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?

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What’s waiting in Washington?

Winning over advertisers could be crucial for the deal to secure regulatory approval, as the Department of Justice threatened a fight to block a similar tie-up between Google and Yahoo last year, due at least in part to concerns from the companies’ advertising clients.

Given the market-share figures, Yahoo teaming with Microsoft is unlikely to raise the same concerns as an alliance with Google, but the companies can bet regulators will take a look at the deal, just the same.

For instance, when the DoJ scotched Google’s ad pact with Yahoo, which was non-exclusive and capped Google’s role at handling 30 percent of Yahoo’s search ads, antitrust authorities expressed concern that Yahoo would gradually fade away as a player in search. They indicated that in light of the competitive landscape of the market, Yahoo was an important player as an independent. Unlike the deal with Google, Yahoo’s arrangement with Microsoft would see it exit the search market entirely.

To lay the groundwork for their cause, they’ve set up a Web site, ChoiceValueInnovation.com, to explain and promote the deal.

Brad Smith, Microsoft’s general counsel, said the companies would start the process of filing documents with regulatory authorities next week. He seemed to expect that Google would raise antitrust objections to the deal, just as it did when Microsoft and Yahoo were batting around various partnership proposals last year, and just as Microsoft did when talks broke down and Yahoo struck the deal with Google.

“As to what a company like Google may do, that will obviously be their call,” he said. “They’ll make their own decision and we’ll look forward to the debate.”

Smith argued that Google’s commanding share of the search-advertising market, which he pegged at 78 percent worldwide, would make it difficult to mount a compelling argument against the deal on anticompetitive grounds.

In a statement e-mailed to InternetNews.com, a Google spokesman said the company is “interested to learn more about the deal,” but declined to comment further.

Sen. Herb Kohl, chairman of the Judiciary Committee’s subcommittee on antitrust, has already raised concerns about the arrangement.

“The deal between Yahoo and Microsoft — industry giants and direct competitors in Internet advertising and search markets — warrants our careful scrutiny,” Kohl said in a statement. “The implications of this proposed joint agreement will be closely reviewed by my Subcommittee.”

Bartz acknowledged that the “deal won’t happen overnight,” adding that the companies plan to do their best to explain the deal to regulators in Washington, Europe and other markets where antitrust authorities are likely to give it a hard look.

The companies hope to close the deal early next year.

Ballmer also noted that the arrangements contains certain restrictions on how consumer data can be shared between the two companies in an effort to stave off the privacy concerns that inevitably arise in deals of such a large scale.

“Regulators will have to demonstrate to both consumers and search advertisers that they will actually benefit from this proposed deal,” said Jeff Chester, executive director of the Center for Digital Democracy. “Will it really reduce the cost of search ads, bring tangible financial gains to consumers, and truly protect our privacy?”

Update adds remarks from conference call with Yahoo and Microsoft executives, comments from analyst, Sen. Kohl, Google, Chester.

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