When Google Inc. (GOOG) released its first public financial statements two years ago, investors weren't the only ones blown away. Sifting through paperwork, number crunchers at rival Yahoo! Inc. (YHOO) were stunned to realize just how much more profit Google generated, compared with Yahoo, from its system of selling ads on Web searches. Yahoo lurched into action, shoveling engineers and research dollars into a massive project for an overhaul of every aspect of its search-ad business, from the underlying hardware and software to the methods and algorithms used to select the most lucrative ads.
Code-named "Panama" for its goal of narrowing the gap between the competing ad networks, the project has pulled in hundreds of Yahoo specialists, many of whom constantly shuttle back and forth between advertising offices in Pasadena, Calif., and the Silicon Valley headquarters. "It has been the single most important project inside Yahoo over the past two years," says Ali Diab, a former Yahoo executive who left in January to join investment bank Roth Capital Partners LLC.
Now Yahoo and No. 3 search engine MSN are about to launch their long-awaited Google counterattack. In May, Yahoo will roll out a revamped technology foundation, including a more robust system of servers and software, followed later this year with improved ways to manage and rank ads. Microsoft Corp.'s (MSFT) MSN, meanwhile, will go public with its first search-advertising network, dubbed adCenter, in early May. Both efforts offer a peek into the hidden half of the search wars: While Yahoo and MSN may not be able to keep pace with Google's popularity among users, they hope at least to blunt its lead in revenues per search.
Don't expect a sudden change in the flow of search dollars, though. Google has only widened its advantage over Yahoo and MSN, grabbing 49% of all search-oriented ad business in the U.S. last year, up from 33% in 2004, says researcher eMarketer Inc. Analysts expect Google to continue gaining share even after its rivals adjust, albeit at a slower pace. One big reason: Even after overhauling their search ad mechanics, Yahoo and MSN won't come close to matching Google's total number of advertisers. Analysts believe Google has north of 400,000 ad clients, twice as many as Yahoo. And while MSN is opening its system up broadly, it's starting from scratch with a limited number of test marketers. The bigger the base of advertisers, the more chances search engines have to find and display ads that will generate the most clicks.
That gets at how Google built such a commanding lead in the first place. Industry pioneer Overture Services, purchased by Yahoo in 2003, auctioned off the first-ever search ads and ranked them according to how much marketers bid. Google followed shortly thereafter, with a twist. It ranked ads by bid price, sure, but also on relevancy. The idea is deceptively simple: An ad that gets 10 clicks at $1 is more lucrative to showcase than an ad that generates one click at $2. Six years and hundreds of billions of queries later, Google has amassed a reservoir of knowledge and underlying technology that Yahoo and MSN can't match with a few tweaks in the software code.
The close attention being paid by techies to different search strategies shows how much is at stake. These tiny text ads, usually no more than a dozen words in length, generated more than $10 billion last year and are expected to top $14 billion in 2006, according to eMarketer. Increasingly, Google, Yahoo, and others send the ads along, for a split of the revenues, to a network of publishing partners so they can run alongside other types of online content, from blog entries to news stories on CNN.com. For instance, auto site Edmunds.com showcases Google text ads for local dealers or car insurance companies alongside its content.
Because of Google's superior relevance and its larger stable of advertisers and publishers, sales of these so-called contextual ads grew 2 1/2 times as fast as Yahoo's last year, according to analyst estimates. That's why Google's stock price is up 123% since the beginning of 2005, vs. a 14% decline for Yahoo.
How much of the gap Yahoo and MSN can close will depend on the outcome of some intriguing choices they've made in how to manipulate data. Microsoft's adCenter, for instance, will incorporate a wealth of user demographic data into its ad-matching equations. Unlike Google, Microsoft knows a great deal about its customers. More than 250 million users have provided Microsoft some level of personal info, such as gender, age, and Zip Code, when signing up for various MSN services, such as a Hotmail account. Microsoft will lay this demographic data on top of contextual ad matches with the hope of providing a radically improved result. Microsoft insists that no personally identifiable info will be disclosed.
Instead of simply bidding on words and phrases, MSN is betting that some advertisers will offer a larger payment if the Web surfer falls inside its target audience. For instance, Kentucky Fried Chicken (YUM) could target women between 35 and 45 at dinnertime with hopes they'll opt to buy a bucket of thighs and breasts instead of cooking. Or Neutrogena Corp. (JNJ) could target one set of ads for its facial cleansers for men and another for women. "Search is a very, very blunt instrument," says Joanne Bradford, vice-president and chief media revenue officer at Microsoft. "AdCenter is a tool that you have much more control over."
This approach could hurt Yahoo more than Google. After all, curious advertisers are less likely to shift money away from Google's larger audience. "It makes the inventory [of available ads] more relevant," says Adam Broitman, senior media strategist at Morpheus Media LLC, an online agency that has helped clients work with adCenter. "If Yahoo doesn't match [MSN's move], I think you could see ad dollars shift."
THE REVENUE GAP
Yahoo officials are determined to make their search ads more relevant, but they're tight-lipped about how they will do it. The company does boast significant demographic data, due to the 200 million-plus consumers who have signed up for various Yahoo services, often handing over data in the process. But three sources familiar with Panama say there has been little discussion about the inclusion of demographics. Instead, Yahoo appears to be following Google's approach: investing its resources in the intricate science of matching ads to search queries and pages of online content. Even if it doesn't completely close the revenue gap, some improvement in search profitability could get Yahoo's stock price moving again.
Google, meanwhile, seems largely unfazed by its scrambling competitors. It appears to be making few overt changes to its method -- Google still collects very little demographic data on users, even those who sign up for its Gmail. Instead, company officials like the long-term prospects of a fledgling personalized search offering, one that stores and analyzes people's past queries to glean insights into behavior and preferences.
That sheds light on what Google still views as the biggest hurdle for all the search engines: understanding the intent of a user from just two or three words typed into a search box. "The final 20% of targeting takes 80% to 90% of the work," says Google group product manager Brian Axe. "We have a strong base but still a lot of work to do."
By Ben Elgin and Jay Greene