Where Does the Microsoft Deal Leave Yahoo?

If Yahoo’s blockbuster agreement with Microsoft clears regulatory approval, it seems clear that the search market will undergo a major shakeup. But where that would leave a post-search Yahoo is perhaps a bit less clear.

The deal, announced this morning, would see Yahoo (NASDAQ: YHOO) abandon its search technology, outsourcing its operations to Microsoft on an exclusive basis for 10 years. Yahoo, in turn would take over the worldwide sales operations, also on an exclusive basis.

“Why would we do this? This deal enables us to keep a healthy revenue stream and invest in areas critical to our future, while Microsoft invests in search technology,” Yahoo CEO Carol Bartz said in a video explaining the deal. “Yahoo is excited about investing more in our sites worldwide, our mobile experience, and in display advertising for our advertising partners.”

Some analysts are less excited.

Reacting to the deal, IDC’s Karsten Weide and Sue Feldman noted that, on the surface, the deal plays to Yahoo’s strengths, namely, media and advertising, while enabling the more technically-able Microsoft (NASDAQ: MSFT) to handle the engineering work.

But it’s a big bet that Yahoo’s making.

“There is no way back from this deal. Once search is outsourced, it will be almost impossible to bring it back in-house,” Weide and Feldman noted. “Should Microsoft lose the race against Google in terms of search relevance and ad placement technology, Yahoo’s ship would sink with Microsoft’s.”

Under the terms of the deal, Microsoft agreed to a revenue split for advertising on Yahoo’s properties that is a premium to the market average. Microsoft would pay out 88 percent of the revenue gleaned from ads place on Yahoo searches. But that hefty revenue split for what’s known as traffic-acquisition costs, or TAC, comes in lieu of the upfront payment many on Wall Street were expecting.

Shares of Yahoo closed down 12 percent today, which several analysts attributed to investors’ disappointment over the absence of an upfront payment.

But that could be a hasty reaction that ignores the near-term value the deal could bring, according to Barclays analyst Doug Anmuth.

“It’s unclear how favorable the deal will be to Yahoo over time, but our fundamental reasons for owning shares remain the same,” Anmuth said in a research note. “We expect better execution on the audience and content business and specifically within display advertising, and we believe Yahoo will be able to take out a meaningful amount of costs from the business aside from search tech over the next couple years.”

Cutting costs has been a top priority for Bartz since she took the top job at Yahoo in January. Once the deal is fully implemented, she said she expects Yahoo to net $200 million in annual savings on capital expenditures, in addition to $500 million in increased operating income.

“The real advantage is allowing Yahoo to focus on what we do best, and that is to be the center of people’s lives online,” Bartz said. “This deal puts our focus front and center.”

[cob:Special_Report]Today’s deal seems to lay to rest any lingering questions about Yahoo’s commitment to search. Company executives on last week’s earnings call had little to say about Yahoo’s search business, focusing instead on its plans to build out its popular content verticals, layer in social features and push deeper into mobile computing as it continues its hub-of-the-Web strategy.

“There’s been this kind of theme since Carol Bartz became CEO, that they have this attitude that search isn’t that important,” Janel Landis, vice president of search marketing at marketing firm SendTec, told InternetNews.com. “It’s sad to see them give up on that, but they are very good at display.”

For advertisers, the deal could be a positive. With a single-digit share of the search market, Microsoft wasn’t a must-buy for many smaller advertisers, despite offering generally lower prices and higher clickthrough rates.

That would all change by acquiring Yahoo’s market share, which by the latest comScore figures was just below 20 percent in the United States.

If the deal goes through, Yahoo said it would still offer search on all the properties it does today, but they would be powered by Microsoft and carry the Bing branding.

But even that change in branding could have a detrimental effect on Yahoo’s fortunes.

“It’s a very loyal user base,” Landis said of Yahoo’s roughly 20 percent market share. “It wasn’t going away. It was the status quo.”

And as for Yahoo’s prospects without search, her outlook is bleak.

“I think Yahoo goes away, eventually,” Landis said. “I think that what’s there is just going to wither away.”

Weide and Feldman weren’t quite as harsh, but still said they viewed the deal as “strategically unwise” for Yahoo, despite the significant revenue boost it’s likely to net in the short term.

“Search will remain the most important online advertising segment for years to come,” they said. “If that is so, why outsource search development to someone else without any control over that someone else’s work?”

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