Why the market's mad at Yahoo

Yahoo CEO Carol Bartz said two months ago that Microsoft would have to cough up “boatloads of money” to get Yahoo’s search business. In the end, it took nothing of the sort.

Apparently, all Microsoft (MSFT) CEO Steve Ballmer had to do was let Yahoo (YHOO) take the lead in selling search to premium advertisers, and promise to supply Microsoft’s Bing search technology on the cheap. Under the terms of a 10-year deal announced Wednesday, the software giant will take a slim 12% cut of the search revenue Yahoo makes from its huge network of sites.

The modest pact marks the end of a Silicon Valley soap opera that began early last year when Microsoft CEO Steve Ballmer launched an unsolicited $45 billion bid for all of Yahoo in an effort to challenge Google's (GOOG) search dominance. Yahoo’s board criticized the offer as too low, then watched the company’s value tumble to less than half what Microsoft put on the table. And now, Microsoft has what it wanted all along – the scale to take on Google – and at a fraction of the price.

Any way you slice it, Ballmer walks away with the better end of this deal. For no money down, he triples his market share, eliminates a search competitor, and scores Yahoo’s endorsement for Microsoft’s long-suffering efforts online. What does Yahoo get? It gets to preserve its revenue, bow out of an expensive search war, and free up time and cash to hunt for the next big thing. Or, if you subscribe to the harsher view that Web entrepreneur Jason Calacanis blogged on Wednesday: “The once-proud warrior of the Internet space laid down its sword, knelt at the feet of Microsoft and gutted itself today.” Ouch.

Wall Street wasn’t impressed with Yahoo’s dealmaking chops, either. Some analysts, including SG Cowen’s Sandeep Aggarwal, expected an upfront payment as high as $2 billion. Others wanted to see savings flow to the bottom line more quickly than the 24-month timeframe Yahoo offered. Investors voiced their disappointment Wednesday by sending the stock skidding 12%, down to $15.14. The punishment continued early Thursday, with the stock starting the day off more than 4%.  (That’s still well above the year’s lows, near $11 in January.)

Bartz and Ballmer are making no apologies. In an interview with Fortune shortly after they announced the deal, the two CEOs seemed surprised at the Street’s ho-hum response. “What we’ve got here is virtually all of our revenue at no cost,” Bartz said of the outsourcing arrangement. Ballmer chimed in: “I’ve gotta say, I’m surprised. If you said to a man from Mars who just arrived: Somebody gets 88% of their revenue, close to 100% of gross margin, and they’re going to get rid of R&D operating expense – it sounds like a lot of money to Yahoo and to Microsoft. So, the man from Mars would think this is a pretty good deal.”

While a Martian would love this deal because it’s about Yahoo saving money, Yahoo’s Earthling investors are justifiably more interested in how the company will make more money. Those investors will be happy to know that dealmakers in the advertising community expect that more search cash will eventually flow to Yahoo and Microsoft, so long as they can quickly put out a good product after getting regulators to bless the deal. (The companies hope to close the deal in early 2010.) Rob Norman, CEO of WPP’s ad buying giant GroupM, said the scale of a combined Microsoft and Yahoo could lure more advertiser dollars away from Google. And David Kenny, managing partner of Publicis Groupe’s VivaKi, said Bartz is “really focused, and she’s making the right calls about which battles can they fight alone, and which ones they’ll need to leave to others.”

Perhaps. But unless Yahoo starts serving up some mind-blowing new products, it risks becoming a dowdy media company that outsources all the most interesting battles to bigger players. That’s honest work, but it's tough to make boatloads of money doing it.