Yahoo's Microsoft search pact: Dissecting the returns

Yahoo's search partnership with Microsoft is expected to be a financial boon to the company and boost free cash flow by 20 percent in the years ahead, but there are multiple wild cards that could hamper the deal.
Written by Larry Dignan, Contributor

Yahoo's search partnership with Microsoft is expected to be a financial boon to the company and boost free cash flow by 20 percent in the years ahead, but there are multiple wild cards that could hamper the deal.

The Microsoft-Yahoo pact received regulatory approval last month. Under the 10 year deal, Microsoft will power Yahoo's algorithm and paid search. Yahoo sells ads for the Microsoft's search properties. Microsoft will hire Yahoo employees and the implementation will be complete in 24 months, or first quarter of 2012. Yahoo will get a $275 million boost to operating cash flow.

JMP Securities analyst Sameet Sinha upgraded Yahoo to a "market outperform" from a "market perform" based on the earnings outlook due to the Microsoft search pact. Sinha is among the first Wall Streeters to take a crack at how the Microsoft search deal will help Yahoo's bottom line. However, there are a few moving parts.

In a research note, Sinha laid out his case. Sinha estimates that the search deal with Microsoft will boost earnings before interest, taxes, depreciation and amortization (EBITDA) to $1.9 billion in 2010 from current estimates of $1.8 billion. In 2011, EBITDA will come in at $2.2 billion compared to a consensus at $2 billion. Yahoo will lay out its outlook for the deal when it reports first quarter earnings in April.

The JMP analyst began with the assumption that revenue per search will benefit as Microsoft's search algorithms benefit from more traffic, relevancy and click through rates. Sinha estimates that revenue per search will improve at roughly 9 percent.

Before that revenue improvement comes though, the Microsoft search deal orchestrated by Yahoo chief Carol Bartz and Steve Ballmer (right) is really about saving dough. Yahoo will shed more than 400 engineers and won't have to crawl, index or rank sites. The company also won't have to invest in search anymore. Here's a look at Yahoo's savings once the Microsoft deal is fully implemented:

But there are wild cards. Among them:

Yahoo can't grow its display business amid tough competition. Yahoo is facing display ad competition from social networks like Facebook as well as Google, which acquired DoubleClick. Toss in economic concerns and it's possible that the Microsoft-Yahoo search pact will be targeting a smaller ad pie. The Microsoft-Yahoo search pact with some real growth could be dangerous but there are no guarantees.

The transition to Microsoft's platform doesn't go well. Sinha estimates that the Yahoo's U.S. search transition to Microsoft's adCenter platform won't happen until 2011. Why? "Our experience tells us that integrating systems always takes longer than planned, so we do not expect a transition in paid search to happen in 2010. Once we reach the holiday season, Yahoo! will not want to rock the boat during the seasonally strong period; hence, we believe they will wait until 1Q11 to begin this transition," said Sinha.

The international search transition won't happen until the second quarter of 2011. Revenue per search metrics don't improve. There's a bit of a delicate search market share dance that Microsoft and Yahoo have to do. The general theory is that the combined search share of Microsoft and Yahoo will be about 30 percent. The rub: Yahoo's search share is in decline and Microsoft's is improving. If those share gains and losses aren't in sync, the Microsoft-Yahoo pact may no deliver the revenue gains. Microsoft does have an ace: Its cashback program, which pays for share. Sinha said:

Cashback has not been very successful with small and mid-size retailers, but adoption among large retailers is good. While there are no current plans of offering Cashback on the Yahoo! platform, we believe this could eventually happen as Microsoft would want to give its retailer partners access to the traffic at Yahoo.

Employee turnover and other synergy headaches. The success of technology implementations almost always boil down to one word: People. How much turnover affect the implementation of the Microsoft-Yahoo deal?

Since the Microsoft-Yahoo search pact just kicked off we won't know how these wild cards play out for about a year. The stakes are high: This deal with Yahoo is Microsoft's last shot at being a search counterweight to Google.

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