SO MICROSOFT

" with Yahoo.

I said just a couple of weeks ago that Yahoo may have blundered its way into a better outcome for its shareholders, and this latest twist strengthens my conviction. With a possible deal with Google still being considered and Microsoft now back at the table, the much derided Yahoo is suddenly looking like Cinderella at the ball. Yahoo's management may yet emerge as heroes.

Microsoft maintains that it isn't discussing another takeover bid after withdrawing its previous offer for Yahoo, though it reserves the right to do so. Let's take that at face value. Surely Microsoft CEO Steve Ballmer isn't that feckless. So what might they be talking about?

Speculation has focused on combining Yahoo's and Microsoft's search businesses, which are a distant No. 2 and No. 3, respectively, to Google's. April figures from Nielsen Online, a research firm that tracks Internet usage, put Google's share of the U.S. search market at 62% vs. 27% for a combined Yahoo-Microsoft. As I've said before, there isn't much doubt that this war is over, and that Google has won. Surely the trend of ever-shrinking market share hasn't been lost on executives at Yahoo and Microsoft. So combining their search operations makes about as much sense to me as the Sears-Kmart merger. Two losers do not a powerful competitor make.

The only advantage would be cost savings. Yahoo spends about $1.2 billion a year on "product development," much of that presumably on the search arms race with Google. It's hard to say how much Microsoft spends, but let's assume a comparable figure. Combining the two operations would presumably cut close to $1 billion in costs. I assume Microsoft would buy Yahoo's search operations, including its Panama search technology, with some sort of continuing revenue-sharing arrangement.

But why stop at search? A combined Yahoo-Microsoft still has the edge over Google in display advertising. Kevin Johnson, president of Microsoft's platform and services division, said in a widely circulated memo to employees this past weekend that his aim was to "disrupt" the market in search, tacitly conceding Google's dominance, and "win" in display advertising. He noted that Microsoft's ad revenues had increased 40%, compared to declines at Yahoo and Google. This intense competition doesn't yet reflect Google's deployment of recently acquired DoubleClick, but suggests an intense campaign ahead.

Display is where Yahoo's sheer numbers are most compelling. What Yahoo has going for it is content and a vast number of unique visitors. I predict that display will be linked to Internet content the same way it is on television, radio or in print. Scale is what matters, just as it does for Super Bowl advertising. Scale is Yahoo's most valuable asset.

In the most recent quarter about 87% of Yahoo's revenues came from advertising. If Microsoft essentially buys all of Yahoo's advertising business, both search and display, then it gets nearly all the benefits of the now-abandoned merger. Yahoo would become a pure content company, essentially outsourcing its ad business to Microsoft.

There's a deal that starts to make sense. This surely wouldn't be lost on Google, which has already concluded a successful search advertising test run with Yahoo, and which would benefit from a display deal as well. In my previous column I called for Yahoo to turn over all its search advertising to Google, but that seems too limited now that Microsoft has upped the ante. Google should also be looking to acquire Yahoo's entire advertising business in a cash and revenue-sharing deal.

The big question is price, but given the huge potential advantages to both Google and Microsoft, it should be a big number. As a Yahoo shareholder (I also own Google), I say let the bidding war begin.

Also See:

• Microsoft Resumes Deal Talk With Yahoo

• Yahoo May Find Victory in Microsoft Deal's Defeat

• Why Google Is a Buy