2005 Tangle: Google, Yahoo! Brace for Round 2

The outcome of this high-stakes Internet ad clash promises to dictate the future of smaller fry.
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The online advertising business -- which gave investors no shortage of twists and turns in 2004 -- looks on track for more growth and more surprises in 2005.

Sitting squarely in the middle of the search-engine advertising business and responsible for much of the growth in Internet advertising,

Google

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and

Yahoo!

(YHOO)

will continue to fight for market share and users' attention.

Microsoft

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, with its own investment in search technology, will continue to have people guessing about what impact it will have on the search business, and when.

And advertisers -- who have grown to appreciate the accountability and measurability of an advertising medium that requires them to pay only for people who respond to their ads, rather than the people who have been exposed to them -- are clamoring for more.

All investors have to do is figure out which of the many variables in search -- locally targeted advertising, Google's pace of innovation, and shopping-related search, for example -- will have the biggest effect on the market, and when.

While analysts acknowledge that the explosive growth of search over the past few years can't go on forever, the pace seems far from slowing down, given recent indicators. Earlier this month, the Search Engine Marketing Professional Organization trade group released research concluding that advertisers plan to spend 39% more on overall search marketing in 2005 than they will end up spending in 2004.

In one sign that advertisers aren't shutting their wallets, the SEMPO survey concludes that advertisers have seen a 26% year-over-year rise in the average amount they pay each time a user clicks on their ad -- but say they can spend 33% more per click and still end up with a profitable transaction.

"It's a big market now that will continue to grow significantly," says Ryan Jacob, portfolio manager of the

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Jacob Internet fund. And that isn't its only significance for online companies, he says: Paid search "really legitimized Internet advertising in the minds of large companies."

As investors look to areas for growth for paid search in 2005, Jacob says that getting plenty of attention is the effort by Yahoo!, Google and others to develop the market for search-engine advertising that's geographically targeted -- enabling Internet users to connect, for example, with dry cleaning establishments in their zip code. "Local has the most hype right now," says Jacob. "Whether it comes to fruition for being a driver for the overall industry is still up in the air, I think."

The biggest wildcard in the search industry, says Jacob, is how much of an effect that Microsoft -- which is developing its own automated search technology to compete with that of Yahoo! and Google -- will have on the search business. "My gut is, they're going to have less of an impact than they would like," says Jacob. "I think their natural, dominant market positions will not be as helpful for them in moving into the search market."

Google has certainly captured people's attention with a series of new technology announcements this year, including its free email service called Gmail, its desktop search for finding material on one's own PC, and its deal to scan and index books from several major libraries. But given the investment money that's available for new search technology and the number of companies wanting to knock Google off its perch, says Jacob, he wouldn't be surprised to see competitors emerge. "I do think it is possible for people to come in with a game-changing technology," he says. Jacob's fund doesn't own any Google shares.

Danny Sullivan, editor of SearchEngineWatch.com, is one of many people who won't be surprised by continued innovation from Google in 2005. "What we can expect from Google is, 'If we can change the rules, we'll do it,'" says Sullivan.

Among all search engines, Sullivan says he expects to see greater integration of vertical search, meaning that subcategories of searching will be more prominently included in a general search. Thus, if one were to enter on a general search engine a search term that clearly indicated a shopping query -- say, "Minolta camera" -- one would get 10 shopping results on the first page, says Sullivan, and not have to go to a shopping-focused search engine to get such results.

Click fraud -- practices such as a company's clicking on a competitor's advertisements in order to increase the competitor's wasted ad spending -- is a growing problem, says Sullivan, though there's no indication that it's causing advertisers to cut back their search-engine spending. He expects advertisers to study the issue more carefully in 2005, though.

Dana Todd, executive vice president of the interactive agency SiteLab International, says she expects Yahoo! to become more like Google in the coming year, and Google to become more like Yahoo!.

Yahoo!, she says, will try to copy Google expanding its network of sites that run contextual advertising -- that is, ads that are tied to the content of the Web page on which they appear. Google, meanwhile, will further duplicate areas and functions that people use most on portals such as Yahoo!, starting with search, email and news.

"They are cherrypicking pieces of Yahoo! to emulate," she says, "but doing it in a more automated way."