By Scott Moritz

What was a little fuzzy last month has become clearer of late: The sagging economy is weighing on Google (GOOG).

Goldman Sachs analyst James Mitchell cited signs of weakness in search advertising – Google’s biggest moneymaker by far — in cutting his revenue growth target for the current fourth quarter from 4% to 1%.

Mitchell is the second analyst this week to lower estimates for Google. On Monday Barclays analyst Doug Anmuth called for fourth-quarter sales to be flat with third quarter’s $4.05 billion. If so, it would be the first time in Google’s history that revenue has not grown from one quarter to the next.

The prospects of little or no growth sent Google shares to a three-year low of $300 Tuesday amid a broad market selloff. The stock has dropped 55% this year. And the news was not particularly good for the rest of the Internet sector with Yahoo (YHOO) dropping 5% to a 52-week low of $11.25.

Why the sudden chill? Google thermometer readers apparently saw a change in tone between the company’s discussions on the earnings call Oct. 16 and the comments in the quarterly filing on Nov.7.

In October, when asked on a conference call how search traffic patterns were going, CEO Eric Schmidt couldn’t draw any conclusions. “We see fluctuations and they are more complex than they may appear; some things go up, some things go down.”

By Friday, when Google filed its 10Q, the complexity had simplified in a not-so-positive way.

“The current general economic downturn will likely affect these seasonal trends, especially the increase in commercial queries that we typically experience in the fourth quarter of each year,” Google said in the filing.

In October, Google executives were partially blinded by the huge increase in search traffic as people swarmed online for news on the financial crisis after Lehman Brothers collapsed Sept. 14. But as search traffic fell back after the initial panic subsided, consumers didn’t revert to their normal behavior and spend their time searching topics like holiday electronics. Ominously for Google, the rate of click-throughs on the sponsored ads that appear to the right of search results also fell, according to some analysts. Marketers pay Google only when someone clicks on their ads.

Goldman’s Mitchell writes that a poor economy is leading to declines in paid search and he noted that the size of purchases at sites like eBay (EBAY) and Amazon (AMZN) are shrinking. Given the lack of pay off, advertisers are likely to resist price increases or even cut spending, according to Mitchell.

In other words: A not-so-happy holidays ahead for the online economy.

By Yi-Wyn Yen

The implosion of Yahoo’s ad partnership with Google may or may not lure Microsoft back to bid on Yahoo, but one thing is clear: Making a deal with Yahoo will be a lot less expensive that it was six months ago.

Yahoo (YHOO) is back on the market after Google (GOOG) on Wednesday bailed on the controversial search ad agreement. Investors signaled their approval of the breakup by sending Yahoo’s shares up 5% to $14.02 in mid-day trading.

Microsoft (MSFT) had no comment on the possibility of opening up renegotiations with Yahoo. But the software giant was pleased with the Justice Department’s decision to nix the Google-Yahoo deal, which would have allowed Yahoo to run some of Google’s search ads on its Web properties.

“The Department of Justice’s finding is significant for advertisers, publishers and consumers, who voiced overwhelming concern about this illegal deal to law enforcement and policymakers,” said Brad Smith, Microsoft’s general counsel in a statement.

Microsoft may have won a victory over Google, its bitter rival, but the real loser here is Yahoo. Wrote Jefferies analyst Youssef Squali in a client note, “In our view the GOOG withdrawal is another black eye for [Yahoo CEO] Jerry Yang and Co.”

Analysts say they expect Yahoo’s best option is to go back to Microsoft for a search deal. Summed up Jefferies’ Squali, “YHOO is left with 3 options: 1) go it alone, 2) merge with AOL, or 3) do a deal with Microsoft.”

“Option #1 is not optimal,” he continued, “as shareholders would need to ride out the current recession to get paid. Also having Icahn on the board should make status quo difficult. Option #2 is possible but not to our liking since YHOO would double-down on Display (the weaker segment) with no material benefit to search. Option #3 is the most likely,in our view.”

Google’s ditching of the deal is a humiliating blow for Yahoo. Google announced in a company blog post – a blog post! – that battling the feds in court to save the Yahoo deal was too risky. Three minutes after the Google blog was published, Yahoo released a statement that the company was “disappointed that Google has elected to withdraw from the agreement rather than defend it in court.”

The Justice Department notified Google and Yahoo Wednesday that it would sue both companies if the pair went through with the ad agreement.  Wrote Google’s chief legal officer David Drummond in the blog post, “Pressing ahead risked not only a protracted legal battle but also damage to relationships with valued partners. That wouldn’t have been in the long-term interests of Google or our users.”

Yahoo scrambled to keep the deal afloat. Earlier this week, Yahoo proposed a drastically-scaled version to Google and the government. Yahoo offered to reduce the terms from ten years to two years and only run a quarter of Google’s search ads on Yahoo’s sites.

Analyst Jeffrey Lindsay with Bernstein Research argues that Yahoo was desperate to keep the Google deal going to stay independent. He also says that without the extra cash generated from Google, Yahoo’s attempts to buy Time Warner’s AOL (TWX) business outright is unlikely. Reports have suggested that Time Warner, Fortune’s parent company, would be willing to sell AOL for $6 billion to $8 billion. Lindsay says that at most, Yahoo can only pay between $4 billion to $4.5 billion without diluting its own shares. “Without the Google deal, Yahoo can’t afford to buy AOL,” Lindsay said.

Yahoo brushes off claims that the Google deal is a major loss to the company. Yahoo had originally said that it could make as much as $800 million in annual revenue from the deal. But in its release Wednesday, the company argues that the deal was only “incremental” to its turnaround strategy. “The fundamental building blocks of a stronger Yahoo in both sponsored and algorithmic search were put in place independent of the agreement,” the company said in its statement.

Yahoo struck the search deal with Google four months ago after it ended talks with Microsoft. The move was widely seen as a way for Yahoo to appease shareholders, who were upset that Yahoo turned down Microsoft’s $33-per-share bid. Microsoft had also offered to buy just Yahoo’s search business for a reported $2 billion in June.

Microsoft is still struggling to make a dent with Google’s dominance in paid search advertising. Analysts say that’s all the more reason for Microsoft to come back. “We can’t see why Microsoft wants Yahoo any less than it did nearly a year ago,” Bernstein’s Lindsay said. “All the same reasons still hold true for why Microsoft needs Yahoo. And now they can offer considerably less.”

By Scott Moritz

Yahoo (YHOO) moves back to the deal market as its controversial advertising partnership with Google (GOOG) is now dead.

As Fortune’s Legal Pad blogger Roger Parloff outlined last month, the legal footing was never very solid as the No.1 and No.2 Internet advertisers explored plans to work together on search advertising efforts.

The plan was first introduced in June as Yahoo was trying to fend off an unsolicited takeover bid from Microsoft (MSFT). Yahoo stubbornly resisted Microsoft’s early offers, including a $33-a-share bid in May. Microsoft then walked away and in July, activist investors like Carl Icahn started pushing for a shakeup of the Yahoo board and a more deal-friendly line up.

Yahoo shares, which had fallen to a five-year low of $11.25 last month, surge up 9% on Wednesday after news that the Google partnership was killed.

Investors apparently like Yahoo’s options a lot better without the antitrust battle that seemed to be looming with its Google ad plan. Microsoft and Time Warner’s (TWX) AOL unit – Time Warner is the parent of Fortune and CNNMoney – are among the potential deal partners.

On a conference call with analysts, Time Warner executives said that the news was positive for AOL. “The opportunity remains open for this business to rebuild itself,” the executives said.

By Yi-Wyn Yen

Some new bad news for Yahoo. Ten days after the troubled web portal announced it will lay off 1,500 employees, the Wall Street Journal reported Thursday that Yahoo’s deal with Google is on shaky ground.

The Journal said that both Google (GOOG) and Yahoo (YHOO) may walk away from the ad search agreement next week because the Justice Department has been moving toward a suit to block the deal. That would be a big blow to Yahoo, which was banking on making as much as $800 million in annual revenues by outsourcing some search ads on its web properties to Google.

In a statement, Yahoo representative Adam Grossberg said the discussions with the feds are “on going.”

Google representative Adam Kovacevich said in a statement that the company is “continuing to have cooperative discussions with the Department of Justice about this arrangement, and agreed to a brief delay in implementing the agreement while those discussions continue.”

Confidence in the deal is waning. In mid-June, Google and Yahoo originally said they would give the feds 100 days to review the ad pact before moving forward with the agreement. But the pair have faced an uphill battle in Washington. In early August, Yahoo filed a heavily redacted version of the deal to the Securities and Exchange Commission. Then Google CEO Eric Schmidt told reporters that he planned to go ahead with the partnership in mid-October with or without approval from the Justice Department. So far, the feds have yet to give the Internet frenemies the green light.

Critics say the ad pact would give Google too much power and make search advertising less competitive. Google currently owns 62% of the U.S. search market, according to comScore’s monthly figures for September. Yahoo is second with a 20% share and has lost 20% of its search share to Google in the past 18 months.

A source familiar with Google’s thinking said no decision has been made. Some analysts have already moved on even if the feds haven’t.

On Wednesday, J.P. Morgan Internet analyst Imran Khan sent a note to clients on why Yahoo should forget about the Google deal and sell its search business to Microsoft (MSFT). Khan suggests that Yahoo can gain an additional $725 million in operating cash flow from outsourcing search to Microsoft. The software company had offered Yahoo a reported $2 billion to buy its search business after talks to acquire all of Yahoo failed.

Writes Khan, “We think that it is unlikely that the Google/Yahoo search partnership will pass DOJ review in its current form….Without its search business, Yahoo would be very clearly positioned as a content and display advertising entity, thereby clarifying and defining its purpose to advertisers and users.”

By Yi-Wyn Yen

It’s hard to believe that just four months ago Microsoft dangled a nearly $48 billion bid in front of Yahoo.

A souring U.S. economy has changed all that. During Microsoft’s earnings call with investors Thursday, chief financial officer Chris Liddell made no mention of the Internet portal or any other potential big acquisitions. The company reported a solid first fiscal quarter, with revenues increasing 9% to $15.06 billion from the year-ago quarter. Profit rose 2% to $4.37 billion. But citing the “challenging economic environment,” Microsoft cut growth projections for 2009 and focused on ways to rein in costs.

When asked by an analyst what kind of acquisitions Microsoft (MSFT) will make, Liddell offered a modest spending outlook. “We will continue to buy small to medium businesses, our sweet spot,” Liddell said. “I don’t see us necessarily increasing our acquisition volume. To the extent that we do buy, it’ll cost us less.”

Microsoft has a lot of money, and could certainly afford to buy Yahoo (YHOO) if it wanted. On Sept. 30, Microsoft had $20.7 billion in cash. (That’s after the Redmond-based company spent $6 billion buying back its own stock last quarter.) With a current market cap of $17.5 billion, Yahoo is a bargain.

Microsoft certainly needs to do something to grow its online business. The company’s goal is to compete with Google (GOOG) for Internet dollars, and Microsoft is unlikely to get there on its own.

The company grew its online service revenue 15% to $770 million for the quarter. That was better than Microsoft’s projections of $718 million to $745 million for the online services unit, which generates revenue from Live search and MSN display ads. However, Microsoft has significantly cut its year-end projections to reflect the tough ad environment. For fiscal 2009, Microsoft expects its online business to grow just 10% to 13% compared to 18% to 20% from its last quarterly estimates.

The cost to run a third-place online advertising business is growing too. The company had an operating loss of $480 million for the first fiscal quarter, an 80% increase from the same period a year ago. Microsoft blamed the bulks of the costs on data centers and expenses related to its aQuantive advertising unit, which rose 47% to $183 million. Microsoft’s online business makes up a mere 5% of quarterly revenues.

The company  may rely on its Office suite and server and client businesses to get through an ailing economy, but the company has repeatedly stated that its future lies in its least profitable group, the online businesses. Perhaps that’s why Liddell didn’t close the door entirely on a big shopping spree within the next year.

“We’re still very cash rich, and that’s a good environment for us,” he said. “The limitation isn’t the capital, but if we have the product road map and ability to integrate [companies].”

By Yi-Wyn Yen

You know it’s a bad quarter when the most encouraging news you offer is job cuts.

During Yahoo’s third quarter earnings call Tuesday, chief executive Jerry Yang made an unconvincing argument that the company is “well positioned for future growth.” Yahoo reported net sales and earnings for the third quarter that fell well below the Street’s consensus.

And Yahoo (YHOO) is bracing itself for a bleak fourth quarter. The company adjusted its year-end gross revenues estimates to reflect worsening conditions. The company projected gross revenues of $1.77 billion to $1.97 billion. And for the second straight quarter, Yahoo reduced its year-end gross revenues estimates by $175 million to $475 million. To get through the “tough environment,” Yang said the company will lay off about 1,500 employees, or 10% of its workforce, before the end of the year. Yahoo’s shares jumped 7% in after-hours trading to $12.95, likely because of the cost-cutting, said one analyst.

But it’s hard to see how Yahoo can slash its way back to greatness, or what other path it could take to get there.  Yahoo’s management has been criticized for not taking Microsoft’s offer to buy the company at $31 a share earlier this year. The stock has fallen 54% since both parties ended negotiations in mid-June. And the alternative strategy for growth Yahoo proposed, a search advertising deal with Google, is now tied up by the feds.

Investors are losing patience for new board members like Carl Icahn to find ways to boost Yahoo’s sagging stock price. Icahn could not be reached for comment on Tuesday.

Wall Street analysts grilled Yang on whether cutting employees was an acceptable alternative to a Microsoft (MSFT) deal.

Yang said that “getting Yahoo more fit” was a way to boost Yahoo’s sagging stock price. “We think that taking aggressive actions on cost structures is one of the ways to unlock shareholder value,” he explained. “By streamlining activities…we hope to come out of this stronger and more nimble.”

Analysts say they are skeptical that cost cuts and Yahoo’s reliance on APT, its new display advertising platform launched last month, will be enough for the company to weather a stormy economy.

Yahoo’s executives were vague on merger talks with AOL (which is owned by Fortune’s parent company Time Warner) and its search agreement with Google (GOOG). Yang said the company is working with the Justice Department, which is reviewing the case for antitrust concerns, to outsource some search ads to Google “as soon as possible.”

“Clearly there is going to be increased pressure on Jerry Yang to take more drastic measures to make the stock work in the short term,” said Jefferies analyst Youssef Squali. “[Carl] Icahn and his two lieutenants and other independent board members should be displeased with the turn of events.”

Yahoo reported net sales of $1.33 billion for the third quarter, which were below Street estimates of $1.37 billion. Yahoo earned 4 cents a share, below the Street consensus of 9 cents.

“The Street’s not happy. Being in a middle of an ad recession and not putting up decent numbers isn’t going to help,” said Christa Quarles, Thomas Weisel’s Internet analyst.

An economic recession spells trouble for Yahoo, the bellwether for online display advertising. The growth rate for display advertising is expected to slow down in 2009. Analysts predict that marketers will spend more on search advertising than display next year because search is considered a more accountable way to directly reach consumers.

Yahoo’s share in search is steadily declining while Google’s continues to grow. Yahoo had 20% of the U.S. search market for September and Google had 63%. Yahoo has lost 15% of its share in search from the same period a year ago, according to comScore.

Yahoo President Sue Decker said internal statistics show that Yahoo is actually faring better than comScore suggests. Yahoo made more money from search than display for the first time. The company grew its search revenue by 17% for the third quarter to $438 million while earning $435 million, a 3% increase, from selling display ads.

However Decker admitted that Yahoo’s search revenues were not enough to compensate for the decline in display advertising. Decker said display advertising started souring by mid-August.

By Yi-Wyn Yen

It’s been four months since Microsoft introduced its cashback rebate scheme that pays people to use its Internet search service. But Microsoft continues to fall behind Google in search.

On Wednesday, Microsoft (MSFT) plans to unveil a new rewards program to get more consumers searching on the company’s Live Search engine. While a company spokesperson would not discuss details of the latest rewards gimmick, a Microsoft executive says the promotion is designed to generate user loyalty and more searches on Live.

The program gives consumers a discount every time they use Live Search to find and buy a product like a digital camera. The company is banking that as more people spend time on Live, the more advertisers will promote their products, and Microsoft will grab a bigger piece of the paid search market.

So far, cashback does not appear to be helping the company’s search efforts. For the seventh straight month, Google (GOOG) widened the gap with MSN’s Live Search. The search king extended its lead to 63% in August while Microsoft dropped to 8.3%, according to comScore’s latest monthly report for U.S. traffic. For the first two months of the third quarter, MSN Live Search has lost 14.4% of its traffic from year-ago levels.

A Microsoft executive says comScore’s figures do not accurately reflect how well the cashback program is doing. “Those numbers don’t seem right to me. We just had our highest month ever [for unique visitors in August],” says Brad Goldberg, Microsoft’s general manager for search.  “There is always going to be volatility with monthly metrics. Cashback is a long-term bet.”

ComScore’s numbers represent the total number of searches, not the number of users. Goldberg says the company is pleased with cashback’s progress though he would not reveal the number of transactions made or how many people that have enrolled in the program.

The cashback promotion is part of Microsoft’s broader goal to combat Google’s ever-growing share of the online ad market. The program marks Microsoft’s first major initiative to grow search traffic since the company ended talks with Yahoo (YHOO), the No. 2 search engine that owns roughly a fifth of the U.S. search market.

Goldberg hints that the company plans to offer consumers even more savings leading up to the holiday season. “We look at traffic, different tactics, and ways of execution… and we’ve learned that the higher the rebate [we offer], the better,”  Goldberg says. “I’m not joking. EBay’s a good example. They have a relatively high rebate level in the 20%-30% range and they had a big increase in traffic as a result.”

Analysts say that Microsoft needs more advertisers to join the cashback program to attract more consumers searching on Live. Cashback has enrolled than 700 merchants, including eBay (EBAY), Hewlett-Packard (HPQ), and Overstock.com (OSTK).

“Our assessment is that MSFT is gaining supply side traction with advertisers and if that remains sustainable, they should eventually gain traction with end users (traffic) as well,” writes Sandeep Aggarwal, a senior Internet analyst with Collins Stewart, in an e-mail to Fortune.

Microsoft, with its deep pockets, may be committed to cashback for the long haul, but industry observers say the company needs to produce results soon.

Search marketers put a January expiration date on Live’s cashback program. “The whole value of cashback is tied to the retail season,” says John Tawadros, the chief operating officer of search marketing firm iProspect. “I would think advertisers are thinking about it now and looking at adopting cashback to differentiate themselves with the competition. After the holiday season would be a perfect time to assess if this has taken off or not.”

By Scott Moritz

The planned advertising partnership between Google (GOOG) and Yahoo (YHOO), which was devised during Microsoft’s (MSFT) unsolicited bid for Yahoo, is headed for a federal antitrust challenge. And that could mean, according to one analyst, that Google could wind up walking away from the deal.

Two days after the Association of National Advertisers sent a letter to the Justice Department opposing the Google-Yahoo ad pact, antitrust regulators hired high-powered attorney Sanford Litvack to lead its legal challenge to block the deal, according to The Wall Street Journal. For a look at what veteran antitrust lawyer Stephen Axinn told CNNMoney.com about Litvack’s hiring and what it means for Google and Yahoo, click here.

Part of Google’s strategy to form a search ad partnership was to keep Yahoo out of Microsoft’s hands. After failing to strike a deal, Microsoft and Yahoo went separate ways and Yahoo continued to pursue the ad partnership with Google.

Now, it might make more sense for Google to withdraw the partnership plan rather than fight the Justice Department in court, said Stifel Nicolaus analyst Blair Levin. Even though Google and Yahoo don’t need regulatory approval for their ad arrangement, Levin wrote in a research note Tuesday that “it would be risky…to proceed if they are getting signals that the agency has serious concerns.”

In addition, another analyst suggested that Google would not suffer too much if its Yahoo search ad plans were killed.  Cowen analyst Jim Friedland wrote in a note that he thought a Yahoo deal would only boost Google’s earnings before charges by 1% to 2% in the first 12 months of the deal.

Representatives for Google and Yahoo did not immediately return calls seeking comment.

But Google has already voluntarily delayed the start of the joint advertising process until October so regulators could examine its potential impact. “We are confident that the arrangement is beneficial to competition,” Google said in statement Tuesday.

The search ad partnership was first proposed in June when Microsoft went public with its offer to acquire Yahoo. The ad arrangement called for Google to run its text ads next to Yahoo’s search results. In exchange, Google would pay Yahoo an unspecified cut of the search revenue. But from the beginning, the deal between the top two Internet search services invited antitrust scrutiny and, as it turned out, some industry opposition.

After reviewing the deal, the ANA said in its letter to the Justice Department that Google and Yahoo would control 90% of the search ad market. “The partnership will likely diminish competition, increase concentration of market power, limit choices currently available and potentially raise prices to advertisers for high quality, affordable search advertising,” the ANA wrote.

Google responded indirectly to the ANA letter saying that “While there has been a lot of speculation about this agreement’s potential impact on advertisers or ad prices, we think it would be premature for regulators to halt the agreement before we implement it and everyone can judge the actual impact.”

In somewhat related news, Google, in an attempt to ease concerns among regulators, announced on its official blog late Monday that it has decided to shorten the length of time it keeps users’ Web information to 9 months from a previous target of 18 months. Google says it compiles some user information like Internet addresses and search history to better match ads to user interests.

By Michal Lev-Ram

MOUNTAIN VIEW, Calif. – If Google’s new Chrome Web browser succeeds, going online will be an all-Google experience.

“The Web has evolved pretty dramatically, but the underlying browser architecture is still very similar to the original Netscape browser,” Sundar Pichai, Google’s vice president of product management, said at a press conference Tuesday at the company’s Silicon Valley headquarters.

Google (GOOG) says Chrome was designed to be “streamlined and simple.” The browser is available for free download in 100 countries starting Tuesday. Initially it will only work on Windows computers, though versions for Mac and Linux operating systems are being developed.

According to Pichai, Google’s intent is to “drive the whole Web platform forward” and thus drive more people to the search giant.

At first glance, Chrome doesn’t look all that different from Mozilla’s Firefox, a competing browser. But unlike Firefox, Chrome combined the address and search boxes to let people search for information and Web sites by entering keywords into the same bar.

“What we did is we smashed the two boxes together,” said Ben Goodger, a software engineer at Google and former Mozilla employee. “We call it the ‘Omni Box.’ “

The Omni Box lets users search for information and go to Web sites directly by typing into the same bar. Other Chrome features include movable “tabs” and an “incognito” window that lets people browse without saving their search history – a feature found on other browsers and which bloggers have nicknamed ”porn mode.”

Google also said its new Web browser will be faster and more reliable than existing browsers. On Chrome, each tab operates separately so, if one crashes, it won’t affect the main browser window.

Chrome is being released as an open-source project, meaning developers will have access to build new features for the browser. Google said its engineers worked on the new browser for about two years.

“It is a huge investment for us,” said Pichai, who added that many Googlers are already using Chrome – including the company’s co-founder Larry Page, who made an appearance at the press conference.

But Chrome is entering a competitive market that Microsoft (MSFT) has dominated for years. The company’s Internet Explorer, which comes pre-installed on computers, accounts for 72% of the browser market. Runner-up Firefox has a 20% share.

“The browser landscape is highly competitive,” Dean Hachamovitz, general manager of Microsoft’s Internet Explorer, told Fortune. “But people will choose Internet Explorer 8 for the way it puts the services they want right at their fingertips, respects their personal choices about how they want to browse and, more than any other browsing technology, puts them in control of their personal data online.”

So is there room for another browser?

Yes, says Citi Investment Research analyst Mark Mahaney.

“There is market demand for a browser that is speedier, simpler, safer, and stabler than IE,” Mahaney wrote in a report Tuesday morning. “What is unknown is whether Chrome is that browser.”