Internet search remains our favourite portion of the advertising market, as we think its inherent advantages (highly targeted, more measurable than traditional media) and the continued growth of Internet usage will lead marketers to allocate more of their ad budget to search. Since we last wrote about the industry, there have been two major developments: the Microsoft-Yahoo search partnership, and the launch of Bing, Microsoft's new search engine. Despite these developments, we don't think Google is in jeopardy of losing its dominant position.
After 18 months of on-again, off-again negotiations, Microsoft finally got what it wanted: Yahoo's search traffic. Under the terms of the partnership, Microsoft will provide the back-end search and advertising technology, while Yahoo will lead the sales effort. Microsoft will pay to Yahoo 88% of the search revenue generated from Yahoo's sites for the first five years of the agreement. Although the partnership won't directly influence the market share of search queries on either search engine (Yahoo or Bing), the combined share is likely to improve the relevancy of search results and bring new marketers to the platform. Therefore, we think striking this partnership was the best option to form a formidable competitor to Google in the lucrative Internet search industry.
The principal beneficiary of the growth in search advertising over the last several years has been Google. Its superior product offering and brand strength have led to impressive gains in market share of search queries. Due to this dominance, some advertisers don't even bother to use alternative search platforms, which has led to an even larger share of search dollars than search queries for Google. The profits generated by Google's search business can be reinvested in additional computing power and human capital to make its search engine even better. Additionally, Google's massive scale of search queries and clicks gives the company unparalleled insights into which search results are most popular with users. This data intelligence can be used to further tweak its algorithms, leading to more relevant search results and an even better user experience.
Search engines also rely on the historical click-through rates to determine which sponsored search results (search ads) are most popular with users. These data help search engines determine which ads are most likely to be clicked on in the future. Thus, the search ad platform actually gets "smarter" with more use, as it partially relies on historical data to determine which ads to display in the future. Due to its massive scale, Google has a vast lead on competitors in terms of this intelligence as well, especially for the long tail of more obscure keywords.
We think the need for scale in queries was the primary factor in Microsoft's interest in Yahoo. Even if Microsoft was able to develop a first-class algorithm, a user-friendly ad platform, and the necessary data centers to index the entire Web, it would still be missing a vital component needed to provide a comparable search experience: scale in queries and clicks. Only by gaining access to Yahoo's inventory will Microsoft gain this key ingredient. Yahoo's scale in search queries will also help Microsoft attract advertisers to its platform. We think a partnership is the best option for Yahoo's shareholders and may be Microsoft's only chance of remaining relevant in search over the long run.
Separately, Microsoft has also recently launched its new search engine, Bing, with some success (Microsoft's market share of search queries improved to 8.9% in July from 8.0% in May, according to comScore). Combined with this, we expect the improved scale of the partnership to also lead to small gains in market share of search dollars. However, we don't think Bing is really an improvement over Google. Therefore, we expect Google to improve its market share of search queries over the long run. If that happens, the combined market share of the Microsoft/Yahoo venture at some point would fall below the point at which marketers felt it was worth their time and revert to advertising solely on Google. As a result, we think Google remains well positioned in the search advertising market.
Search partnership impact on Yahoo
The expected cost savings of outsourcing its search technology to
Microsoft should greatly outweigh the loss of revenue (Yahoo will share
revenue with Microsoft), resulting in improved profitability for Yahoo.
We think the present value of Yahoo's discounted future cash flows could
improve by about 25%. However, the majority of Yahoo's total enterprise
value is derived from its foreign investments (Yahoo Japan, Alibaba) and
its $4 billion cash balance. Based on our assumptions, our estimate for
Yahoo's equity value rises by only about 10%, or just $1 per share, as a
result of this deal. Because this impact is not material, we didn't
change our fair value estimate after the deal was announced.
Impact on Microsoft
Search has been and will remain an insignificant portion of the
company's overall cash flow. While Microsoft is likely attracted to the
economics of the search industry (at scale), we think the company's
primary goal in improving its search position is to slow down Google. If
Google is forced to allocate more resources to search, the company will
have fewer resources to develop its other offerings (Apps, Docs, App
Engine, Android, Chrome, ChromeOS, etc.) that compete more directly with
Microsoft's main business lines.
Impact on Google
We think the search partnership (ironically) may actually be beneficial
in the long run. Google has been the target of numerous antitrust
inquiries over the past year, and having a more formidable competitor
(by combining the number-two and -three players) may keep regulators at
bay. Additionally, the existence of a (semi)strong competitor will
prevent Google from becoming complacent and will force the company to
continue improving its search technology.
