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.”

By Yi-Wyn Yen

Former Viacom CEO Frank Biondi and former Nextel CEO John Chappel will join Carl Icahn as the newest additions to Yahoo’s board.

All eyes are on Icahn and his gang. The three amigos will need to start making changes to placate shareholders soon because if they don’t, it’s likely that nobody on the board will. The three were part of Icahn’s original proxy slate that ran under a campaign to sell Yahoo (YHOO) to Microsoft (MSFT). Icahn dropped the fight in July in exchange for three seats on the company’s board.

Shareholders are still waiting for Yahoo to come up with a plan that will drive up the stock. Since mid-June, when Yahoo announced that talks with Microsoft were over, the stock has dropped roughly 20% in value and has hovered in the low $20s. Microsoft had originally offered to buy Yahoo at $31-a-share. Earlier this month investors re-elected Yahoo’s eight incumbents. But investors signaled their unhappiness with CEO Jerry Yang and chairman Roy Bostock. Yang received 66.3% of the votes while Bostock received the least, with 60.4% votes.

Wall Street isn’t convinced that Icahn and co. can do much to turnaround Yahoo. Says Thomas Weiser Partners analyst Christa Quarles, “Yahoo needs someone to help fix the business, and I don’t know if Icahn has the background to do that.”

Icahn has yet to reveal what his plans are to drive shareholder value for Yahoo beyond selling part or all of the company to Microsoft. The corporate raider has most recently pushed for management change at Blockbuster (BBI) and Motorola after securing board seats at those companies. Last year, Blockbuster CEO John Antioco agreed to step down after Icahn initiated a campaign to cut his salary. After Icahn won two seats on Motorola’s board in April, he persuaded the company to dump its cell phone division and was instrumental in pushing out former CEO Ed Zander.

Chappel, who is president of Seattle-based private equity firm Hawkeye Investments, was unavailable for comment. Biondi, a senior managing director of private equity firm WaterView Advisors, responded in an e-mail that he does not comment on boards that he serves. Biondi is currently a director of five other boards, including Seagate (STX) and Cablevision Systems (CVC).

By Yi-Wyn Yen

Finally, some good news for Yahoo. Major tech advertisers are shifting a bit of the money they spend on Google (GOOG) to Yahoo (YHOO), according to a new report by marketing firm Covario.

Advertisers from 12 tech companies, including Research In Motion (RIMM), Hewlett-Packard (HPQ), Intel (INTC), and Lenovo, collectively moved 4% of their U.S. search advertising budget from Google to Yahoo in the second quarter. Covario notes this is the first quarter that spending for Yahoo’s paid search increased in two years.

However, the incremental shift should give little reason for Google to worry. These tech advertisers, whose online ad spending is tracked by Covario, are still spending the bulk of their money on Google. The search king received 81.2% of the paid search spending from these advertisers for the second quarter compared with just 14.3% for Yahoo. Microsoft (MSFT) came in a distant third with 4.3%.

Wall Street analysts say the small shift in ad dollars from Google to Yahoo is not surprising. Google has deliberately throttled back on paid search – those blue text ads that appear on the right side of a Google search results page - to give Internet users a better browsing experience. Direct marketers who still want to place their ads somewhere could be moving their spending to Yahoo.

Explains Thomas Weisel analyst Christa Quarles: “Say I type in ‘Harry Potter’ into Google. I don’t get any ads. But put those keywords into Yahoo and you get ads up the wazoo. The bigger question is, has Google gone too far with their initiative?”

Jonathan Rosenburg, Google’s top executive for product management, says the company is unlikely to change its game plan. During Google’s earning call last month, Rosenburg acknowledged that ads shown on the site were “at an all-time low relative to the last few quarters.” The company will continue to work on improving the quality of its ads. “Larry [Page] often says that we’d be best off if we just showed one ad, the perfect ad,” Rosenburg said.

If Google doesn’t reverse its less-is-more policy, Yahoo could continue to benefit from a shift in ad dollars for the current quarter.

By Yi-Wyn Yen

Last month Google’s chief economist Hal Varian discussed the durability of the search giant’s business model during the company’s quarterly earnings call. “During periods of slow economic growth, the last thing an advertiser wants to cut is its spending on search-based advertising,” Varian said.

In other words, display advertising (the flashy and creative side of the business) will take a bigger hit than paid search (the directly-targeted and accountable portion that Google excels at) as marketers tighten their purse strings.

Microsoft (MSFT), however, argues that search ads get too much credit for click-throughs while display ads don’t get enough. The company, which is struggling to build an online ad business to compete with Google (GOOG), is challenging that notion with a new tool that measures the effectiveness of display advertising in an online ad campaign.

Atlas Institute, which is part of Microsoft Advertising’s research division, has released a study that shows that people are more likely to click on ads or buy things online when they are exposed to display ads. In a study called “Illuminating the Alltel Wireless sales funnel,”  those who clicked on search ads for the cell phone maker were 56% more likely to buy a phone or wireless plan from the company when they saw Alltel’s display ads compared to those who only saw Alltel’s search ads.

Search ads typically get the most credit for contributing to a sale because they’re the last ad that is viewed. “When someone is ready to take action by clicking on an ad or buying something, they will go to a search engine and type in what they’re looking for,” explains Morris Martin, an analyst with Atlas Institute who led the study. “The very last ad is the one that gets 100% of the credit. We did this case study to get a better understanding of the synergies between search and display.”

Microsoft’s new measuring tool tracks branded ads that an Internet user comes across before making a purchase. The tracking system, which gathers the wealth of data through the Atlas ad server, then assigns a value for all the ads that contribute to a successful sale. Along with Alltel, Microsoft says 14 other advertisers, including Best Western, Citi Cards and Sprint (S), are testing the product

Google spokeswoman Lynn Tornabene says that its display ad server Doubleclick introduced a similar tracking tool a year ago but would not say how many clients are using the product. She declined to comment on the Microsoft study.

Fundamentally marketers know it’s not all about search ads. It’s just that Google knows how to be at the right place at the right moment. “Google is so close to the point of sale,”  says Jeffrey Lindsay, an Internet analyst with Bernstein. “When people type in those keywords, they are at an extreme point of sale. That’s well understood. Everyone knows Google gets a whole heck of a lot more credit for searches than what is attributable.”

Marketers say they welcome tools to get better gauge the impact of display ads.  “I don’t think media buyers are making decisions based on [these tracking systems] yet,” says David Cooperstein, the chief marketing officer for Burst Media, an online ad agency. “But they are asking about it a lot more than they were six months ago. As this media matures, brand advertisers will start to look for more response the way direct marketers do.”

By Yi-Wyn Yen

Within hours of being launched Monday, Cuil – a new search engine created by former top Google engineers – was already being touted in the blogosphere as the next Google killer. But unless Cuil (pronounced ‘cool’) can develop an ad platform to rival Google’s, the startup will have a difficult time challenging the search giant.

The comparisons to Google (GOOG) were inevitable. Cuil was founded by several lead engineers from Google, including Anna Patterson, chief architect of the company’s TeraGoogle search index. Cuil also claims its search algorithm scans 120 billion web pages – three times the number that Google sifts through. And Cuil’s spare start page is reminiscent of Google’s minimalist home page.

The launch of Cuil certainly raised eyebrows at Google. Though the company would not comment on Cuil, Google’s web search team stuck it to the small search startup on Monday with a blog post that begins, “We knew the web was big….We’ve known it for a long time.”

Cuil representatives did not return phone calls.

Despite the buzz – and Cuil’s PR folks deserve credit for spinning this David v. Goliath story – it would be foolish to argue that Cuil will be the next big threat to Google.

“It’s a new kind of technology and platform that is going to unseat a company like Google – not a company that’s trying to beat them at their own game,” says Scott Kessler, Standard & Poor’s Internet analyst.

Both Yahoo (YHOO) and Microsoft (MSFT) have spent billions in an effort to make a dent in Google’s paid search business, which accounted for 40% of all online search dollars in 2007, according to eMarketer.

Microsoft CEO Steve Ballmer admitted last week to investors that Google has such a huge advantage over other search engines because it delivers more relevant ads and has more advertisers in its system.

Yahoo has also conceded that it can’t beat Google at its own game. In June, Yahoo struck a deal to run Google’s superior search advertising technology on Yahoo’s web properties alongside its own search results.

Cuil currently offers no ads on its pages. And the company claims it won’t monitor a user’s search habits in order to target advertising the way Google, Microsoft and Yahoo do. That’s an ambitious goal. But one of the biggest advantages Google has over its competitors is that it can provide better search results due to its massive advertising platform.

“Google is receiving so many searches per second and gathering incremental information from new [auction] bids and new advertisements that the search engine gets more relevant and powerful,” Kessler say. “It’s self-perpetuating.”

Cuil, which has raised $33 million, could find its niche in search – or become an attractive acquisition for Microsoft, Yahoo or Google itself. The company says it will stand out because it delivers results with images in three columns and it will scour the web more aggressively than the other big search engines. So far, the site has been sporadically unavailable because of the high volume of searches.

News Corp. President Peter Chernin says online video is a premium money-making opportunity. Image: News Corp.

By Jon Fortt

HALF MOON BAY, Calif. – Looking at big money-making opportunities online, News Corp. (NWS) President Peter Chernin pointed to video, mobile and overseas markets as good long-term bets.

In an interview with Fortune editor at large Richard Siklos at Brainstorm Tech on Tuesday, Chernin said advertisers still haven’t completely embraced the online opportunity, and that they continue to have a television mindset. He said an advertiser recently told a MySpace sales rep to come back when the social network has a “SuperBowl-level” event. What the advertiser failed to recognize, Chernin said, is that the MySpace homepage has as many viewers every day as the SuperBowl has once a year. (Of course, there’s a good argument that MySpace visitors aren’t quite as engaged with the content as SuperBowl viewers are.)

He also addressed the challenges News Corp. faces in getting a decent price for ads on MySpace. (The company partners with Google (GOOG) to monetize the site.) The answer, Chernin said, may be to look beyond banners and text ads. “What drives ad prices is scarcity,” he said. “The place that is most promising is probably in video. By definition there’s more scarcity in video, and there’s even more scarcity in premium video.”

Mobile is attractive because of its scale. It “is by far the most penetrated device on earth,” he said. “So it’s this enormous distribution platform, but by definition you’re not going to be watching two-hour movies. It’s going to be interesting to see people develop uniquely mobile content.” It will take the medium a long time to develop, he said and predicted that in two years, the industry will still be trying to figure mobile out.

Geographically, Chernin said he expects emerging overseas markets to show faster revenue growth for News Corp. than the U.S. and more developed markets. “We’ve invested in cable channels in all sort of Podunk places.”

By Yi-Wyn Yen

Google stirs up hype wherever it goes. Last week, Google introduced a free product called AdPlanner to help media agencies find the best sites to place banner ads. The news shook up comScore, which offers similar Web-tracking information for a fee, as its shares took a 23% nosedive the day the new Google service was announced. 

Fears that AdPlanner would crush Internet media research companies like comScore (SCOR) and privately-held Nielsen Online were overblown. Mark May, an Internet analyst with Needham & Co. said several companies that use comScore told him they weren’t impressed. AdPlanner, he said, is ”just not as robust and doesn’t have all the functionalities that comScore has. It’s not an immediate risk for comScore.” A Nielsen Online executive said in a statement that the company has a business agreement with Google (GOOG) to provide its TV demographics to Google’s online platform for TV ads, and supports the new online ad offering.

Google’s new ad tool may have rattled the online measurement industry, but competitors say they’re not scared of the search giant. Quantcast, a San Francisco-based startup, points out that it released a similar product to identify the demographics of a Web audience two weeks before Google did. “We had expected Google would attempt audience measurement. It’s the next logical step from them,” said Adam Gerber, Quantcast’s chief marketing officer. “The important point to remember is that Google has launched lots of services into the market in the past five years, but plenty of them have not gotten off the ground.”

Meanwhile, ComScore CEO Magid Abraham tested the new service and says that comScore’s paid offerings were far superior. “The first look that we have of the data is a sigh of relief,”  Abraham said during a conference call Thursday hosted by Deutsche Bank.

A Google spokesman was not available for comment.

Google is an easy target for criticism whenever it challenges an established industry outside of its core search advertising business. The company has gained a lot of new “frienemies” as it steadily expands its empire. And because of its tremendous success in paid search, expectations for Google to flourish in other areas are high. 

Some welcome Google’s new move into the media planning business. Kelly Towhig, a senior executive at Starcom agency, is testing the new Google AdPlanner tool to help her figure out the best Web sites to buy ad space for her clients, which include Nintendo, ESPN and AllState. “We love nothing more than having incremental data. We collectively believe this is a great first attempt by Google,” she said. Towhig says AdPlanner is a good supplement to the data she receives from comScore and Nielsen.

Those who aren’t affected by Google’s new venture also applaud the service. “I think this will bring more companies into the online marketing space, specifically because of the price point since it’s free,” said Marc Johnson, the chief marketing officer of Hitwise, an online marketing company that researches internal data for publishers. The company, along with Coremetrics and Omniture (OMTR) competes with another Google product, Google Analytics.

Danny Sullivan, a search industry expert with Search Engine Land, notes that these digital marketing companies have continued to survive despite Google’s footprint in the market. He said, “Google has released another set of tools that is interesting, but is not going to kill others.”

In case Google’s AdPlanner is the next killer product, comScore’s Abraham says the company is prepared. ComScore’s shares have climbed up since Google’s news, but remain 18% below where they opened last Monday, the day before Google announced AdPlanner. “The doomsday scenario is that this will take over ad agencies because Google is free. If we absolutely have to, we’ll just give the damn thing away for free to agencies too,” he said. “For now, we’re staying put.”

By Yi-Wyn Yen

A major Yahoo investor has been urging executives from both Microsoft and Yahoo in the past couple of weeks to revive their talks, and it looks like those efforts haven’t gone to waste.

A source at Microsoft told Fortune on Tuesday that while there was “no big deal” in the works – meaning a full acquisition of Yahoo – he implied that his company hasn’t ruled out the possibility of buying Yahoo’s search business. Shares of Yahoo had reached a five-month low Tuesday, but finished up nearly 3% after two tech blogs reported that Microsoft was revisiting its bid for the battered Internet portal.

The Yahoo investor said he has spoken with company board members about reconsidering Microsoft’s (MSFT) offers to buy the whole company and, failing that, part of it. Yahoo directors, the investor said, have admitted that they made miscalculations in negotiations with Microsoft CEO Steve Ballmer. “They dragged this out for a couple months and were shocked when Steve went away,” the investor said.

Calls to Yahoo were not immediately returned.

The Yahoo investor said that selling Yahoo’s search business to Microsoft is a far better alternative than its Google ad pact. Shares of Yahoo (YHOO) dropped nearly 18% in value after the company announced it ended buyout talks with Microsoft on June 12. Instead, it said it would ramp up an online ad partnership with Google (GOOG) that would run some of Google’s search ads. “I would take anything that beats the current status quo,” the investor said.

Shares of Yahoo have been steadily falling for the past two weeks after the company announced it ended buyout talks. On Tuesday, Yahoo’s shares opened at $21.18, the low since Microsoft made an unsolicited offer to buy the company on Feb. 1.

A Microsoft source shot down rumors that the software giant is again interested in acquiring all of Yahoo. Microsoft had previously offered $33-per-share for the company and walked away from that bid in early May. “Nothing has changed in that respect,” the source said. Asked if Microsoft was making a small deal, the source chuckled and said he had no comment.

Microsoft, however, has always been open to discussing an alternate deal. One day after Yahoo said talks were off for good, Microsoft’s top advertising executive Kevin Johnson revealed in a letter to employees that the company had returned with a partial offer to buy Yahoo’s search business for $1 billion and invest another $8 billion in Yahoo.

Silicon Valley blog TechCrunch on Tuesday cited sources who indicated that Microsoft and Yahoo were discussing a full buyout. CNET reported that a partial deal was being kicked around.

Wall Street analysts took in the latest rumors with mild amusement. Said Thomas Wiesel Partner’s Christa Quarles, “This is about the 8,000th time I’ve heard Microsoft is going to buy Yahoo. Everyone’s parsing out what their sources are saying or not saying. They’re reading tea leaves at this point.”

That said, both companies have reason to keep talking. Yahoo is under heavy pressure from dissatisfied investors, and it’s facing a brain drain as top employees leave for greener pastures. Microsoft, meanwhile, views Google as its biggest competitive threat and has yet to find an alternative to catch up to the search giant in the online ad market.

Analysts say they’re not convinced the deal ever went away because neither Microsoft or Yahoo have offered a better Plan B. Wrote Ben Schachter in a recent note to UBS clients, “We continue to believe that, at some point, Microsoft will acquire all of Yahoo. Unfortunately, for all of us that are beyond tired of the constant news flow and speculation around a possible Microsoft/Yahoo deal, the Google/Yahoo agreement will not put an end to this story as we still think Microsoft needs Yahoo.”

By Yi-Wyn Yen

The summer’s biggest shareholder showdown is finally set. Yahoo will hold its annual  meeting at the Fairmont hotel in downtown San Jose on Aug. 1.

Yahoo (YHOO) originally set the date for July 3, but the meeting was postponed in anticipation of Carl Icahn’s proxy fight. The billionaire activist vows to replace Yahoo’s nine board members, including Yahoo CEO Jerry Yang, with his own slate if the company doesn’t reach a deal with Microsoft (MSFT). He has also threatened to fire Yang as CEO.

Yahoo again urged its shareholders to vote for the incumbents and not Icahn’s nominees. “OUR BOARD….URGES YOU NOT TO SIGN OR RETURN ANY PROXY CARD SENT TO YOU BY THE ICAHN ENTITIES,” the company wrote in a Securities & Exchange filing.

Many of Yahoo’s shareholders are upset that Yahoo turned down a $33-per-share offer from Microsoft. Yahoo maintains that it is still holding talks with Microsoft though the software giant withdrew its bid a month ago. Yahoo also says it is pursuing a search advertising partnership with Google (GOOG) despite antitrust concerns.

Those on the sidelines are still rooting for Icahn to make a summer miracle happen between Microsoft and Yahoo. “We estimate that Icahn and those who have already endorsed his efforts control up to some 15% of the outstanding shares,” wrote Standard & Poor’s Internet analyst Scott Kessler in a research note. “We think there is a good chance Icahn will prevail and a merger with Microsoft will eventually be consummated.”

By Scott Moritz

After an alarming first quarter U.S. search advertising slowdown, Google (GOOG) managed to reignite growth in the all-important paid click category according to April data from comScore.

Last month, Google’s paid clicks grew 19.6% over year-ago levels, improving on an much-watched trend of slowing paid click numbers in the first quarter of this year, thanks to a strong rebound in U.S. growth. The nearly 20% year-over-year increase compares with a less than 1% decline in January and about 3% growth in February and March, according to comScore.

The results weren’t so good for rival Yahoo (YHOO), which saw paid clicks fall 4.4% in April. And Microsoft’s (MSFT) MSN numbers were even worse showing a 9% decline from last year, says comScore. The weak numbers underscore the logic behind a proposed merger between the No.2 and No.3 players in online search. For Yahoo, the trend is particularly dour.

“In January, Yahoo’s paid clicks accelerated 15% year-over-year, 5.3% year-over-year in February, but then fell 3.1% in March, and fell 4.4% Y/Y in April,” Lehman Brothers analyst Doug Anmuth wrote in a research note based on comScore’s data. “Prior to March’s decline in paid clicks, we note that Yahoo! had consistently seen growth in comScore’s paid clicks,” Anmuth notes.

Good news also came from Time Warner’s (TWX) AOL unit where paid clicks reversed the decline in April by surging 28.3% over year-ago levels, according to comScore. Time Warner has been shifting its AOL strategy from the declining subscription business to more of an advertising model. The company, which also owns Fortune and CNNMoney, has been exploring deals that would pair AOL with partners like Yahoo.

By Yi-Wyn Yen

With Bill Gates preparing to retire next month, the Microsoft chairman gave his take on the future of the software maker’s online strategy – search advertising.

“You make these bets and you stick with them for more than five years,” Gates told an auditorium filled with Microsoft advertisers last week at the company’s Redmond, Wash., headquarters. “You bet on graphics interface, you bet on Internet browsing. Here with search, we believe that we can take it and embed it in a broader experience.”

But some observers say that Microsoft (MSFT) is gambling its future on the wrong type of online advertising. If Microsoft really wants to be a market leader, it should focus its efforts on display advertising.

“Display is a much more wide-open and fragmented market,” said Paul Levine, marketing vice president of AdBrite, a leading online ad network. “There’s an opportunity to be a real leader. The display market today is where search was five years ago. No one has a winning formula yet.”

Display is the preferred method of brand advertisers to broadcast messages through images and videos rather than text ads.

A Microsoft spokeswoman says the company is working equally hard on its display advertising efforts. The company has bulked up its display advertising presence in the past year with the purchase of marketing firm aQuantive and by signing partnerships with Viacom and social media sites Digg and Facebook. It also bought YaData, an Israeli startup that serves banners ads based on the way Internet users browse sites, and rolled out a new analytics service called “engagement mapping” to let advertisers know which of their online ads – display or search – are most effective.

Still, no one has yet found the way to dominate display advertising the way Google has done with search. Not even Google (GOOG) is there yet. “It’s fair to say that Google is not the leader in display ads,” Google CEO Eric Schmidt admitted to CNBC’s Maria Bartiromo in an interview last month.

Microsoft doesn’t hide the fact that it desperately wants to compete with Google in online advertising and that it bid $47.5 billion for Yahoo in an effort to catch up to the market leader. Google market share rose to 61.6% in April with Yahoo (YHOO) at 20.1% and Microsoft at 9.1%, according to comScore.

Though Microsoft CEO Steve Ballmer withdrew the offer to buy Yahoo earlier this month, he’s reconsidering a deal to acquire Yahoo’s search business.

Analysts don’t think that’s a good idea, either. “It makes more sense for Microsoft to work with Yahoo on display because it’s a much more open market and it will attract brand marketers,” said David Hallerman, an analyst with research firm eMarketer.

While Microsoft is pouring billions to catch up to Google in search, its competitor is investing billions to make its mark in the graphical display market.

Google’s acquisition of DoubleClick and YouTube are widely seen as ways to buy into the untapped market of delivering ads when people aren’t searching online. According to eMarketer, the U.S. search ad market is expected to double to $19 billion by 2012 while the display ad market, which also includes videos and rich media, is projected to triple to $18.7 billion.

With or without Yahoo, Microsoft is forging ahead with plans to chip away at Google’s dominance of search advertising. “A pure keyword search has its limits,” Gates said last week. “People want refinement. When a search doesn’t work, they want to know how they can go to that next step.” Gates said Microsoft will focus on delivering better results in specific search domains like commerce, travel, and images.

Microsoft’s first stab at taking search to the next level is through its “cashback” program, a rebate scheme that will pay Internet users money whenever they buy products like cameras and electronics through Microsoft’s Live Search engine. Microsoft is banking that as more people spend time buying on Live Search, more advertisers will promote their products, and Microsoft will grab a bigger slice of the paid search market.

AdBrite’s Levine, a former Yahoo exec, thinks that’s the wrong strategy. “People think of search on the Internet as a utility, like sticking a plug into a wall and getting electricity,” he said. “I have trouble believing that people will flock to different search engines for different purposes.”

Even if Microsoft is able to attracts enough consumers and marketers to worry Google, analysts say the cashback scheme isn’t a game changer. “In the unlikely event that Google experienced significant share loss to Microsoft as a result of Cashback, it would retaliate with a similar scheme of its own,” wrote Bernstein Research analyst Jeffrey Lindsay in a note to clients. “We see Live Cashback as more of a competitive discounting challenge than a truly disruptive new pricing model.”

Some argue that at least Microsoft should be applauded for finding an alternative to Google. “Big advertisers like eBay have a love-hate relationship with Google,” said Yen Lee, CEO of travel search engine Uptake and a former exec for Yahoo’s search business. “That Microsoft has a clever way of price-cutting, well that’s interesting to big advertisers.”