NEW YORK (CNN/Money) -
Look out Google and Yahoo! The search engine wars have just gotten more interesting. Microsoft announced a major overhaul of its MSN search engine late Wednesday night.
Yahoo! investors were clearly alarmed by the news Thursday morning. The stock sunk nearly 5 percent. Google isn't public yet. But if it were, I bet that its stock would have seen a similar decline.
That's because Microsoft is showing that it is not messing around in the world of online advertising, which has rapidly become one of the most lucrative parts of the tech sector.
Until now, Microsoft was kind of like the Wendy's of the search engine world: a solid #3, but no McDonald's or Burger King.
In fact, Microsoft still relies on search technology from Yahoo! for both algorithmic results (a normal Web search tied to keyword relevance and with no advertising tied to it) as well as sponsored links that appear on the side from Yahoo!'s Overture subsidiary.
MSN's deal with Overture expires in June 2005 and its license with Yahoo!'s search technology division for algorithmic results ends in December 2005.
But in addition to unveiling a new look for its MSN search site, Microsoft said that it was working on its own algorithmic search engine technology, which the company said should be launched within the next year.
Meet the new butterfly
While the MSN news isn't exactly a shock -- Microsoft has made more rumblings about its interest in search recently -- the fact that the company appears to be so close to having its own search technology available took some by surprise.
It also would seem to put to rest speculation that Microsoft could use some of its more than $56 billion in cash to buy a rival search engine company for its technology.
"Microsoft is much further along than people anticipated and it's clear that it will rely on its own search technology rather than acquiring," said Marianne Wolk, an analyst with Susquehanna Financial Group.
Wolk adds that she expected Microsoft to launch its own sponsored search advertising division sometime next year, which could compete against Yahoo!'s Overture unit and Google's ad division.
And if that happens, the battle for online advertising dollars would become a lot fiercer, which could drag down what are healthy profit margins for Yahoo! and Google.
"This is not great news for Yahoo! and Google because search has been very much a duopoly," said Youssef Squali, an analyst with Jefferies. "To the extent that MSN can come up with its own monetization system for search, it could begin to take business away from Yahoo! and Google."
I took a quick look at Microsoft's revamped MSN and I have to begrudgingly admit that I was impressed. Microsoft seems to realize what works well for Yahoo! and Google and in some respects, improves on them.
For one, the new MSN Search home page is very clean, uncluttered by ads, just like Google. But it has some features that Google lacks on its home page, such as the ability to easily search a dictionary and encyclopedia (naturally, it is Microsoft's Encarta) as well as get stock quotes and movie listings through a drop down menu.
And the new MSN also includes links that can get you to MSN Messenger as well as sports news and weather in one click. There are no such links on Yahoo!'s search page to easily get you to Yahoo! Messenger or similar sports and weather pages.
Search gets serious
A spokesperson for Yahoo! said the company welcomed new entrants to search and that more competition would be good for consumers. Officials from Google declined to comment about Microsoft's search plans.
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But of course, Yahoo! (YHOO: Research, Estimates) and Google are busy making changes of their own to stay on top in search. Both companies have recently unveiled local search capabilities (think Web Yellow pages) as well as online comparison shopping services. They are also aggressively looking to expand overseas.
So it's not as if search engine dominance is a gimme for Microsoft once it fully enters the market. To that end, Wolk thinks that the major damage will be done not to Yahoo! and Google, but to smaller players like Ask Jeeves (ASKJ: Research, Estimates), InfoSpace (INSP: Research, Estimates), LookSmart (LOOK: Research, Estimates) and FindWhat.com (FWHT: Research, Estimates), which also fell sharply on Thursday.
Nonetheless, Microsoft's looming presence in search is something that Yahoo! and Google will have to keep an eye on, especially since Microsoft has more resources at its disposal to use to advertise the MSN brand.
That could mean that Yahoo!, which recently started a new national ad campaign, may have to further step up its marketing efforts. That costs money. And Google, which so far has followed the word of mouth school of promotion, might have to spend some of those IPO proceeds on advertising.
"As MSN moves to its own technology, it's a reasonable assumption that they will put more marketing behind it," said Steve Weinstein, an analyst with Pacific Crest Securities. "I expect them to be material players."
Of course, Yahoo! and Google are unlikely to get Netscaped by Microsoft.
Yahoo! is expected to post extremely strong second quarter results and give healthy third quarter guidance when it kicks off tech earnings season next Wednesday. And Google proved when it filed to go public that its business model works: the company is insanely profitable.
But Microsoft's search intentions do have to make you question whether it's justifiable to pay more than 100 times earnings for Yahoo! now that it finds itself facing a more formidable competitive threat.
Ditto for Google. Microsoft's search news should slightly dampen enthusiasm for Google's IPO later this year.
The search engine world is now a legitimate three horse race.
Analysts quoted in this piece do not own positions in any of the stocks mentioned. Jefferies has done investment banking for Yahoo! but the other firms have no banking ties to companies mentioned.
CNN/Money has a business relationship with Overture Services, a subsidiary of Yahoo!
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