Can Yahoo catch Google?

NEW YORK (Fortune) -- The real online race is the one for ads, with everybody struggling to catch up to Google. You may think of Google as a search company, but selling and deploying ads is the business that drives its stratospheric stock price.

Google (Charts) now talks internally about building a "global operating system for advertising." It's already - through its AdSense program - selling ad space on many affiliated non-search Web sites and matching their content to ads. And as it adds similar systems to place ads on radio, in print and eventually on TV, Google aims to build an operating system for ads in all media. That is an amazingly ambitious business goal.

Google leads the race, by a mile, to sell ads on affiliated Web sites, though Yahoo (Charts) and Microsoft (Charts) have similar programs. But the real money is in ads aligned with search results. The rate at which viewers click on ads in search results can be as high as 20 percent, and never lower than 10 percent. That's a far better money-making opportunity than selling conventional banner ads, which get clicked at most 1 percent of the time.

Yahoo is hoping to get a bigger piece of that business with the launch of its long-awaited "Panama" advertising system. Finally, Yahoo will have modern software for advertising that compares to Google's.

Yahoo's old ad system, which it acquired when it bought Overture, gave prominence to the advertisers who paid the most. But Google, when it mimicked Overture and created its own system, took the concept a step further - it positioned ads based on the amount of revenue an ad would bring to Google. An ad that costs 15 cents but gets clicked on twice is thus placed more prominently on a search results page than one that costs 29 cents but is only hit once in the same period.

Yahoo's Panama has caught up to that aspect of Google's system. Yahoo Vice President for Product Strategy Brad Horowitz says that up to now Google had what he calls the "second-mover advantage". But Yahoo's new system brings it back in the game, he says: "This encourages the advertiser to create more relevant ads, and it's better for the user who sees more useful ads."

Today Google overwhelmingly dominates the search business. It thus has by far the largest inventory of ad space to sell (especially when you include the non-search AdSense inventory) as well as the largest number of advertisers seeking to buy advertising.

The risk for Yahoo and Microsoft, Google's top rivals, is that much as eBay (Charts) has developed the de facto dominant marketplace for buyers and sellers of goods, so Google could start to be seen as the de facto marketplace for ads. Buyers of ad space want to go where there are the most sellers and vice versa. It's what you call a "network effects" business - the more people who go there the more other people want to go there.

Word in the industry is that Yahoo now has about half as many advertisers as Google (neither company will reveal the actual numbers).

Could Yahoo regain strength with Panama? Perhaps. But it has a better chance if it bands together with Google's other rivals to offer an alternative marketplace that is competitive in size.

It's all about traffic. Google, with its affiliates like AOL and Ask.com, commands well over 50 percent of all searches in the U.S. in October, according to numbers compiled by Neilsen NetRatings. The combination of Yahoo, with 23.9 percent of searches, and Microsoft, with 8.8 percent, would be, at about 33 percent, a much more formidable rival than either company can be on its own. (That's why many believe Microsoft will either try to buy Yahoo or else link up in some other way to sell ads collectively.)

The wild card is Ask.com, owned by IAC/Interactive (Charts). Its own site accounts for 2.8 percent of searches, according to Nielsen. But Ask CEO Jim Lanzone explains that if you add in both other search sites Ask operates (like Excite and iWon) as well as other sites that use Ask's search (like Lycos and Infospace), its total volume accounts for more than 10 percent of all searches. Though Ask has its own distinctive (and impressive) search technology, most of the ads on its searches are put there by Google, in a deal that expires at the end of 2007. Expect a hot contest for the deal that succeeds it.

Adding in Ask could bring a Yahoo/Microsoft axis much closer to parity with Google in terms of traffic. (Google would lose the 6-7 percent and Ask's new partner would gain it.) Alternatively, either Yahoo or Microsoft could do a deal with Ask on its own. "We have the opportunity to be a swing state," says Lanzone with relish.

Meanwhile, Ask is slowly but steadily growing its share of search traffic. As it does, it makes itself an even more attractive partner for the next round of matchups when Ask's Google deal expires.

Google won the majority of the lucrative search ad business by creating the search site most people like to use, and by building a wonderfully-efficient engine for placing ads on those searches. But in a business that good, competitors will spend almost any amount of money to compete. Now we'll see if they can succeed.

_____________________

Diller's bet: Nice Ask

IAC to launch Web-based local info service