Analyst: Feds will limit Google-Yahoo pact

September 24, 2008: 3:43 PM ET

By Yi-Wyn Yen

The Google-Yahoo search advertising pact will get approval from the Department of Justice in the next few weeks, but not without some serious scaling back of the deal, according to one analyst.

Thomas Weisel Partners managing director Christa Quarles expects the Justice Department to put limits on how often Yahoo will be allowed to run Google's (GOOG) ads on Yahoo's web properties. Yahoo's revenue-sharing agreement gives the Internet portal flexibility on the number and the type of Google ads it can show. Quarles predicts that the Justice Department will not trust Yahoo enough to give it that much freedom.

"The DOJ will put some caps on how much Yahoo can move over to Google," Quarles says in an interview.

Google and Yahoo (YHOO) plan to start the partnership in October. The pair gave the Justice Department 3.5 months to review the agreement for antitrust concerns after striking a deal on June 12. Any restrictions on the deal that the government wanted could either be accepted by the companies or not, in which case the feds would have to decide whether to pursue court action. The department has reportedly hired Sanford Litvak, a top litigator, to head up any case.

The agreement the companies struck allows Yahoo to use Google's technology to display Google's ads alongside Yahoo's search results. The search giant will pay Yahoo a portion of the revenues it gets over four years. Yahoo will have the option to renew the deal in two straight three-year terms. Industry analysts estimate Google gives its AdSense partners 80% of search revenue, and that Yahoo will get a similar arrangement.

For the month of August, Google controlled 63% of the search traffic in the U.S and Yahoo owned 20%,  according to comScore.

Yahoo is vague about exactly how often it will turn to Google's search-ad engine to supply results on a Yahoo page. But executives insist they plan to run Google's ads only when Yahoo has low ad inventory, especially in "long-tail" searches such as "red roses in Birmingham, Ala."  Yahoo says that the Google partnership can increase annual revenue by $800 million, or 11%.

Quarles argues that the feds will want to put more limits on the deal to keep Yahoo from becoming addicted to Google. "Let's say Yahoo starts with long-tail queries. Then they start turning up the dial to include the retail segment. And then it's, 'Ooh, my. We can double monetization.' There's a very high temptation for Yahoo to shift over to Google," Quarles says.

The ad partnership has received criticism from powerful interest groups such as the Association of National Advertisers and the World Association of Newspapers. Advertisers say they fear the combination of the top two search engines will drive up the prices they pay for search keywords. Newspaper publishers worry that the combined forces of Google and Yahoo will reduce competition and ultimately lead to less revenue and higher fees for them.

Both Google and Yahoo insist that competition will get better as the tarnished Internet portal invests the additional money to improve its search ad system.

Quarles predicts that Yahoo will make far less than the $800 million the company says it can.

That's not good news for investors who saw a buyout from Microsoft (MSFT) as a better alternative to the Google pact. In a June note to clients, Quarles wrote that Yahoo's revenue opportunity for the first year will be between $313 million and $563 million. She speculates that Yahoo will outsource no more than 15% of its search ads to Google.

She says now that based on her market research and conversations with Yahoo insiders, the feds will likely limit the agreement in a way that keeps Yahoo's take to her estimates.

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