Yahoo inks search ad pact with Google

Google will supply Yahoo with search ads in a partnership Yahoo believes will raise revenue by $800 million in its first year--but that also could give more power to Google.

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Stephen Shankland
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Update 5:14 p.m. PDT: I added more comment on antitrust matters. Update 4:32 p.m. PDT: I added comments from the conference call and more partnership details. Update 3:36 p.m. PDT: I added more detail about the deal, more background, and comment from Google.

Yahoo announced a nonexclusive partnership Thursday under which rival Google will supply it with some search ads, a move that could increase Yahoo search revenue but that also gives Google even more power in the market.

Yahoo expects the deal, which was expected, to raise revenue by $800 million in its first year and to provide an extra $250 million to $450 million in incremental operating cash flow. That's a major potential boost, given that Yahoo reported revenue of $1.53 billion in its most recent quarter, after ad commissions are subtracted.

"We see this as a good, open, flexible deal and (one that) helps Yahoo be strengthened as a good longer-term competitor," Chief Executive Jerry Yang said in a conference call Thursday.

Some saw more urgent motives at work, though.

"They're using this as a tool to boost short-term cash flow," said Canaccord Adams analyst Colin Gillis. "They're trying to keep the wolves at bay."

Yahoo expects the revenue to help the company invest in its dual-pronged advertising strategy that's designed to offer advertisers an easy ability to buy text ads on search results and to buy graphical "display" ads elsewhere on Yahoo's considerable Internet properties.

"This agreement provides a source of funds to both deliver financial value to stockholders from search monetization and to invest in our broader strategy to transform display advertising and advance our starting-point objectives with users," Yahoo President Sue Decker said in a statement. "It enhances competition by promoting our ability to compete in the marketplace where we are especially well-positioned: in the convergence of search and display."

Shareholders looking for a quick payback should be prepared for a wait, though. The companies are voluntarily delaying implementation of the partnership for up to three and a half months to let the Justice Department review the deal, Yahoo said, a nod to antitrust concerns raised about the deal.

Yahoo CEO Jerry Yang
Yahoo CEO Jerry Yang Yahoo

"We believe, given that it's a commercial agreement, there's not formal regulatory approval" required, Yang said. "We agreed with the Department of Justice on a voluntary basis to have them review this deal."

Antitrust scrutiny
One U.S. senator, meanwhile, urged scrutiny.

"We will closely examine the joint venture between Google and Yahoo announced today," Sen. Herb Kohl, Democratic chairman of the Senate Antitrust Subcommittee, said in a statement. "This collaboration between two technology giants and direct competitors for Internet advertising and search services raises important competition concerns. The consequences for advertisers and consumers could be far-reaching and warrant careful review, and we plan to investigate the competitive and privacy implications of this deal further in the Antitrust Subcommittee."

While Yahoo evidently expects a stronger future out of the deal, a tight partnership is a double-edged sword. In the long run, Yahoo likely will find its Google partnership hard to dial back even if it wants to: "The reality is it's going to be hard to unhook from the Google cash flow," Gillis said.

Under the deal, Yahoo will select the search terms for which Google will supply ads, the companies said. The ads will be displayed in the United States and Canada, and Decker took pains to say how Yahoo controls which Google results are displayed and when.

Yahoo's search ad engine, Panama, is competitive with Google's for many popular queries, but Yahoo plans to use Google with less common searches, Decker said. "Yahoo monetizes very competitively with Google for query ads but is not as competitive in the tail," she said, referring to the long statistical tail consisting of a large number of infrequent searches.

IM partnership
The partnership also extends beyond advertising. The two companies will make their instant-messaging services interoperable, lowering a barrier that separated two communities of users at the sites.

The agreement allows either party to cancel under circumstances such as an acquisition or other "change in control." However, Yahoo must pay $250 million, minus the revenue Google earned, if it's terminated within 24 months.

The partnership is a 10-year deal, a four-year initial period and two options for Yahoo to renew for three years, Decker said.

Google and Yahoo declared a limited two-week search ad deal in April a success, but even the limited partnership raised antitrust hackles at Microsoft.

Google is the leading search engine by a wide margin. Google increased its share of the U.S. search market to 68.29 percent in May at the expense of Yahoo and Microsoft, according to Hitwise.

Having more searches means more virtual real estate for ads and therefore a more desirable place for advertisers to bid for placement. Google also has worked aggressively to try to deliver only ads that are relevant to particular search queries, a move geared to increase the revenue generated per click.

Microsoft, adieu
The partnership idea came to light during Microsoft's attempt to acquire Yahoo, which put more pressure on the Internet company to improve its financial results. Both a full-on acquisition and a narrower partnership appear to be no longer an option, though.

Yahoo announced Thursday that it and Microsoft couldn't close a deal and that Microsoft wasn't interested in buying Yahoo outright even at the earlier price of $33 per share. Yahoo's shares dropped more than 10 percent, or $2.63, to $23.52.

Microsoft quickly raised antitrust concerns when the search ad test began, saying the move would reinforce Google's dominance in the search ad business. Google has countered that search ads are only a narrow part of the online ad market, and that Yahoo is the strongest company when it comes to the graphical "display" ads.

Google spoke highly of the deal on Thursday, too, though it didn't offer any projections of its financial effects.

"This commercial agreement provides Yahoo with the opportunity to deliver more relevant ads to users and provide advertisers and publishers with better advertising technology to help them succeed in their own businesses," said Google CEO Eric Schmidt in a statement. "This agreement will preserve the competitive and dynamic online advertising space."

News.com staff writer Ina Fried contributed to this report.