Yahoo’s Survival Depends upon Microsoft and Bing

We are very good at providing people with the information and content they need. We are not a search company.

 – Carol Bartz, CEO of Yahoo!

Yahoo! (NasdaqGS: YHOO) may have only existed for 16 years, but in the rapid-fire, evolving world of the Internet, it is already an old and decaying has-been.  Just compare Yahoo!’s second-quarter earnings report with that of Google (NasdaqGS: GOOG):  

Google is the future; Yahoo! is the past. Both derive the vast majority of their revenue from advertising, but Yahoo’s strength is display advertising (e.g., banner ads) whereas Google’s expertise is search. Whereas Google is clearly #1 in search, Yahoo! isn’t even #1 in display, having lost its leadership position in display to Facebook (12.1% of all display ad impressions are Yahoo! vs. 16.2% for Facebook). Game over.

Paid Search is Everything

Ask any advertiser which form of advertising is more important and it will tell you search. In fact, a 2006 study (page 2) found that potential customers exposed to search advertising are 3.3 times more likely to convert (i.e., buy) than those exposed to display advertising. A 2009 study found that the number of people online who click display ads has dropped 50% in less than two years, and only 8% of internet users account for 85% of all clicks. The reason is simple: search advertising is measurable and is targeted to customers who have already shown interest in a particular topic, whereas display advertising is a blunt instrument imposed on a general audience. As a Goldman Sachs analyst recently stated:

Many advertisers view Yahoo! display as a more discretionary buy than search or offline mass media (e.g., TV), so Yahoo display revenue is unusually sensitive to short-term corporate confidence.”  

Looking at search engine market share (based on query volume), Yahoo! has been losing ground to Google for years, while Microsoft’s Bing has recently been gaining ground:

Source: Hitwise

But even Yahoo’s market share decline understates the problem. Query volume doesn’t tell you anything about the conversion rate of those queries. For example, Yahoo! actually grew its query volume by more than 7% in the second quarter, but its revenue per query declined by a similar amount. Yahoo! is having trouble monetizing the searches it generates. Not good.

Yahoo is Losing Web Traffic

Another negative: Internet audience shares are fragmenting as the number of Internet websites — and the competition for eyeballs — increases. This means old, established websites like those of Yahoo! are having a tough time growing traffic. The same thing happened in the offline media world with the advent of cable channels that stole market share away from the broadcast TV networks. Yahoo’s websites (e.g., Finance, News, Sports) remain among the most popular Internet destinations with 600 million users per month, but Yahoo’s total page views actually declined by 4% in the second quarter.  In the conference call, CEO Bartz called the page view decline “a little bit of surprise” and said more analysis needs to be done to understand it. In other words, Yahoo! management doesn’t have a clue what’s going on.

Lastly, the percentage of Internet time spent on Yahoo! websites hit an all-time low in June (9.7%). Perhaps even worse, the time spent on Google websites was greater than the time spent on Yahoo! websites for the first time ever. Ouch!

Microsoft to the Rescue!

No doubt about it, Yahoo! is going down the tubes. Given the lack of growth in its website traffic, Yahoo’s only hope for a real turnaround is in search. Fortunately, it has one last great chance to make its mark in search. In July 2009, Yahoo! and Microsoft joined forces in a 10-year search partnership. Microsoft’s Bing will become the exclusive search engine on all of Yahoo’s websites and Microsoft’s adCenter portal (used by paid search advertisers to bid on keywords and measure the conversion effectiveness of their ads) will replace Yahoo’s inferior Panama portal. Yahoo! will receive 88% of all paid search revenue generated on its websites. In return, Yahoo! will be responsible worldwide for generating paid search advertising revenue for both companies. In essence, Yahoo! will be handling sales and Microsoft will be handling technology. By combining forces under Bing, Yahoo and Microsoft’s joint market share of search queries will exceed 25%, which is high enough that advertisers will be interested in doing some serious paid search business with them.

Since February 2010 when the partnership received U.S. and European regulatory approval, Microsoft has been making reimbursement payments to Yahoo! for the costs of running the Yahoo! search business. In the second quarter, these reimbursements totaled $86 million.  The reimbursements will continue until the transition to the Bing search engine is complete and Yahoo! is no longer responsible for maintaining a search workforce and search system equipment.  Microsoft has also agreed to pay Yahoo! $150 million in transition costs.

The transition is occurring in two stages. First up is Yahoo’s transition to the Bing search engine, which is 25% done and is scheduled to be complete by August, or September at the latest. This is the free, algorithm-based search (“algo” for short).  The second stage of the transition is paid search, which involves Yahoo’s switch to Microsoft’s adCenter portal. While this is scheduled for October — in time for the 2010 holiday shopping season — CEO Bartz said during the conference call that the transition to adCenter may be postponed if things aren’t working perfectly:

Paid search is where we make our money. So we are going to be very, very careful as to when we transition that. Because the holiday season is so important to our advertisers, we will not give the go-ahead unless we are confident of a smooth transition with quality.

The uncertainty surrounding the adCenter transition may partly explain Yahoo’s poor financial performance in the second quarter. Advertisers may be holding back ad buys for the holiday season until they know that adCenter is in place. If the switch to adCenter is delayed, advertisers will continue to shy away and Yahoo’s financial performance will remain lousy for the rest of the year. But if the October timeframe holds up, Yahoo’s stock could see a nice pop going into year’s end.

Yahoo! is High-Risk, High-Return

Longer term, Yahoo! remains a gamble. If Bing pays off, Yahoo! could double. Microsoft has a huge cash hoard of almost $40 billion, more than enough to invest in the technology needed to make Bing a worthy competitor to Google in search. Furthermore, Yahoo’s CEO Bartz is cutting costs by reducing headcount, divesting non-core business (e.g., sold HotJobs to Monster Worldwide for $225 million and office email Zimbra to VMWare), outsourcing back-end administration of Yahoo! Personals, Real Estate, and Local to “best of class” third-party websites, and focusing on growing core profit-makers Yahoo! Shopping, Autos, and Travel.

Lastly, don’t forget that Yahoo! has significant equity investments, owning a 35% stake in Yahoo! Japan and a 40% stake in China’s Alibaba Group (the eBay of China). Some analysts believe that these equity investments combined with Yahoo’s cash on hand are worth half of Yahoo’s share price. In other words, Yahoo’s core advertising business (display and search) is actually selling for around $7 per share. If Yahoo! can maintain its page views and stop its advertising business from declining further, the current stock price looks pretty cheap.

Gentlemen, place your bets.

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