Microsoft, Yahoo Deal Fraught With Risk

Jul 29, 2009 (01:07 PM EDT)

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Investors hammered down Yahoo's stock more than 12% Wednesday on worries that the company's search deal with Microsoft undervalues its technology and will do little to shore up its balance sheet. Looming integration, privacy, and regulatory issues also fueled uneasiness over the deal.

Yahoo shares fell 12.08%, to $15.14, while Microsoft gained 1.41% to close at $23.80.

After months of negotiations, Microsoft and Yahoo unveiled a wide ranging search alliance under which Microsoft's Bing technology will power queries on all of Yahoo's Web properties while Yahoo assumes broad sales responsibilities for both companies' Internet platforms.

Analysts said the arrangement makes sense in theory but could be fraught with practical management and technical obstacles that could steer customers to rival Google.

"The implementation of this deal will not be without its challenges," said Ovum's David Mitchell, in a research note. "There are significant engineering challenges that both companies will need to work through and a substantial change management task to accomplish in implementing the agreement and the vision that it encapsulates," he added.

Indeed, Microsoft and Yahoo said it would take two years for their alliance to become fully operational and that many of its financial and commercial benefits would not be realized until then.

Another area of concern is privacy. By joining forces, Microsoft and Yahoo together will have access to the Web browsing and purchasing histories of millions of Web users—a fact that could draw scrutiny from government watchdogs and consumer advocates. "Microsoft is a lightning rod for attention from governing bodies in both the U.S. and Europe," said Gartner analyst Allen Weiner.

The companies said they would only share data in instances where it's necessary to improve the search experience. They added that they would continue to use their existing privacy policies to govern most data usage.

On the upside, Ovum's Mitchell lauded the fact that, "Both companies are playing to their core competencies."

The ten year agreement gives Microsoft an exclusive license to Yahoo's search technologies, which Microsoft will be free to integrate into its own.

That means Microsoft could borrow elements from Yahoo's new Front Doors homepage and add them to Bing. Front Doors offers direct links to popular sites like Facebook, Twitter, Ebay, and others. The links can be added to a new "My Favorites" column that appears on the home page's left hand side.

Microsoft could also integrate Yahoo Search Pad to Bing. Still in beta testing, Search Pad gives users a platform on which they can create notes based on their search results, share the information with friends, family, or business associates, and save the results for future use.

Microsoft's AdCenter platform will serve as a self-service search advertising tool for both companies. The deal does not extend to Internet display advertising. Yahoo, meanwhile, will continue to "own" the overall user experience on its search pages, though Bing will carry out the actual queries.

Microsoft will compensate Yahoo for traffic from Yahoo's sites under a revenue sharing formula under which Yahoo will retain 88% of the search revenue generated on its pages for the first five years of the deal. Yahoo said it expects the arrangement to add $500 million to annual operating income and $275 million to cash flow while cutting capital expenses by $200 million.

"This agreement comes with boatloads of value for Yahoo, our users, and the industry," said Yahoo CEO Carol Bartz, in a statement. "I believe it establishes the foundation for a new era of Internet innovation and development," said Bartz.

Microsoft and Yahoo have been working on a deal for more than a year. At one point, Microsoft offered to buy Yahoo outright for $45 billion. That offer was rejected by former Yahoo CEO Jerry Yang. Yang was replaced by Bartz in January—a move that paved the way for renewed talks.

Microsoft CEO Steve Ballmer hailed the agreement as a chance for his company to expose its search tools, including the new Bing "decision engine", to a wider audience and make inroads against current market leader Google. "Through this agreement with Yahoo we will create more innovation in search, better value for advertisers, and real consumer choice in a market currently dominated by a single company," said Ballmer.

"Success in search requires both innovation and scale. With our new Bing search platform, we've created breakthrough innovation and features. This agreement with Yahoo will provide the scale we need to deliver even more rapid advances in relevancy and usefulness," Ballmer said.

Google presently controls about 65% of the U.S. search market, while Microsoft owns only about 8% of the market, according to the most recent numbers from ComScore. Yahoo, the number two player, holds 20% of the market.

The companies said they hope to close the deal by early 2010, but noted that it's likely to come under close scrutiny by federal antitrust regulators and other authorities.

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