Google's Yahoo Rebound Play

With Microsoft out of the picture, Web search king Google strikes a search ad deal with Yahoo. But where does that leave the struggling portal?

by Robert Hof

After more than four months of Sturm und Drang, the blockbuster Internet deal of the year is over, with only one clear winner: Google. On June 12, Microsoft and Yahoo said they ended talks that focused on, at turns, an outright takeover by the software giant to a combination of the companies' Web-search operations. Within hours, Google swooped in with a long-discussed alternative deal that involves placing search ads on Yahoo pages.

Despite hints before the market closed that a Google (GOOG) deal might finally come to pass, the sudden end of chances for a more sweeping Microsoft (MSFT) transaction left Yahoo (YHOO) investors fleeing for the exits. The company's stock fell 10%, to 23.52. That's still considerably above the 19.18 where Yahoo's shares sat just before Microsoft made its original $45 billion bid on Feb. 1, but far below the $33 a share Microsoft offered before bowing out.

Ichan Unlikely to Prevail

Yahoo valued its deal with Google at as much as $800 million in annual sales. Under the nonexclusive arrangement, Google will run search-related text ads on Yahoo in the U.S. and Canada. The deal caps Google's dominance of search advertising, the most lucrative market on the Internet. The company's 62% share of online search queries, and an even higher share of search-ad revenues, continues to grow. "It's a great deal for Google," says Shar VanBoskirk, an analyst with Forrester Research (FORR).

The announced end of the Microsoft deal also leaves Carl Icahn, the financier who launched a proxy fight (BusinessWeek.com, 5/15/08) in hopes of forcing Yahoo back into a deal with Microsoft, with few apparent alternatives. Icahn, who bought his Yahoo stock at an average of about $25 a share, now could lose money if he can't come up with another plan and decides to sell. "He took the horses to the water but he couldn't make them drink," says Barry Genkin, who chairs the shareholder activist practice at law firm Blank Rome.

Genkin says it's now unlikely shareholders will vote for Icahn's proposed new slate of Yahoo directors ahead of Yahoo's Aug. 1 annual meeting unless he can articulate another plan to improve Yahoo's stock price. Absent that possibility, Genkin favored a Google deal. But investors so far don't seem impressed with it.

Welcome Cash

Yahoo's shares initially rose 1% in post-close trading after the Google deal was announced. But later they continued falling, perhaps in part because Yahoo said the Google deal won't result in material cost savings. Yahoo will continue to operate its own search engine and search-ad system, called Panama, on most search queries in the U.S. and Canada and on all queries elsewhere in the world. The upshot: Opportunities for cutting staff and technology spending are few.

Under the deal, Yahoo can run Google text ads alongside Yahoo search results, as well as on other Yahoo pages on its U.S. and Canadian Web sites. Yahoo controls when and where Google ads will run, and executives said during a conference call that Google ads would appear only on a portion of Yahoo search results. The long struggling Internet company called the deal an "$800 million revenue opportunity," though neither Yahoo nor Google would reveal whether there are any revenue guarantees.

Yahoo also estimates that within the first year of implementation, it will generate $250 million to $450 million in additional operating cash flow. "This puts Yahoo on a faster track to creating shareholder value," Yahoo co-founder and Chief Executive Jerry Yang said on a June 12 conference call. Yahoo President Sue Decker said the additional revenue should help Yahoo spend more on its other opportunities, such as its leadership position in display ads, the marketing messages that appear in fixed blocks on Web pages.