Yahoo! (Nasdaq: YHOO) wasn't bluffing when it announced that it would be testing the outsourcing of Google's (Nasdaq: GOOG) paid-search ads on its own pages. The taste test is going well, according to this morning's Wall Street Journal. Unnamed "people familiar with the matter" have told the paper that both sides are pleased with the results, making it likely that the deal will expand deeper into Yahoo!'s pages.

Of course this partnership is going well! Google generates roughly three times the ad revenue of Yahoo!, despite serving up fewer pages. Google's ad inventory is deeper, giving it a wider range of relevant ads from sponsors bidding against one another for placement.

Yahoo! will definitely make more money -- and be able to shave even more of its margin-choking overhead -- by delegating more of its ads to Google. But that doesn't necessarily mean the deal is the best long-term move for Yahoo!.

You don't see Big Macs being served in Whopper wrappers at the local Burger King just because McDonald's sells more burgers. You won't find Coca-Cola concentrate going into Pepsi cans. Conceding to the competition -- in this case letting "Ads by Google" notices fill Yahoo!'s pages -- seems like surrender. Cashing the product-placement checks may ease the pain, but you're still admitting defeat.

Mr. Softy sighs
If you're Microsoft (Nasdaq: MSFT), you're off the hook. The buyout bid for Yahoo! that has weighed down its shares now has a shot at a graceful exit. Yahoo! will want to see how much it can earn with its new satchel of Google toys. Microsoft, on the other hand, should interpret Yahoo!'s willingness to hand over its paid-search business -- the most lucrative piece of the online advertising pie -- as a testament to Yahoo!'s inferior paid-search product. In other words, Microsoft has to realize that it was ultimately overpaying for little more than a ton of poorly monetized page views, which it can acquire elsewhere for less.

Microsoft is a mess in cyberspace. MSN is losing money, generating even less ad revenue than Yahoo!. It never had a shot to compete against Google, even with Yahoo! on its side. The handoff to Google over at Yahoo! should hammer that home clearly.  

If anything, the Google-Yahoo! team-up should awaken Microsoft from its slumber. If Yahoo! turns over the paid-search keys to Google, concentrating instead on its healthier display-advertising business, Microsoft slips into the second-place slot by default. And if advertisers grow unhappy with Google to fill their paid-search needs, Microsoft just became the top alternative. Yahoo!'s ad outsourcing may make Google stronger, but it ultimately eliminates a rival.

Isn't that what Microsoft wanted all along? To be the clear silver medalist? It's almost there now, without having to spend more than $40 billion in cash and dilution to get the deal done.

Hopping on the Google bus
The appeal of outsourcing seems contagious. Yahoo! isn't the first search-engine company to hand over at least a piece of its billable ad space to Google. Time Warner's (NYSE: TWX) AOL, IAC's (Nasdaq: IACI), and MIVA (Nasdaq: MIVA) are just a handful of the companies that have reaped bigger profits by letting big G handle their ads.

Google just has to make sure that it doesn't get too confident. It pays nearly 80% of the revenue it receives from placing its ads on third-party publisher sites right back to its partners. That's a generous cut, but anything short of 100% is a big win for Google for several reasons:

  • A 20% cut on ad inventory that would have gone unsold is found money.
  • Plastering its ads on third-party sites attracts more sponsors to Google.
  • A partner on the Google AdSense bandwagon is one less competitor.

There's always the temptation to pay less, especially since Google has missed analyst estimates in two of the past three quarters. Outsourcing ads to Yahoo! would also help Google pretty much kill Yahoo!'s YPN program, which never gained traction as an AdSense alternative. If Google feels that it's the only game in town in this space, can't it just slash its payout rates?

Not so fast. Microsoft outsources its ads, but only through huge sites like Facebook. With Yahoo! backpedaling and Google giggling, Microsoft has an opening to step up and become a valid online ad alternative -- but will the House of Gates be shrewd enough to make the most of it?

I've previously suggested that Microsoft should expand its ad program to AdSense-esque proportions, and pay out more than Google to lure publishers to its considerably smaller network. Even if Microsoft has to pay out 100% of the related revenue -- if not more, initially -- it's the only way to make sure that the company doesn't repeat Yahoo!'s mistakes. 

"It's a lot like a supermarket selling milk at a loss and stocking it in the back of the store, to make sure that guests pick up impulse items along the way," I argued at the time. "Even if Microsoft takes a margin hit, doing so could help slow down Google, if it means broadening Microsoft's own pool of sponsors."

There's always a chance that Microsoft will still acquire Yahoo!. Heck, there's probably even a chance that Microsoft will follow the pack, outsourcing its MSN ads to Google as a way to end the bleeding.

Those would all be big mistakes for Microsoft right now. This may be its last chance to battle the ever-growing Google beast. Mr. Softy's going to need money, swords, and a little thing called action to make things interesting.

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Longtime Fool contributor Rick Munarriz doesn't really like the Microhoo moniker, but he finds himself overusing it anyway. He does not own shares in any of the stocks in this story. He 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.