Cap’n Ken’s Homespun Wisdom

In an award-eligible and widely-ignored piece about five weeks ago, I detailed my unoriginal thoughts on a potential search outsourcing deal that could save Yahoo from collapse in the wake of Microsoft’s failed bid to buy the company.

And today Yahoo and Google struck just such a deal. So I figured it worthwhile to take a look at what they’ve announced and what it means to Yahoo’s financials and future. It’s less worthwhile to write about it here, but what the heck.

Disclosures and street cred: I am still a Yahoo shareholder and picked more up on the tanking this afternoon. I am no longer a Microsoft shareholder. And I used to run a Google-powered web search product for what used to be a major Internet company. So AdSense for Search … I’ve been there.

OK, so what’s the deal? Most significantly, Yahoo is not shelving its own paid or natural search systems; they are simply bolting AdSense on to some or all of their search results page in the U.S. and Canada. AdSense becomes just another monetization route for Yahoo Search - if they can’t serve a valuable ad; just let Google handle it.

And maybe that’s a smart move. It might quell some of the anti-trust sentiment already swirling around the deal, and allows Yahoo to still tinker around trying to build a better search. On the “anti-trust” stuff, by the way, I’m still perplexed at what the issue here would be. Yahoo is entering in to a contract with Google, and other competitors from AOL to the New York Times have the same deal with Google. Google will have no ownership in Yahoo … just a contractual relationship. The companies said flat-out today that the deal is not an anti-trust issue, so we’ll see.

OK, so the financials. Yahoo says they expect to see an extra $800 million in annual revenue, so running the assumptions from my first piece ($80 gross RPM from Google; 75% rev share) alongside ComScore data suggesting Yahoo’s annual query volume - that comes out at right about 50% of searches being monetized by Google. Hey, a round number - and room to grow. Yahoo says Google is going to be serving the deeper “tail queries”, which makes a lot of sense. Yahoo probably gets good value for everyday terms, but there’s no way their base goes nearly as deep as Google’s.

But Yahoo says the $800 million in annual revenue will result in just $250 million - $450 million in incremental net cash flow.

That incremental cash flow is projected to be only 31% - 56% of gross revenue is an interesting projection. Assuming the AdSense deal is set up as Google usually does it, that $800 million should have very little operating expenses laid against it (maybe 10% in administrative / support costs), so I’m thinking Yahoo is going to use a lot of the Google revenue to increase investment in their own search and advertising systems while showing enough bottom-line benefit to hold off the wolves.

Based on Yahoo’s projections, the deal would boost annual revenue 11% from the last four quarters and net income between 24% - 42% depending on where incremental cash falls in their projected range. That … ain’t bad.

Project that out with Yahoo’s current stock P/E ratio and you get a suggested value of $29 to $33 a share. Thirty-three dollars a share … why does that sound familiar?

So if you believe Yahoo’s projections (Google has provided no guidance on what to expect), the company gets a lot healthier real quickly. And I’m inclined to think they have a good handle on what to expect and are providing good guidance.

The Google Effect is very, very real. Hooking up with AdSense is like turning on a money faucet if you have any decent level of search traffic. There’s no reason to believe Yahoo won’t see a tremendous Google benefit. There’s a lot more work to be done in Sunnyvale (let’s see Jerry step aside at the annual meeting for starters), but what Yahoo has shown Mr. Icahn, Mr. Ballmer and everybody else is they do have value to tap and selling out at a discount isn’t in the best interest of the company.

Update: Interesting conclusions can be drawn from Yahoo’s SEC filing on the Google deal. Google has a right to cancel the deal if it doesn’t end up pacing at $1 billion a year in gross revenue for Google; Yahoo projects $800 million a year in gross revenue to them - suggests an 80% rev share for Yahoo. Yep, that’s about right.

Also, the rev share will adjust based on “specified monthly gross revenue thresholds”. Google’s not going higher than 80% rev share, so I’m thinking Yahoo’s take goes down as monthly gross goes up. So Google is giving Yahoo the surety of the big rev share up front to shore up their earnings; then the benefit to Google is a higher take than usual once Yahoo has made its nut.

The “Change in Control” terms are also interesting:

As defined in the Services Agreement, the term “Change in Control” means (a) a merger, consolidation, statutory share exchange, recapitalization, restructuring or business combination involving directly or indirectly a party or a subsidiary of a party in which voting securities of the party outstanding immediately prior to such transaction do not continue to represent more than 50% (or 65% in the case of a transaction involving Microsoft Corporation (“Microsoft”), Time Warner Inc. (“Time Warner”) or News Corporation (“News Corp”), in each case together with their respective affiliates) of the voting power represented by the outstanding voting securities of the surviving entity immediately following the transaction; (b) any “person” or “group” becoming the “beneficial owner” (as such terms are used or defined in Sections 13(d) and 14(d) under the Securities Exchange Act of 1934, as amended) of more than 50% of the voting power of the then outstanding voting securities of the party, except that, in the case of Time Warner and News Corp, the percentage will be 35% instead of 50% and, in the case of Microsoft, the percentage will be 15% instead of 50% and a Change in Control will also be deemed to occur if Microsoft (i) beneficially owns 15% of the voting power of the party or (ii) acquires directly from a party any equity or voting securities of that party representing (or having a right to receive in the aggregate) 5% or more of the total equity value of the party or 1% or more of the party’s annual revenues on a consolidated basis); (c) approval by the stockholders of a party of a plan of liquidation or dissolution; (d) the sale or disposition of all or substantially all the consolidated assets of a party; or (e) at any point in time, Yahoo! no longer owns and, with respect to the U.S. and Canada, controls a majority portion of Yahoo!’s technology and intellectual property assets that in the 12-month period prior to that time had been owned by Yahoo! and used by Yahoo! to provide services in the U.S. and Canada for either its algorithmic search or search advertising business. The Services Agreement also permits Google to suspend performance of the Services under certain circumstances, including a pending Change in Control of Yahoo! involving Microsoft, Time Warner or News Corp and a change in a majority of the board of directors of Yahoo! following an annual or special meeting of stockholders if a majority of the new directors did not serve on Yahoo!’s board immediately prior to such stockholder meeting and were nominated or solicited for by Microsoft, Time Warner or News Corp or, solely with respect to Yahoo!’s first two annual or special meetings held after the Effective Date where the election of a majority of directors is before Yahoo! stockholders (but not later than September 1, 2009), by any other person or group.
If the Services Agreement is terminated by either party within 24 months of the Effective Date as a result of a Change in Control of Yahoo! (other than a Change in Control triggered only by Microsoft either (x) acquiring beneficial ownership of voting securities representing more than 15% of the voting power of outstanding Yahoo! voting securities or (y) acquiring directly from Yahoo! equity or voting securities representing 5% or more of Yahoo!’s total equity value or 1% or more of Yahoo!’s consolidated annual revenues, unless Microsoft becomes the beneficial owner of more than 35% of the voting power of such securities within such 24 month period), Yahoo! is required to pay to Google the sum of $250,000,000, which payment will be reduced by one-half of an amount equal to (a) all gross revenues received by Google pursuant to the Services Agreement through the date of termination less (b) the amount equal to Yahoo!’s share of such gross revenues during the same period.

Lots of financial legalese up in there. Specific references to Time Warner and News Corp. are interesting, as is the reference to Yahoo not owning its search business anymore.

So last night Microsoft officially bailed on its offer to buy Yahoo. Jerry’s kids stuck to their guns on acceptable pricing and scared Ballmer away from a proxy fight with talk of a Google alliance. Well done, I say.

The only thing that would have made sense about this acquisition was a really big premium for Yahoo shareholders (I am one), and what Microsoft (I own it, too) was offering was a big premium on a stock depressed by a lot of missteps and the general decline in stocks over the past six months. YHOO was trading above Microsoft’s offer as recently as late October, you know.

It was an opportunistic move by Microsoft to snap up a battered company at its weakest moment. That Yahoo wiggled its way out of the Redmond Death Grip is impressive. In the short term, I’m sure Yahoo stock is going to get hammered, shareholder lawsuits will be filed and the pain of the Microsoft ordeal will linger a while.

But ultimately, Yahoo is much better off not being a subsidiary of Microsoft. Yahoo is a much, much stronger online brand than MSN (as represented by MSN.com, Live.com, Hotmail.com, MSNBC.com and whatever else makes up the mishmash of Microsoft’s online presence), and Microsoft is the poster boy for the futility of just throwing money at the Internet.

Microsoft has been growing its online business of late, and also growing its online losses. In the first quarter of 2008, Microsoft did $843 million in revenue and lost $228 million in their online segment. Yahoo, by the way, did $1.8 billion in revenue and made $121 million in the quarter.

Why, then, would Microsoft be a better owner of Yahoo? They wouldn’t. Microsoft just has plenty of cash on hand ($26 billion in cash equivalents) and thought they could pick up a great online asset on the cheap. And it would have been a hell of a nab for Microsoft, but ultimately “Yahoo - A Microsoft Company” would really sell short the Yahoo potential.

Having been a part of the kind of b.s. company outlook presentation Yahoo put together (PDF) to counter Microsoft’s advances, I don’t buy the “look how big we’ll be!” make-believe numbers, but Yahoo is right that the market under-values the company right now.

And the reason is this - all of the focus these days is on search advertising. Yahoo has poured a ton of time and money into their Panama ad platform with little effect against the Google machine, and that failure is what Wall Street has focused on. Microsoft, as well, has failed to put a dent in Google with its Live Search and AdCenter platforms.

Google has won web search as we know it. Period. Fighting that battle has been very bad for Yahoo, and it’s time to wave the white flag. With $50 billion in revenue and net income of $14 billion a year, Microsoft has the ability to continue the fight should they chose, but Yahoo needs to get out.

The logical move for Yahoo now is to syndicate Google AdSense for Search. Not outsource their search engine; just kill Panama and serve AdSense ads instead. An informed hypothetical effect of such a move:

- Say Yahoo now earns $50 per thousand queries (which is probably a high estimate) and their net margin after development costs, administrative costs, etc. of web search and Panama is 25% (what Google nets).

- Say using AdSense, Yahoo would see $80 per thousand queries (a reasonable estimate), get a 75% rev share (also a reasonable estimate) and have administrative expenses at 5% of their Google net. Then spend another 30% of that net on search engine development.

The Yahoo DIY model would net out $12.50 per thousand queries, while the AdSense syndication would net out $39.90 per thousand queries. Throw some conservatism into the estimates and it’s a safe bet that Yahoo could double its net search revenue while getting out of the losing game of chasing Google. Using my hypotheticals and ComScore search data, it seems plausible that Yahoo could add somewhere around $1 billion in net income per year just by getting (back) on board the Google train.

There is, of course, the anti-trust consideration. In a practical sense, Google (through its own site and its many, many syndication partner sites) currently has about 68% U.S. market share for search, with Yahoo probably holding about 23% - 24% with its sites and partners, and Microsoft picking up the remaining 8% - 9%. So if you’re arguing against a Google / Yahoo deal, you’d say essentially that Google would end up with 90+% market share. Of course, if you’re arguing against the deal, you’re probably Microsoft, which holds a 90+% market share in operating systems.

Adding Yahoo would obviously be a huge market share gain for the AdSense platform, but Google is already the ad provider for AOL (No. 4 in web search), Ask.com (No. 5), the web portals for Comcast, Verizon, AT&T, Cox and most other major ISPs, CNN.com, MySpace, NYTimes.com, LATimes.com, etc. etc. You get the picture - Google is web search advertising.

Would the Trust Busters really block a service agreement (not an equity stake) between Google and Yahoo because of AdSense market share concerns? Maybe, but it seems like a stretch to block a non-equity contract between two companies. Akamai is pretty dominant in the content-serving business, so are they going to be denied big new contracts because of “anti-trust” concerns?

I have to think the anti-trust hurdle is one Yahoo could clear on an AdSense deal with Google. The actual combination of the No. 1 and No. 3 display advertising companies and No. 2 and No. 3 companies in total online audience probably would have been a bigger anti-trust concern. And Yahoo’s long-held position as the king of online content is at the heart of its real value.

Even having lost a lot of luster during its “Hollywood” years, Yahoo is a stellar online content brand. Their future promise lies not in fighting Google, but in building online audience and monetizing well through display ads. If they had been focusing on that instead of chasing after movie deals and search advertising for the past several years, they would be in much better shape today.

When they’ve done smart things (like buying Flickr), they’ve managed to totally screw up integration after the fact. I guess they’re working on that now, but a real sharp focus is needed on re-crafting the Yahoo product set. The company was barely over its Semel Hangover when the Microsoft bid hit, so it’s going to take a while to really right the ship.

Once tightened up, Yahoo will be in a great position to fight the next online revenue battle - targeted display advertising that yields much higher CPMs. Google, of course, has taken note with its DoubleClick acquisition, and AOL is raising eyebrows with its Platform-A program.

Again, had Yahoo recognized earlier that search was lost, its focus could have been put on the next battle - one it was once in a dominant position to win. But Yahoo is about on par with AOL in terms of its display advertising network and dominates inventory on its own sites. Be smart, focus on the right things … and for God’s sake get a real CEO in there. Jerry Yang stopped being CEO the first time a year and a half before Yahoo reported having 155 employees (including 44 “surfers”) and generating $19 million in revenue. And he’s the guy to turn around a troubled $7 billion company? Please.

Yahoo is full of potential, but given their miscalculations and missteps over the last five years, their potential remains just that. The company could be the Google of Display Ads 2.0 if they start doing things right, or it might get picked up by Microsoft next year for half the offer they just turned down. I’ll be interested to see what the fate of Yahoo is now.