Yahoo! Strikes to Fend Off Microsoft - TheStreet

Yahoo! Strikes to Fend Off Microsoft

The Overture buy answers a perceived threat from Redmond, Wash. Could an M&A frenzy follow?
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Updated from 12:47 p.m. EDT

In a tightening race to control the Internet advertising market,

Yahoo!

(YHOO)

has struck first.

With Monday's

agreement to buy pay-per-click advertising company

Overture

(OVER)

for $1.6 billion in stock and cash, Yahoo! took a big step to shore up its position on the Web against rival

Microsoft

(MSFT) - Get Report

.

Both Yahoo! and Overture gain numerous competitive advantages by combining, and Yahoo! gets to use its fast-appreciating stock to buy precious growth. But most important to the Sunnyvale, Calif.-based media company is keeping Microsoft's hands off a key property, says Ethan McAfee, technology analyst at Capital Crossover Partners.

"If Microsoft bought Overture,

Yahoo! would really be out of luck," says McAfee, whose firm doesn't currently own stock in Yahoo!, Microsoft or Overture.

Overture stock rose 11% Monday, and the paid-search linkup ignited jumps in also-ran Web properties such as

LookSmart

(LOOK)

, which leaped 20%, and

FindWhat.com

(FWHT)

, which added 6%. Yahoo! slipped 24 cents to $31.95 and Microsoft added 35 cents to $27.66.

Strategy

Certainly, Yahoo! will enjoy strategic advantages from having Overture in-house, what with Overture's pay-per-click search engine generating ever-increasing percentages of Yahoo!'s advertising revenue.

And from Overture's perspective, coming under Yahoo!'s aegis gets the company around the growing problem it faced of competing with Google for partnerships with unaffiliated publishers.

But perhaps more important for Yahoo!, the deal also removes the risk that the supplier of one of its most promising sources of revenue will fall under the dominion of its biggest rivals in the Internet advertising market: Microsoft.

Overture accounted for 19% of Yahoo!'s advertising revenue in the latest quarter and much of its year-over-year growth. In separate agreements, Yahoo! and Microsoft accounted for nearly two-thirds of Overture's revenue, through agreements in which Overture pays publishers a cut of the revenue it garners from pay-per-click search results it supplies to their respective sites.

Yahoo! Chief Operating Officer Dan Rosensweig told

TheStreet.com

Monday that the motivation for the deal was mostly about the benefits to Yahoo! if it could work closely with this major supplier in-house "as opposed to wait for somebody to develop things that may or may not be great for you or right for your advertisers."

Continued Rosensweig, "For advertisers on the Yahoo! network, we want to be able to be sure that we have a seamless, integrated marketing experience for them. And having to do business with multiple partners doesn't actually create that."

Asked whether the possibility that Microsoft might make overtures for Overture was a part of Yahoo!'s decision to buy, Rosensweig said, "Hypothetically, we look at all the different things that could happen," adding later, "There are really two large players in this game, and so it made sense for us to do this."

The Google Factor

Along with Overture, the other large player, of course, is Google -- a company that doesn't release its financial results but whose presence has forced Overture to hand over an increasing percentage of its advertising revenue to the partners that run Overture's listings on their sites.

For Overture's part, thus, one advantage of allying itself with Yahoo! is that it will have better access to capital as it -- and Google -- expand into new elements of the search business. Both Overture and Google, for example, recently introduced pay-per-click advertising designed to run on non-search Web pages with content relevant to the advertising.

From Overture's perspective, the deal also reflects the diminishing value of what the company has said for years is one of its distinguishing advantages in its relationships with Web site publishers: its neutrality. Unlike Google, said Overture, it wasn't competing with its partners for revenue by competing for their traffic with its own Overture-branded destination Web site.

But now Overture is part of Yahoo!, that neutrality disappears -- raising the possibility that partners might desert the company for their own in-house solutions or some independent pay-per-click suppliers.

"From an economic perspective, we obviously modeled that possibility and built that into the price that we were able to pay," said Rosensweig. "We understood that the affiliate marketplace might heat up."

Back to Washington

One sell-side analyst, speaking on condition of anonymity, says he doesn't expect a mass exodus of Overture customers because of the Yahoo! deal. The analyst, whose firm owns neither Yahoo! nor Overture, says he suspects that those customers will decide that doing business with a pay-per-click supplier with its own Web site -- either Overture or Google -- will be inevitable, if not ideal.

One major question arising from Monday's announcement is what Microsoft's response will be. Given Microsoft's MSN Web sites' competition with Yahoo!, it seems unlikely that Microsoft would remain for long as a customer of the Yahoo!-owned Overture. Certainly, Microsoft has the resources to develop its own paid-search technology to use in place of Overture's; SoundView Technology analyst Jordan Rohan reported in April that

Microsoft was doing just that, though a Microsoft executive publicly denied it.

Microsoft conceivably might have a mergers-and-acquisitions-type response to Monday's transaction. One possibility would be to outbid Yahoo! for Overture. Yahoo! and Overture Monday didn't mention any breakup provisions in their proposed deal.

Alternatively, Microsoft could buy a smaller supplier in the paid-search business. Such speculation on Monday fueled the LookSmart rally and nudged both

Ask Jeeves

(ASKJ)

and FindWhat.com toward smaller gains.

"To me, it's a no-brainer that Microsoft cuts a deal for somebody," says a second anonymous buysider -- a LookSmart shareholder who says he's still holding onto his stock after Monday's leap. Though Microsoft could build its own back-end search technology, the buysider argues that the software colossus will more likely be a purchaser so it can speed its time to market with its own paid search product.

Lisa Gurry, a spokeswoman for Microsoft's MSN, declined to comment on any M&A speculation. As for the company's relationship with Overture, she said there would be no changes anytime soon, though she propped the door wide open for changes later. "We don't anticipate today's announcement to impact our business in the short term," she said Monday.

Paid search has been "an incredibly successful part of our business over the past year," said Gurry. Microsoft looks forward, she said, to talking with Yahoo! and Overture within a few days to gain "a deeper understanding of their agreement," she said.