Yahoo's Overture economy

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news analysis Last November, Yahoo CEO Terry Semel laid out a broad recovery plan to return the battered Web portal to profitability.

Now, as the company has begun to deliver on some of its promises, one success stands out above all others: A deal with Overture Services to add advertising linked to keywords in its search results, which analysts estimate generated some $30 million in cash in the third quarter alone.

The partnership is remarkable both for the size of its contribution to Yahoo's financial revival and the deep changes it signals for a company founded on a free Web navigation service. Having turned a search directory into a brand that now draws hundreds of millions of Web surfers a month, Yahoo is busy turning much of its traffic into cash by delivering it to an outside search company.

Although Yahoo has jettisoned many assumptions that animated the company during its go-go years, analysts see the overhaul of its search business as among the most significant changes to date.

"Revenue from Overture is extremely profitable at Yahoo and without that revenue stream, it seems quite possible that Yahoo would not have reported any operating profit over the last two quarters," said Derek Brown, an analyst at W.R. Hambrecht.

In a landscape littered with failed dot-com business makeovers, the Overture deal has few peers in terms of the speed and size of the payoff. But it has also created new uncertainties for Yahoo, which has effectively handed significant control over its future to outsiders.

The three-year deal, which is not exclusive, leaves Yahoo room to tinker with its search services, including syndicating advertising links from other paid search providers and adding its own if it so chooses.

Still, some analysts question whether Yahoo will become too dependent on Overture, leaving it exposed to potential missteps from its partner. If the service thrives, on the other hand, Yahoo could find itself facing tougher demands when the deal comes up for renewal in April 2005.

"Search is a pretty core and important element of Yahoo and I don't want to see them mortgaging the farm for some short-term upside," said Jim Preissler, an equity analyst at Investec. "I think it's a long-term critical element."

Yahoo downplayed the worries that it has placed too many eggs in one basket.

"One of reasons why we decided to partner with Overture was so we could get into what we saw as a lucrative business very quickly rather than building it our own," said Joanna Stevens, a Yahoo spokeswoman.

Inside the Overture deal
No one questions the immediate value of the Overture deal for Yahoo's bottom line.

Over the past two financial quarters, Overture has buoyed Yahoo with some $55 million in hard cash, analysts estimate.

The Overture effect was especially pronounced last week, when Yahoo reported $57.3 million in free cash flow and $60.2 million in earnings before interest, taxes, depreciation and amortization (EBITDA) for its latest quarter. Overture revenue contributed to more than half of cash flow and EBITDA for the quarter, analysts estimated.

Neither Yahoo nor Overture would disclose how much Yahoo gets paid for carrying Overture's listings. But the common estimate among Wall Street analysts is that Yahoo gets 65 percent of the take each time someone clicks on a paid link.

The generous split is likely due to the heavy traffic that Yahoo drives to its partner. About 57 percent of Overture's revenue is derived from its deals with Yahoo and Microsoft's MSN portal and Internet Explorer Web browser, Overture revealed in a recent Securities and Exchange Commission filing. Financial analysts estimate that Yahoo accounts for a bit less than half of that, or about 25 percent of Overture's overall sales.

"Yahoo produces the user on the search page, which is why Yahoo has an upper hand in these negotiations," said Jeffrey Fieler, an equity analyst at Bear Stearns. "Yahoo has the most valuable commodity, which is the user coming to the search page."

Symbiotic relationship
Yahoo's reliance on Overture is a quite a turnabout from 1999. At that time, Overture, then known as Goto.com, was a company just going public in an IPO class that included fellow search company Looksmart.

Yahoo was the big dog on the block, and the buzz was that it could become a media company rivaling the likes of Disney and others.

Once the new economy boom ended in 2001, however, the fortunes of Yahoo and Overture flipped. Yahoo ran aground with advertisers, and revenue fell to $717 million in 2001 from $1.1 billion in 2000.

Enter CEO Terry Semel, who joined Yahoo in May 2001 with a mandate to turn around the company. After a slow start, Semel moved to diversify the company's revenue base. Earlier this year, Yahoo acquired online job listings site HotJobs.

Last November, Semel offered a road map to recovery through a restructuring process that divided the company's multitude of business units into six categories, search being one of them. Across these categories, Semel and his executives earmarked some properties for the trash heap while pulling others, such as online personals, into the spotlight.

While Yahoo was revamping, Overture was thriving as its pay-for-performance business struck a chord with Internet advertisers.

In 2001, Overture reported revenue of $288 million, up from $103 million in 2000. For 2002, Overture is expected to report revenue of $650 million, according to First Call.

Even though Yahoo and Overture are seemingly headed in two different directions, the two companies need each other.

"If it wasn't for Overture, Yahoo would have done something else," said Safa Rashtchy, an equity analyst with U.S. Bancorp Piper Jaffray. "You can credit Overture for opening Yahoo's eyes that search is a gold mine."

Search: Yahoo's bedrock
Buoyed by Overture's success, Yahoo has regained its religion about search.

"We are committed to be the leading search service throughout the world," said Semel on Yahoo's earnings conference call. "No one can match the depth and breadth of the Yahoo platform."

Semel and his team highlighted search as one of Yahoo's greatest assets. The company began as a Web directory conceived by two Stanford University graduate students Jerry Yang and David Filo. Web surfers flocked to Yahoo's search directory and eventually became consistent users of other properties on the network, such as e-mail, finance, news and instant messaging.

Yahoo has recently begun to downplay its own directory in favor of results provided by outside search partner Google. A recent search on "books" on the service first revealed some links to other Yahoo properties, then listed Overture's "sponsored matches," and then "Web matches" from Google's search engine.

Yahoo renewed its deal with Google for a "long-term" period, executives said last week.

In the past, the company had promoted its own categories of relevant sites and editor's picks, relying on outside results to fill holes in its own directory.

The big question now, some analysts wonder, is how far Yahoo has put its greatest asset into the hands of competitors.

Analysts say Yahoo can outsource search as long as it has the users and commands a healthy split of the revenues. Nevertheless, there remains a lingering concern that Yahoo may have given away too much.

"This is an area that was historically their birth, and now they might be a search aggregator," said Investec's Preissler. "Over time, as Yahoo becomes more of a pure aggregator, who knows what will happen to the balance of power from a content provider like Overture and an aggregator like Yahoo."