Yahoo! Caught in Net Crossfire

Its top spot in online display ads could be threatened by a battle between Microsoft and Google.
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Microsoft's (MSFT) - Get Report latest shot at Google (GOOG) - Get Report could end up hitting an unexpected target: shareholders of Yahoo! (YHOO) .

The Wall Street Journal

reported Wednesday that Microsoft was in talks to acquire privately held

DoubleClick

, which lets customers publish ads across Web sites. The move would allow Microsoft to garner a bigger share of the booming online ad business, where it so far has had limited success.

Google, meanwhile, is also eyeing DoubleClick's market. The search giant plans to roll out a competing service that lets users place ads on sites beyond the search giant's own network in the next few months, the

Journal

quoted sources as saying.

But the ensuing brawl between Google and Microsoft could end up damaging investors in Yahoo!, too. As Google continues to dominate text-based search, to the Redmond, Wash., software giant's dismay, Microsoft may be angling for another way to participate in the booming online ad market by going after rich

video-related display advertising instead.

And DoubleClick, a player in the display market with its huge roster of relationships with online publishers and its blue-chip list of clients, could give it an entry point.

"It would be a good start from Microsoft's perspective because it would give it a much broader reach for rich media and a way to get more into the business," says Ani Kortikar, the CEO of search marketing firm Netramind. "And if you're Microsoft, you don't only want to go after Google in text advertising, which is

Google's strong point."

But while Google has every intention of getting into the display advertisement business, that arena is clearly Yahoo!'s crown jewel -- for the time being. "For the quarter and for the year, we believe that we once again outperformed the marketplace, notwithstanding that we already have the largest display advertising business," Yahoo! CEO Terry Semel told investors in the company's latest conference call. "Because we are well-positioned to develop greater context and relevance for consumers and advertisers, our aim is to outpace the industry again in 2007."

At a technology conference in February, Google Vice President of Advertising Sales Tim Armstrong said the search giant was taking its usual deliberate approach to push into the display ad market. "We could have easily just plastered graphic ads all over YouTube," Armstrong said, referring to the popular online video-sharing site that Google acquired in 2006. "But we wanted to see if there might be a way to do it that better serves the user."

But Microsoft staking out territory in the lucrative market may be exactly the type of motivation Google needs to quicken its pace. And while intensified competition would be an obvious consequence for Yahoo!, cash-laden competitors launching a price war would be an even uglier scenario.

Reports of Microsoft mulling a DoubleClick acquisition come at a precarious time for Yahoo!. The Internet giant has rallied sharply since the beginning of the year -- the stock gained 21% to close at $31.34 on Thursday -- as its highly anticipated Panama ad-ranking system has met with rave reviews. But while Panama's success is undoubtedly a feather in Yahoo!'s cap, the company is still heavily dependent on display advertising.

While Yahoo! reveals only that 88% of its calendar 2006 revenue came from marketing services, AG Edwards analyst Denise Garcia estimates that 60% of that comes from search-related ads, meaning that the remaining 40% comes from rich ads.

That would peg a sizable 35% of Yahoo!'s total revenue to rich-media advertising. Yahoo! also commands a hefty price tag for its high-end ads, according to Garcia's estimates. For each 1,000 impressions, Yahoo! gets between $25 to $30 for rich-media ads, $5 to $6 for banner ads and an average of $1.39 for text ads.

AG Edwards doesn't have an investment banking relationship with Yahoo!

Losing even a comparatively small number of rich-media advertisers to Google or Microsoft could put a dent in Yahoo!'s rich valuation. The company currently trades at about 43 times forward earnings, compared with 25 for Google and 16 for Microsoft.

While Yahoo! continues to make impressive gains in not only its search business but also emerging areas

such as the mobile Internet, the company may find trouble in the one arena it dominates.

And while the war between Google and Microsoft is usually framed as a titan-vs.-titan battle, investors should be aware that some shells will inevitably land in Yahoo!'s backyard.