Google, AOL Cement Advertising Partnership

Beating out rivals that reportedly included Microsoft and Yahoo!, Google took a stake in Internet service provider AOL. Both companies have a lot to gain from the deal, but it does have its down side — and AOL may yet regret the move. Keep reading to find out more.

The deal itself was reportedly a year in the making, though the press leaked details about rival suitors in the lead-up to the late December 2005 announcement. It was a coup for Google, and left Microsoft out in the cold. It made Carl Icahn and the group of investors he heads up apoplectic. And it caused analysts of all stripes to display their “armchair quarterbacking” skills as they talked about what the deal meant and whether it was really the best one possible for all involved.

The basics of the agreement between Google and Time Warner are relatively simple. Google will invest $1 billion for a five percent stake in America Online. Time Warner retains management control and full strategic flexibility over AOL, while Google will have certain customary minority shareholder rights, including those associated with any future sale or public offering of AOL. (I’ll talk more about that point later). Though the deal values AOL at $20 billion, which sounds a little high to some analysts, the point isn’t the money so much as the other aspects of the partnership.

The deal expands an agreement the two companies made about three years ago. In addition to the $1 billion from Google, AOL gets a $300 million credit that it can use to buy keyword-based ads from Google, a valuable commodity indeed. AOL should be able to monetize that credit nicely, since another part of the deal allows it to sell all types of ads, including search, banner, and display, across Google’s network – including on Google’s own websites.

But Google isn’t the only one making concessions in this deal. AOL’s notoriously popular – and notoriously closed to the competition – Instant Messenger will interoperate with the search engine giant’s four-month-old Google Talk. There is a condition here, though a small one: Google Talk users need to sign up for a free AIM screen name if they want to be able to IM users of AIM. This point is particularly interesting, given that Microsoft and Yahoo!, who were also courting a deal with AOL, recently reached an agreement to allow their IM clients to interoperate.

Another aspect of the deal involves “Making AOL content more accessible to Google web crawlers,” according to the Google press release. This particular point has stirred a bit of controversy among Google watchers. Some analysts even suggest that it might offer an indirect opening for Microsoft in the search engine advertising marketplace.

We can start to understand why these two companies are making this agreement by looking at the numbers. During the first nine months of 2005, AOL accounted for $429 million of Google’s revenue – about ten percent. Even after giving AOL its percentage of those advertising dollars, Google kept $63 million by some estimates, and that’s nothing to sneeze at.

Of course, that’s not the full story, though it often seems to come back to that. In addition to its share of the advertising revenues, AOL and Time Warner have plenty of reasons for wanting the deal. A high-flying Internet company about five or six years ago, AOL has fallen upon hard times. The Time Warner merger is widely seen in the industry now as a mistake, or at least a huge disappointment. Now that AOL is trying to remake itself as a free portal, it has a great deal to gain from making its content more available to Google, to say nothing of the benefits from the advertising portion of the deal.

Google, too, can gain much from the content end of the deal. As one analyst pointed out, “AOL has great programming and knows how to program content.” And there’s no question that this content draws visitors; according to Nielsen/NetRatings, during the month of November AOL attracted 74.3 million unique visitors, making it the fifth most popular website on the Internet. Who was number four? Google.

Large numbers of visitors give a website the ability to attract a large amount of advertising dollars. The Interactive Advertising Bureau expects that $12 billion will be spent on Internet advertising this year, a 25 percent increase over last year. By 2010, that number is expected to increase to $55 billion. An important portion of that online advertising market will go to display and banner ads. Google has not done much with those kinds of ads yet, preferring to focus on smaller, keyword-based text ads. But Yahoo! is already tapping into that market. Google’s deal with AOL will allow it to break into display ads in a big way.

Not everyone who owns a piece of Time Warner is wildly enthusiastic about the deal. Carl Icahn, who leads a group of investors who together own about three percent of Time Warner, wrote a very nasty letter to its board of directors when he heard that the agreement was in the works. He believes the sale of the five percent stake to Google to be a “disastrous action” that could preclude a sale of AOL to some other company.

To use Icahn’s own words, “Like all shareholders, I am not opposed to Time Warner entering into an AOL transaction that creates long-term value…However, I am deeply concerned that the Time Warner Board may be on the verge of making a disastrous decision concerning an agreement with Google.” He may indeed have a point. Google’s stake gives it a say in any future sale or public offering of AOL. You can bet the search engine giant would have something to say if Time Warner contemplates selling even a small part of AOL to Microsoft or Yahoo! or even eBay.

That’s not the only potential down side to the deal. With Google’s statement that it would help AOL’s content show up better on Google, some observers are wondering whether Google will maintain its neutrality. Google CEO Eric Schmidt insists it will: “We are not giving (AOL) preferential treatment, nor did they ask for it…I am making this clear: we will not let a business deal interfere with our search engine results.” Not everyone believes him. One commentator at the Register looked at this insistence from Google and wrote “Translation? Yep, it looks like Google will continue to water down its results, which already suffer from an unhealthy relationship with blog garbage.”

Indeed, this could be a unique opening for Microsoft. Sources close to the deal said that Microsoft was left out in the cold because it wasn’t interested in investing cash in AOL. But advertisers are going to wonder now whether Google will truly be neutral in its search results and give their customers a level playing field on which to display their advertising. One analyst observed that “If I were Microsoft, I’d certainly want to play up the fact that it is neutral with respect to search and search placement.”

There are some analysts who argue that Time Warner would have been wiser to pair up with Microsoft than Google. The same analyst who mentioned that AOL knows how to program content pointed out that “Microsoft has great technology and knows how to distribute content. Put the two together and it’s potentially [a] powerful set of online services. They may have missed a great opportunity here.”

For the reasons mentioned above, though, Google wasn’t going to let AOL walk into Microsoft’s hands. One analyst argued that the current agreement merely expands the one that Google already has with AOL, simply making it costlier for the search engine giant. That may be true, but it would have been far costlier for Google if AOL had signed a deal with Microsoft. First, Google would lose ten percent of its income; then, as Microsoft and AOL started working together, it would lose market share in the growing, cutthroat field of search engine advertising – which, let us not forget, is where Google earns 99 percent of its revenue.

The loss might force Microsoft to reflect on its strategy. Since the company still gains most of its income from its software, it might have thought that it could afford to lose this battle (though, according to all reports, it did work hard to try to get a deal). Indeed, it’s even possible that this deal truly was something that merely would have been nice for Microsoft, as opposed to how important it was for Google. But in the long run, that kind of thinking will lose it market share in the future – at least currently, there really isn’t any monopoly on search engines. And Microsoft is already starting out behind.

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