Microsoft CEO Says 'Nobody Gets' Yahoo Deal

Microsoft CEO Steve Ballmer told investors Thursday that he was surprised by the mixed stock market reaction to the search and advertising partnership Microsoft announced with Yahoo Wednesday, and argued that people don't understand the deal's implications.

"Taking questions over the last 18 months, including yesterday, and walking through the deal and watching the market reaction, nobody gets it," he said at the company's annual Financial Analyst Meeting at Microsoft headquarters in Redmond, Wash. "I know some people were sort of frothy in the market. I was surprised by the market reaction."

Ballmer did admit, however, that both the deal and future benefits to both Yahoo and Microsoft are "a little bit complicated."

Microsoft's partnership with Yahoo, which is subject to regulatory review and not expected to be fully in place before sometime next year, would make Microsoft's Bing the search engine for Yahoo's sites while making Yahoo a primary sales partner for Bing. The two companies would share search revenue over the life of the deal.

The key to the deal, Ballmer said, will be increased scale and market share. Combining Microsoft's search and advertising scale with that of Yahoo, he said, will be a "tool for product improvement." The more searches a search engine sees, the more relevant the results as algorithms get tweaked.

Similarly, the more searches the search engine sees, the more and better the information that the search engine provider can give to advertisers. As the search engine improves, Ballmer predicted, the combined Microsoft-Yahoo could grow market share even further.

Ballmer said that the reason people were confused by the economics of the deal is likely due the fact that there was, in the end, no acquisition, and no up-front exchange of money. "Nothing got bought, nothing got sold, but the partnership in and of itself creates economic value," he said. "It creates an immediate opportunity for synergy." Yahoo, for example, expects its operating income to increase by up to $500 million after the partnership gets implemented and cut capital expenses by $200 million.

Yahoo shares were hit hard after the deal was announced. Shares were down 14.2% Wednesday afternoon to $14.75 from their Monday close of $17.20. Microsoft, meanwhile, was up a modest 3.7% from $23.11 to $23.96 as investors saw their side of the deal more positively.

"On the Yahoo side -- this is the one that stuns me that people haven't figured it out," Ballmer said. He pointed out that while Yahoo loses 12% of its search revenue as part of the deal, it will eliminate a significant amount of ongoing research and development costs and capital spending.

In a PowerPoint slide deck posted online to accompany Ballmer's presentation, Microsoft initially included a slide about the Yahoo deal, which Ballmer did not reference in his presentation.

That slide has since been removed from the deck, but it included details about the Yahoo deal that the presentation said were "not for disclosure," including a breakdown of expected costs like $170 million in additional search research and development expenses.

The slide said that Microsoft expected the deal to begin impacting the companies' businesses in the second half of 2011. The slide also noted that Microsoft expects that the deal would be a net money loser for the first two years, with the tide then turning. "More of our financial upside comes from long-term work," Ballmer said during his speech.

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