising for IAC/InterActiveCorp’s unit. In December, according to comScore, Ask handled 1.1 percent of all search queries worldwide, while Yahoo had a 12.8 percent share. That means Yahoo has 11.6 times the volume of Ask. If you multiply the $3.5 billion figure by 11.6, you get a theoretical $40 billion over 5 years. That may be a bit high, as Yahoo had a total of $6 billion in ad revenue in 2007, split between search ads and graphic display advertising.

Regardless of the exact numbers, there are tens of billions of dollars in play that could be used to enable all sorts of financial engineering meant to keep Yahoo out of Steve Ballmer’s hands.

I’m not so sure any of these is likely to happen. What’s more, they are almost all really bad ideas, if you look at the long term value created by what is now the Yahoo business.

The reason gets to the challenge of running Yahoo, as well as Google, Microsoft and AOL: A company can make the most money at the highest margins if it has the biggest network of advertisers, the biggest network of sites on which ads run, and the largest group of sites it owns and operates. But those economic forces push companies to almost unmanageable sprawl.

Advertisers value both reach and effectiveness. That means they will pay higher rates for their ads to be shown to the most targets; broad media, like network TV, get a premium over targeted media like cable channels. But in search in particular, they do also value ads that are shown to the most likely prospects. Having the biggest network, and the right technology, allows a company like Google to offer both broad reach and effective targeting. As a result, ads on Google command a premium over ads on other ad networks, like Yahoo’s.

The way to get the biggest network is to negotiate for the rights to sell ads on lots of other sites. But the problem with this is that ad networks like Google give away about 80 percent of the money spent by advertisers to the sites on which ads appear. For sites that the ad company owns outright —Google’s own search pages, for example — it can keep all of the ad revenue. That’s why AOL’s new management has rejected, so far, proposals to sell off its portal business so it can concentrate on its growing advertising business. When it looks at this, it realizes that owning sites on which it can place ads is the best way to reap the profits from the ad network.

All of this means that if Yahoo splits its ad network from the rest of the sites it operates, it will erode the value of both halves of its business.

Lots of very smart people disagree with this assessment. Many current and former Yahoo executives, and lots of others in the Valley, argue that Terry Semel made a terrible mistake in trying to take on Google in search, and that it would have been better to double down on parts of its site that were most conducive to brand advertising, where it had been the leader. It certainly is true that the race to build Yahoo’s search engine and then the Panama search advertising system diverted resources from what could have been other initiatives that didn’t compete head on with Google.

But for Yahoo not to be in search or in search advertising, I think, would consign it to a much smaller role in the future. Search is so much a part of how people navigate the Web that it is hard to imagine being a successful Web portal without search at the center. Moreover, there is no longer a strict difference between search ads — sold in a huge auction — and brand ads — sold by a sales force over lunch. Rather, there is increasingly a smooth gradation, with even some graphic ads for big brands placed through automated systems and, soon, advertising exchanges. I suspect — although I’m not sure — that one big system that can handle all sorts of ads will have advantages over narrower advertising networks.

That’s why the combination of Microsoft and Yahoo in theory has the best likelihood of creating real value. It will have the second-largest ad network and a vast array of sites on which to place its own ads. Microsoft, moreover, has resources to pay for the development of lots of corners of the business at the same time in a way Yahoo did not.

The caveat here is management: If Microsoft and Yahoo cannot actually build sites and ad technology the market wants to use, none of this theoretical profit will wind up in the bank. And one of the few advantages of a complex arrangement that gives Yahoo’s search business to Google is that the remaining company would be easier to run.



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