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Yahoo!'s Deal With Microsoft Is a Mistake

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Yahoo! (Nasdaq: YHOO  ) CEO Carol Bartz doesn't look much like Wile E. Coyote, but she sure has a funny way of falling into the same animated traps her predecessors did.

Despite the colorful "Microsoft, Yahoo! Change Search Landscape" headline blaring out at us all this morning, the announcement of a partnership with Microsoft (Nasdaq: MSFT  ) really doesn't change much at all.

  • Yahoo! is outsourcing its search platform to Microsoft's Bing -- and in doing so, Yahoo! is repeating the mistake it made when it let Google (Nasdaq: GOOG  ) power its engine.
  • Yahoo! may have set the tone in self-serve advertising several years ago, when it acquired pioneer Overture -- the juiciest part of the online-advertising market -- but now it's letting Microsoft's fledgling AdCenter take over. In other words, Yahoo! is back to milking the less lucrative display advertising market.
  • There will be cost savings and incremental operating profits, but the end result is that Yahoo! will continue to fade in relevance. There's no joy in calling "shotgun," even in a shotgun wedding.

Silly Yahoo!, rifling through the Acme Products catalog -- as if it will ever come up with a third-party contraption to catch up to Google's speedy roadrunner.

Shares of Yahoo! opened sharply lower this morning, and not because of the "buy on the rumor, sell on the news" cliches that CNBC has been volleying around this morning. Its depressed share prices comes from two -- and only two -- reasons:

  • There was always a little helium in Yahoo!'s stock, on the dimming hopes of an outright buyout. But this partnership puts an end to any chatter that Microsoft will buy Yahoo! -- in the near term, anyway. After all, why buy the cow when you can get the milk for a fee?
  • Quite frankly, the deal stinks.

Yahoo! could have done better. Microsoft continues to lose money in cyberspace, and it should be on the ropes right now, just days after posting its first annual revenue decline since going public. It's enough to make one wonder whether Yahoo! conducted a sobriety test before handing the software giant the keys this morning.

Microsoft will compensate Yahoo! for rolling over. In exchange for letting it plaster Yahoo!'s query result pages with Microsoft-sold ads, Yahoo! will receive 88% of the resulting revenue through at least the first five years of the 10-year term. That's a big number -- Google shared just 74% of its gross partner revenue with publishers this past quarter -- but it's not big enough.

Slicing pies and taking names
There's more to math than percentages. For starters, it's been widely assumed that Google offers far more than the 74% average to its largest customers. You also have to consider the pie being divided. Google is the undisputed leader in online advertising. More sponsors translate into better keyword bids and a deeper bench of relevant ads.

Google's girth should translate into higher click-through rates, so 74% of something is better than 88% of nothing.

Yes, Microsoft is guaranteeing revenue-per-search minimums in every country, but only for the first 18 months of a 120-month deal.

Yahoo! claims that it will be able to reap immediate results. Operating income will grow by $500 million annually. The consolidation will allow it to shave annual capital expenditures by $200 million.

Missing in the mix is the long-term cost of letting Microsoft become the silver medalist in search algorithms and paid search. By ceding its search capabilities to Microsoft and getting rid of its search developers, Yahoo! is putting itself in a weak negotiating position when it comes time to renegotiate this deal 10 years from now. What's more, taking a weedwhacker to capital expenditures is a euphemism for future rounds of morale-snuffing layoffs.

The positional retreat will also make Yahoo! less aggressive in contextual marketing. Instead of snapping up logical traffic magnets for its paid-search ads, Yahoo! may be too weak to raise a bidding card if Time Warner's (NYSE: TWX  ) AOL or IAC's (Nasdaq: IACI  ) ever go on the block. Future Yahoo! deals will likely be in the display-advertising field, and that's sure to break out the yawns if ValueClick (Nasdaq: VCLK  ) or the remnants of China's Focus Media (Nasdaq: FMCN  ) become new targets.

Yahoo! will become the relationship salesforce for premium advertisers on both Yahoo! and Microsoft -- but that's little more than resume filler, when you consider what Yahoo! is giving up in return.

Go ahead and applaud the promise of a fatter bottom line in the near term. Once investors realize that this is another step down in the company's descent from greatness, they, too, will be cursing at the crummy quality of this Acme business model.  

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Microsoft is a Motley Fool Inside Value pick. Google is a Motley Fool Rule Breakers recommendation. Try any of our Foolish newsletter services free for 30 days.

Longtime Fool contributor Rick Munarriz is a fan of Yahoo! and Microsoft but not of bad weddings. He owns no shares in any of the stocks in this story and is also part of the Rule Breakers newsletter research team, seeking out tomorrow's ultimate growth stocks a day early. The Fool has a disclosure policy.

Read/Post Comments (5) | Recommend This Article (7)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 29, 2009, at 5:06 PM, plange01 wrote:

    mistake? more like a disaster for stockholders! hopefully bartz has already been fired!!

  • Report this Comment On July 29, 2009, at 5:35 PM, nin4086 wrote:

    Yahoo is in bad shape and this deal can help keep it alive. Without it, Yahoo would have gone bankrupt in a few years. You complain about layoffs but they are good for Yahoo shareholders. Yahoo has been mismanaged for a long time and the damage was done before Carol Bartz stepped in.

    You are right in pointing out that Yahoo could be in a weak position 10 years from now...but at least it will last 10 years with this deal. On the other hand, it could be in a better position. Technology changes fast and nobody knows how things will be then. Search could become a commodity and there could be hundreds of search engines that can be licensed. Or Yahoo will invest its new cash in improving its search (Microsoft is licensing Yahoo's search with this deal) and get a better deal next time. Or Yahoo will figure out a new market or technology. To do any of that, it needs to survive.

    So for Carol Bartz, this is just step one: stay alive. Next step is to try and grow. Let us see how that goes.

  • Report this Comment On July 29, 2009, at 5:49 PM, TMFBreakerRick wrote:

    nin, I don't know if I'd be writing Yahoo!'s obituary without this deal. The company is perpetually profitable and has about $4 billion in the bank.

    This deal is likely to decrease traffic to Yahoo!, once folks decide that they may as well go to Bing itself for their searches.

  • Report this Comment On July 29, 2009, at 7:16 PM, memoandstitch wrote:

    I wonder if Icahn had a say on this deal. This sounds like locking in his loss.

  • Report this Comment On July 30, 2009, at 10:45 AM, RaulChapin wrote:

    I think Yahoo needs to improve on what it has even if it does concede that Google is the de facto search engine.

    Its email is great, some people prefer gmail... but I have not found the need to switch and with a few megabytes of stored messages... i will stay a yahoo mail person for a long time.

    Yahoo has yahoo groups, ask yahoo (or whatever it is called), small business webpage services and extremely low quality content.

    Humans are lazy by nature. I have done search in yahoo, although i much prefer google... but if i am going there for my email... i might give yahoo search a try. Similarly i have been tempted by some of their headlines, just to find incredibly sub par content (some of its writers have poorer English than me and that is hard to achieve)

    My point is that one will put up with mediocre or subpar services if they are attached to great ones... but a big collection of just so so services is a sure way to lose clients.

    I put up with some of Yahoo's lower quality services because i am a loyal yahoo mail fan... a new client however might just go ahead and get gmail and then never ever even think about visiting yahoo.

    If this deal allows them to get cash to invest in improving its other services, or it allows them to concentrate their resources in creating or increasing their competitive advantages, preparing for the next round of search engine innovation, developing something new and innovative... then it is the cost of survival/growth... if it is just a lazy way to milk their cow for as long as that cow might live... then it is their retirement years before death comes to it.

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