Why Yahoo's Panama Won't Be Enough

The Web's most visited site lags Google by billions in advertising revenue, and it's going to take more than its new ad-delivery technology to close the gap

Yahoo! had a rocky 2006. In fact, it had a Rocky Balboa kind of 2006. The pounding came from all sides. Investors—unwilling to hang in as Yahoo (YHOO) tried to match search giant Google (GOOG)—shied away, causing the stock price to fall roughly 40% to $25.56 over the past year. Social-networking sites, such as News Corp.'s (NWS) MySpace, created extra competition, jabbing at Yahoo's sides for advertising dollars. The organization even faced fighting from within, culminating in a leaked internal memo unfavorably comparing the company's efforts to peanut butter.

Now a new year is on the horizon, and there are hopeful signs that Yahoo, like the recently reappeared Rocky, is ready for a comeback. The most encouraging is the impending full release of Yahoo's "Project Panama." The long-awaited technology promises to whip Yahoo back into shape by delivering better targeted advertising with greater impact on Yahoo's bottom line.

But Yahoo may need more than Panama to convince investors it's a winner. While the company has concentrated on search advertising, rivals have gained ground by focusing on other methods of delivering targeted ads and brand experiences to online consumers. The competition also has been working hard to sell advertising on the social-networking and user-generated content pages that have exploded on the Web in the past two years, seemingly eclipsing the amount of more specialized editorial content around which Yahoo sells much of its most expensive advertising.

Ad Revenue Gap

Take, for example, MySpace, which receives search ads from rival Google. The social-networking site has developed popular friend pages for brands with which users can interact and create communities around (see BusinessWeek.com, 8/8/06, "Google Gets Back into MySpace"). Burger King's (BKC) "The King" campaign had 135,228 friends at last count. Yahoo, meanwhile, has only recently begun experimenting with similar marketing tactics.

If Yahoo doesn't figure out how to make significant money off its social media and user-generated content pages, it risks widening the ad revenue gap with Google, which has begun expanding beyond search ads into Yahoo's specialty—online branded advertising (the term given to ads intended to promote brands and cultivate an image of a product rather than simply make a sale). Yahoo already has quite a way to go to match Google in overall ad revenue. The search giant took in roughly $7.32 billion in ad revenues during the first nine months of 2006. Yahoo made just $4.14 billion during the same period.

Yahoo knows it must pick up the pace in areas outside of search. During its third-quarter earnings call, outgoing Chief Operating Officer Daniel Rosensweig discussed the need for greater quantity of "nonpremium" inventory, such as lightly targeted social-networking sites and user-generated content pages, and the company's need to better compete for ad dollars with such pages. "There are many new players and alternatives in the market," Rosensweig told analysts. "What we have to do is continue to adjust and evolve and to build packaging that marketers cannot get elsewhere."

Panama's Potential

First, Yahoo has to deliver Panama. The technology was originally due in mid-2006 and now is scheduled for a full rollout during the first quarter of 2007. Panama should deliver ads more closely related to search queries, resulting in greater ad clicks from Yahoo's audience and more pay-per-click revenue for Yahoo. And it should also increase revenue by accounting for the number of clicks that ads receive instead of just the amount bid for keywords. This is important because top-bidding advertisers don't pay Yahoo anything unless their ad is interesting enough to generate clicks.

Yahoo executives say Panama is on track to be a great success. "We are seeing the type of engagement from advertisers that we were hoping for," says Steve Mitgang, Yahoo's senior vice-president of advertising products and platform.

It's difficult to put a dollar figure on how much Yahoo stands to gain from Panama because the company does not reveal how much of its overall advertising revenue comes from search. Using data on total search queries, released by comScore, Caris & Co. analyst Tim Boyd estimates that Yahoo made on average between 10¢ and 11¢ per search in 2006, bringing in a total of $1.61 billion for the first nine months of the year. Google, meanwhile, makes between 19¢ and 21¢ per search. As a result, it made an estimated $4.99 billion during the same period.

If Yahoo could match Google, say, by earning 20¢ per search, it would double its money, making roughly $3.2 billion from the same search volume it had this year. "I think, if they really execute well next year, the stock could go $40 per share and beyond," says Boyd. Of course, Boyd and other analysts caution, Yahoo won't match Google dollar for dollar. "Yahoo will never completely close the gap," says CIBC analyst Paul Keung. "But they should close some of it."

Other Rivals for Advertisers

Even narrowing it, however, is enough for Yahoo to have a banner 2007, says venture capitalist Paul Kedrosky, a partner with Ventures West and former technology equity analyst at HSBC. The reason, says Kedrosky, is that Yahoo's extensive platform and large audience mean it has a lot of inventory on which to serve many ads. If Panama can even marginally increase clicks on each of those ads, Yahoo would see much higher search revenues. "It doesn't have to be as good as Google," says Kedrosky. "Yahoo has this bazooka. It stomps Google in page views. And Yahoo is still the king of audience. There is a huge upside for them."

But Google isn't the only competitor giving Yahoo a fight. New upstarts are competing for the advertisers that have traditionally flocked to Yahoo in hopes of buying space on its contextually targeted properties, such as Yahoo! Autos and Yahoo! Finance, and getting seen by millions that visit those sites monthly. Yahoo can charge a premium for such sites because advertisers want to be associated with more specialized content.

TACODA, a six-year-old ad placement company that works with 4,500 sites across the Web, is one of the companies trying to develop relationships with Yahoo's advertisers. The company has behavioral targeting technology that enables advertisers to, in essence, follow users around the Web through the use of cookies. When a user visits a site in the TACODA network, such as a daily newspaper's auto section, the user picks up a cookie. When the same cookie, now on the user's computer, visits another Web page also in the company's network, TACODA can recognize the cookie and serve, say, an auto ad on the page.

Thus, TACODA can deliver the advertisers' message to the same targeted user, often without charging as high a rate as the original content site. TACODA splits the revenue 20-40-40—with 20% going to the original content site, 40% earmarked for the site serving the ad, and 40% for TACODA. "We are now opening up the vast majority of the Web's pages to relevant, valuable advertising, and we are able to do it at rates that are, in most cases, more competitive than Yahoo's," says company chairman Dave Morgan.

Causes of the Slump?

Another Yahoo competitor, Quigo Technologies, allows advertisers to bid directly for ad placement on a network of branded sites that have context associated with particular products. Unlike Yahoo and Google, where advertisers cannot always tell on exactly which pages their ads will show up, Quigo lets advertisers choose the pages they want as well as the particular sites. ESPN, a former Yahoo client, is now working with the small company. "In many cases, publishers who were working with Google or Yahoo have switched over," says Quigo Chief Revenue Officer Henry Vogel.

It is not clear just how much companies like TACODA and Quigo are eating into Yahoo's profits. Yahoo's marketing services saw 35% year-over-year growth in the first quarter of 2006, but by the third quarter, year-over-year growth had slipped to 18%. Meanwhile, overall spending on Internet advertising is expected to grow 31% by the end of this year to $16.4 billion, according to eMarketer reports.

In September, Yahoo announced it was experiencing a softening in the autos and finance markets. While Yahoo suggested that the slump was due to several advertisers cutting back on their advertising budgets owing to industrywide slowdowns, analysts speculated that a couple of major advertisers were taking their business to cheaper online advertising sites and ad placement companies able to offer similar and new targeted options. Analysts believe Yahoo's clients may have put some of their money into MySpace and others rather than spend it all with Yahoo, thus accounting for the slower-than-anticipated growth (see BusinessWeek.com, 9/21/06, "Yahoo's Ad Slump").

Every Last Drop from Content

For an established company such as Yahoo to grow at a significantly higher rate than the online ad market, it can't just rely on making more from search-related text ads. Such ads currently make up only 46% of the online advertising market and will grow to just 49% of the market by 2010. The majority of online advertising is still focused on increasing brand awareness, according to JMP Securities.

Yahoo has to wring more money from all of its available inventory. That means attracting advertisers to the social-networking and user-generated content that has ballooned on Yahoo's site, in some cases growing faster than Yahoo's premium properties and creating tons more inventory on which Yahoo can serve ads. Yahoo's photo-sharing site Flickr, for example, had 200 million page views and 7.2 million unique users in November, according to Nielsen//NetRatings. Yahoo! Autos, by comparison, had 61.7 million page views and 3.8 million unique users (see BusinessWeek.com, 10/2/06, "Yahoo's Strategy: Growth by Acquisition").

One way to do this is to retarget ads in a similar way to what TACODA does. The extra targeting would allow Yahoo to charge more. It does do some of this already, but it could apply this method throughout the long tail of its properties and more aggressively on its key social media sites. Flickr has some advertising but not much, and Del.icio.us doesn't seem to have any ads.

What's Another Billion Dollars?

Another way is to ensure advertisers pay as much as possible for such "nonpremium" advertising through bidding. In October, Yahoo announced it had become a majority investor in Right Media Exchange, an ad marketplace. It has tasked the company with auctioning off its nonpremium space, such as the social-networking inventory and e-mail, to the highest bidder. The hope is that as advertisers duke it out to be top bidder, Yahoo will collect the highest cost per click or cost per impression possible.

However, making a ton from these properties will not be easy. David Hallerman, a senior analyst at eMarketer, says that Yahoo will never be able to charge true premium prices for advertising on social media and networking sites. "It is still going to be relatively low-priced ads in contrast to the autos or finance sites," says Hallerman.

Caris & Co.'s Boyd estimates that, if Yahoo were to develop the right formula for placing ads on its social media and user-generated content sites, it could add $1 billion in revenue—but not for several years. "I think you are talking about an opportunity that could probably add an incremental billion in revenue three or four years from now," says Boyd. "But I don't think they are really going to be in a position to move the needle next year."

Still, if Yahoo hopes to get back in the ring with Google anytime soon, it can't pull any punches.