Yahoo management’s moves over the past year are rapidly slipping into tragicomedy. As we’ve noted frequently over the past few weeks, the Yahoo-Google search deal is on the rocks, and both the company and now Wall Street are flopping around for alternatives.
The obvious alternative? Rekindling that search deal with Microsoft–the one Yahoo blew off twice in the late stages of its desperate attempts to get Microsoft to go away. Yahoo board members are reportedly reaching out to Microsoft to try to restart these talks, and JP Morgan’s Imran Khan has now published a note (below) recommending this option.
But there’s an elephant in the room.
When Microsoft made its second search offer, which was much better than the first, it was trying to woo Yahoo out of the arms of Google. If the Justice Department blocks (or fully neuters) the Yahoo-Google deal, that incentive for Microsoft disappears. So whatever deal Yahoo could have gotten from Microsoft when Google seemed like a viable alternative, any future deal will likely be a lot worse.
So Imran’s careful cash flow analysis below is likely just academic at this point. We agree with the rest of it.
As we think that it is unlikely that the Google/Yahoo! search partnership will pass DOJ review in its current form, we are taking a closer look at the possible option of Yahoo selling its search business to Microsoft. While this is a hypothetical exercise, we think that this could be a viable option that Yahoo! could consider. Following are our key points:
- Is search a losing battle? While we acknowledge that Yahoo! has posted a very healthy search growth rate over the past couple of quarters, we believe that this is due primarily to monetization gains. We believe that this growth is unsustainable and may actually reverse itself with continued market share losses. From September 2006 to September 2008, Yahoo! US core search market share declined from 29.0% to 20.2%, according to comScore data. In our view, the company’s initiatives will not prevent further declines and we believe that further erosion of market share could reverse some of the monetization gains.
[Yes, search is a losing battle. This is why the sale of the technology to Microsoft AND the Google partnership made sense.]
- Fully outsourcing search operations makes strategic sense. We think Yahoo!’s increased investment in search, has come at the expense of display investment, and has given competitors the opportunity eat away some of Yahoo!’s leading display ad market share. We believe niche sites are a particular threat. Over the last year, Yahoo! has achieved display ad revenue growth well below IAB estimates for the US display ad market. As such, it is important that Yahoo! allocate assets to further build its vertical content and improve the user experience. We believe that Yahoo! would be able to gain user loyalty and increase its market share by becoming more relevant and deep in niche categories, as the online market continues to fragment.
[Agreed: It makes good sense. Allows Yahoo to focus on what it’s best at while milking its remaining queries as long as it can.]
- We estimate that Yahoo! could gain an additional ~$725M in annual OCF through a Microsoft search deal. In our estimates, outsourcing search to Microsoft could lead to ~$1.4B in cost savings which would more than offset our estimated revenue loss of $694M resulting from affiliate revenue loss and the revenue split with Microsoft.
[That’s what the OLD Microsoft search offer might have yielded. We expect the new one will yield considerably less than that.]
- Yahoo! would be more focused and nimble. Without its search business, Yahoo! would be very clearly positioned as a content and display advertising entity, thereby clarifying and defining its purpose to advertisers and users. Additionally, the one time cash infusion of ~$1B (as was made in a previous offer) from the search asset purchase would allow the company to be nimble in buying back shares at depressed prices, making strategic acquisitions, and making more targeted headcount cuts.
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