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Microsoft and Yahoo Deal on Search, At Last

They finally got it done.

After several years of on-again, off-again talks about various iterations of an alliance, Microsoft (NASDAQ: MSFT) and Yahoo (NASDAQ: YHOO) this morning announced a partnership that will see the two team up on search and advertising sales.

"This agreement has been a long time coming, and we are so delighted to see it come to fruition," Microsoft CEO Steve Ballmer said on a conference call with analysts and reporters. "This really is a win-win agreement for Microsoft and for Yahoo."

Pending regulatory approval, the deal would see Microsoft take over the technical side of Yahoo's search offering, using its own Bing platform and AdCenter technology to become the exclusive provider of search on Yahoo's sites for 10 years.

Yahoo meanwhile would take over the global advertising sales operations for the joint search venture. Yahoo's platform for selling search ads through an automated auction where advertisers bid on keywords, called Panama, would be folded into Microsoft's AdCenter.

That means that some Yahoo engineers would eventually be asked to transfer to Microsoft, some would eventually be laid off, while still others might switch to Yahoo's display business, which is not included in the deal.

"On the display side, frankly, we wanted to keep this as straightforward and simple as possible," said Yahoo CEO Carol Bartz.

Sticking to search, the two companies are pitching the alliance as a path to greater choice for advertisers, whom they suggest are currently at the mercy of one player with more than 70 percent of the search-ad market, leaving the name "Google" (NASDAQ: GOOG) unmentioned in their joint press release and often referring to it as the "market leader" the conference call.

"Yahoo is a great business," Bartz said. "We face a formidable competitor in one aspect and that is search."

Under the terms of the deal, Yahoo does not receive any upfront payment from Microsoft. Instead, Microsoft will share 88 percent of the revenue from ads sold on Yahoo and the sites it owns and operates. Once the deal is fully implemented, Yahoo estimated that those revenues, known as traffic acquisition costs, or TAC, will net the company an additional $500 million in annual operating income. By ceding its search technology and ad platform to Microsoft, Yahoo expects to yield an additional $200 million in expenditure savings.

The companies are hoping that the global integration of their sales and technology operations will be completed within two years of securing regulatory approval in all the relevant markets.

[cob:Special_Report]The absence of an initial lump-sum payment raised a question for Bartz, who had previously said that she would be open to a deal with Microsoft, but only if it delivered "boatloads of money."

"As far as we're concerned, the boatload of cash is us preserving our revenue line," Bartz said this morning. "Having a big cash payment up front doesn't really help us from an operating standpoint."

She added, "This agreement enables us to keep a healthy revenue stream and invest in areas that are critical to our future." Yahoo has been developing its strategy to transform itself into a more social, relevant hub on the Web, demonstrated most recently by a redesign of its home page that integrated external sites like Facebook and MySpace.

"Our vision is to be the center of people's lives online," Bartz said.

The deal would also see Microsoft take over Yahoo's search and advertising on its mobile properties. Unlike the PC side of the deal, the mobile provisions are nonexclusive, though Bartz said she expected Microsoft would be the sole provider of mobile search for the foreseeable future.

For Microsoft, the benefits would be less immediate. Ballmer reiterated this morning that his primary goal is to become "a strong number two player in search advertising," but acknowledged that the revenue sharing agreement is steep and that Microsoft will shoulder most of the costs of integrating the companies' engineering platforms.

"We paid a high TAC rate, there's no question," he said. "For us, the investment in the near term will be a few hundred million in the first few years."

At first blush, Standard & Poor's analyst Jim Yin seemed to buy in to Ballmer's pitch that the deal will improve Microsoft's search product in the long run.

"Though we think Yahoo will derive most of the financial benefits, we think Microsoft will improve its search algorithm by obtaining more information on users' preference," Yin said in a research note. "We also think both companies can increase their online ad pricing by better matching advertisers with Internet users."

Page 2: What's waiting in Washington?