The 10-year deal announced Wednesday gives Microsoft access to the Internet's second-largest search engine audience, beefing up the software maker's arsenal as it tries to better confront Google, which is by far the leader in online search and advertising.
Microsoft didn't have to give Yahoo an upfront payment to make it happen, as many Yahoo investors had been counting on ever since Microsoft dangled $1 billion last summer in an attempt to forge a search partnership then.
Google tried to stop Yahoo from falling into Microsoft's camp. Last year it formed its own proposed search advertising deal with Yahoo, only to be forced to retreat from that alliance after U.S. antitrust officials threatened to sue.
Now the extended reach Microsoft is gaining will let it introduce its recently upgraded search engine, called Bing, to more people. The Redmond, Wash.-based software maker believes Bing is just as good, if not better, than Google's search engine. Taking over search responsibilities on Yahoo's popular site gives Microsoft a better chance to convert Web surfers who had been using Google by force of habit.
"Microsoft and Yahoo know there's so much more that search could be," said Microsoft Chief Executive Steve Ballmer. "This agreement gives us the scale and resources to create the future of search."
Even with Yahoo's help, Microsoft has its work cut out. Combined, Microsoft and Yahoo handle 28 percent of the Internet searches in the United States, well behind Google's 65 percent, according to online measurement firm comScore Inc. Google is even more dominant in the rest of the world, with a global share of 67 percent compared to a combined 11 percent for Microsoft and Yahoo.
In return for turning the keys to its search engine over to Bing, Yahoo will keep 88 percent of the revenue from all ads that run alongside search requests on its site for the first five years of the deal. Yahoo also will have the right to sell search ads on some Microsoft sites.
Yahoo estimated the deal will boost its annual operating profit by $500 million and save the Sunnyvale, Calif.-based company about $275 million on annual capital expenditures because it won't have to invest as much in its own search technology. An unspecified number of Yahoo engineers will lose their jobs as the company scales back, Yahoo Chief Executive Carol Bartz told analysts in a Wednesday conference call.
The deal isn't expected to close until early next year, and then it could take another two years before all the pieces of the partnership are in place. The companies first will give antitrust regulators time to review the possible effects on the Internet ad market. Then they will need time to stitch together their different technologies.
Shares of Yahoo plunged $2.03, or 12 percent, to $15.19 in early afternoon trading, as investors expressed disappointment over the fact that the company won't be getting an immediate windfall. Microsoft shares edged up 8 cents to $23.55 while Google shares shed $4.44, or 1 percent, to $435.41.
"I think the market hasn't figured out that there's not much I can do with an upfront payment," Bartz said in a Wednesday interview.
"It's very clear that (in this deal) I get virtually all my revenue at no cost. That's what's important on an ongoing basis. A one-time upfront payment, what am I going to with it? Collect interest on it every year? That doesn't help me with" Yahoo's finances.
The alliance could give Yahoo a chance to recoup some of the money it squandered in May 2008, when it turned down a chance to sell the entire company to Microsoft for $47.5 billion. Yahoo's market value currently stands at about $22 billion, and the company, while profitable, is coming off a quarter in which revenue slid 13 percent.
The two rivals began talking about a possible partnership as far back as 2005 before Microsoft intensified the courtship with last year's attempt to buy Yahoo.
It took Bartz just six months to strike a deal with Microsoft -- something that neither of her predecessors, Terry Semel and Yahoo co-founder Jerry Yang, seemed interested in doing.
Shortly after her arrival, Bartz made it clear she was willing to farm out Yahoo's search engine for "boatloads of money" as long as she as thought the company would still receive adequate information about its users' interests. Although Yahoo won't get any immediate cash, Bartz predicted the deal will still be a boon for the company.
"This agreement comes with boatloads of value for Yahoo, our users, and the industry," Bartz said.
Under the agreement, Yahoo will have limited access to the data on users' searches -- which yield insights that can be used to pick out ads more likely to pique a person's interest. The value of that information is why Microsoft wants to process more search requests.
Like Yahoo, Microsoft has invested billions in its search technology during the past decade, yet remained a distant third in market share while its online losses piled up. The company's Internet services division lost $2.3 billion in the fiscal year ending in June, nearly doubling from the previous year.
Microsoft is counting on Bing, unveiled last month, to turn things around.
Bing has been getting mostly positive reviews and picking up slightly more traffic with the help of a $100 million marketing campaign. Analysts believe Bing's successful debut pushed Microsoft to reopen negotiations so it could expose its search engine improvements to a wider audience more quickly.
"The reason the deal happened now is the recent success of Bing. I think it put pressure on Yahoo, as well as Yahoo not being able to turn it around on its own," said Gartner Inc. analyst Neil MacDonald.
Microsoft and Yahoo are bracing for scrutiny into whether the combination would have an adverse effect on competition in the online ad market.
The U.S. Justice Department spent five months dissecting last year's proposed search advertising partnership between Google and Yahoo before concluding that it would give Google too much control over the market. And under the Obama administration, the Justice Department is promising to pore over deals more rigorously than it did when the proposed Google-Yahoo partnership came up.
Microsoft used its lobbying muscle to spearhead the campaign against Google teaming up with Yahoo, so it wouldn't be a surprise if Google turned the tables.
"There has traditionally been a lot of competition online, and our experience is that competition brings about great things for users," Google spokesman Adam Kovacevich said. "We're interested to learn more about the deal."
A key lawmaker on antitrust issues said the Yahoo-Microsoft plan "warrants our careful scrutiny." Sen. Herb Kohl, a Wisconsin Democrat, said the Senate antitrust subcommittee he chairs will review the deal "because of the potentially far-reaching consequences for consumers and advertisers and our concern about dampening the innovation we have come to expect from a competitive high-tech industry."
Peter Kaplan, a spokesman for the Federal Trade Commission, declined to comment. A Justice Department spokeswoman couldn't immediately be reached.
Ballmer expects that support from online advertisers and Web publishers who would like a stronger rival to Google will eclipse any objections that Google might raise.
"We think this is one of these cases where the coming together will produce more effective market competition, not less," he told analysts in Wednesday's conference call.
Microsoft is doubling down on Internet search at the same time Google is attacking Microsoft's bread-and-butter business of software for personal computers.
Google is working on a free operating system for inexpensive PCs in a move that could threaten Microsoft's Windows franchise. If it gains traction, Google's alternative, called Chrome OS, could divert revenue from Microsoft while the software maker is trying to grab more money pouring into search advertising.
Chrome OS isn't supposed to hit the market until the second half of next year. That means Microsoft could get a head start on Google in the duel to steal each other's financial thunder.
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