Why Microsoft will buy part (but not all) of Yahoo

Microsoft, working in its well-honed Black Widow Spider mode, has sucked the soft part out of Yahoo. At least publicly, the Yahoolies don’t seem to have noticed that they’ve been out-manuevered by the Redmond Horde. But they have. Rumors are flying that Microsoft may make yet another bid for Yahoo. I don’t believe it. Microsoft already has everything it wants out of Yahoo, with one exception. I figure MS will join with several other companies and make a bid for Yahoo, soon. I also suspect MS won’t pay much, and won’t want much out of the transaction. Here’s why.

Last Tuesday night, Yahoo announced truly abysmal financial results. Yes, Yahoo’s stock shot up on Wednesday, and it’s been holding strong. The MarketBeat blog at Wall Street Journal says that analysts reacted positively to the Yahoo Earnings announcement, even though earnings fell somewhere between 6 and 8% from 1Q 2010 to 1Q 2011, depending on how you count. Revenue was down a whopping 24%.

The universally-acknowledged bugaboo, per Yahoo’s press release: “the required change in revenue presentation related to the Search Agreement and the associated revenue share with Microsoft. For transitioned markets (U.S. and Canada), Yahoo! now reports revenue associated with the Search Agreement on a net (after TAC) basis rather than a gross basis.” TAC is the Traffic Acquisition Cost, or the amount that Yahoo pays other parties to generate search revenue.

But the numbers speak for themselves, and the numbers don’t do Yahoo any favors. Display revenue is up, but search revenue – the part that got Binged – is down 19%, between 1Q 2010 and 1Q 2011. More than that, Yahoo may blame revenue sharing with Microsoft for its losses, but that 19% drop is simply money – it has nothing to do with TAC. Microsoft gets 12% of Yahoo’s search revenue, and the MS cut doesn’t have anything to do with TAC. For the details, see Greg Sterling’s analysis in his SearchEngineLand blog.

Taking the analysis one step further, Sterling shows that Yahoo’s search revenue has taken a long, sustained, steep drop since mid-2008. The Microsoft search deal only exacerbated an already-bad problem. As Sterling puts it, “In the end, I come away with — and sorry to say it — not a whole lot of faith in what Yahoo’s been saying, much less the grand master plan that outsourcing to Microsoft was going to save its search business. Yahoo still has substantial search traffic, but it remains dwarfed by Google while Bing has been closing the gap… there’s no doubt that Yahoo’s not in the driver’s seat on search.” This, in spite of the fact that Yahoo has a considerably larger share of the US search market than Bing. “[Yahoo]’s having to pray that its partner (which is also a chief competitor) will fix things to boost its revenue. If that doesn’t happen, what Microsoft has to pay out seems like pocket change.”

Look at it from the Microsoft side. Ballmer tried to buy Yahoo for $44.6 billion in February 2008, met fierce resistance – including a threat to sell Yahoo to News Corp and mingle with MySpace – then Microsoft gave up in May. In November 2008 the shotgun came out again, and it looked like MS and Yahoo were headed to the alter. Ballmer reportedly offered $20 billion for Yahoo’s search business – at the time Yahoo’s total market value was about $16 billion – but Yahoo, it’s said, wanted more. Yahoo co-founder and CEO Jerry Yang stepped down, replaced by Carol Bartz, and the deal fell through.

In July 2009, Microsoft and Yahoo reached a 10-year deal that moved Yahoo search to the Bing engine, in the US and Canada. Yahoo would pay Microsoft 12% of the gross revenue from all of the ads that run next to search results. Based on Yahoo’s results just announced, Microsoft got the better end of the deal: Bing more than doubled its market share, overnight – and Yahoo pays Microsoft for the privelege.

Yahoo still has the most-visited site on the Internet; according to Comscore, Yahoo just edged out Google and Microsoft as the most-visited site, from the US, in March 2011. Yahoo’s advertising revenue is doing well. Yahoo has $3.5 billion in cash, and owns big parts of Yahoo Japan and Alibaba.com. But the value of its search capability is seen almost universally as turning an enormous belly flop.

All of this has led to speculation that the sharks are circling, and Yahoo’s days as an independent company are numbered. Kara Swisher at All Things Digital has developed several possible scenarios.

Microsoft already has the most important piece of Yahoo, from their perspective – search market share. The other pieces of Yahoo aren’t nearly as compelling. But there are two missing parts, which lead me to believe that MS will be interested in participating in the dismembering of Yahoo.

First, MS hasn’t nailed down international search rights. The current search agreement only includes the US and Canada. International search is a key future sticking point for Bing, and owning part of Yahoo will help put yet another foot in the door.

Second, Microsoft doesn’t want to give Google even a tiny slice of the pie. Any pie. The best way to ensure that – to make sure that a Google-leaning exec doesn’t head up the reconstituted Yahoo, for example – is to have a stake in the company.

Softbank is chomping at the bit to consolidate its part of Yahoo Japan. Alibaba wants its shares back. No matter how you look at it, Yahoo is worth more in well-defined pieces than a jumbled hole. Microsoft didn’t start Yahoo’s downward spiral – I would argue that was inevitable, given Yahoo’s traditional businesses and the march of technology. But the Softies certainly sent a big piece of Yahoo into the trash bin. And the remainder is ripe for picking.