Yahoo’s ad alliance with Google seems like a great deal to Messrs. Brin, Page, and Yang. Now they just have to win over the Justice Department.

Google and Yahoo had hoped to have it all up and running by now. As you may recall, the two Internet giants announced an alliance last June in which Google would supply Yahoo with search ads to supplement Yahoo’s own. Google would get a big new customer for its ad-delivery service, while Yahoo would get a new source of revenue – and best of all, they’d keep Microsoft from swallowing Yahoo.

Then Washington got in the way. Due to pushback from antitrust regulators, in early October, Google (GOOG) and Yahoo (YHOO) put off the launch to give the Justice Department more time to chew on it. In September, Justice reportedly hired veteran antitrust litigator (and former Walt Disney vice chairman) Sandy Litvack to help review the deal, and soon thereafter Canadian authorities hired an outside lawyer too. The European Union is also taking a hard look.

What’s the hang-up? Well, there are three basic concerns about just what this alliance really amounts to. First, if it had been a merger between Google, with 70% share in the paid-search market, and Yahoo, with the next 20%, it would clearly violate antitrust laws by creating a monopoly. (Paid-search ads are the ones that show up near the top of a search-result screen or off to the side, under the rubric “sponsored links.”) Second, if Google were paying Yahoo to exit the paid-search arena, that would be an illegal agreement between competitors to allocate markets. Third, if Google and Yahoo were agreeing to set a price floor for the two companies’ paid-search offerings, that would be illegal price-fixing.

The actual deal being proposed looks something like a slow-motion version of the first two scenarios, and it might constitute an immediate realization of the third.

Google and Yahoo have tried to placate skeptics with a raft of reassurances: They’re not merging; Yahoo will continue to compete in paid searches; ad prices will continue to be set by auction, with each company’s auctions operating independently; Yahoo will only run Google ads to the extent it chooses; and Yahoo is still free to display ads from other paid-search providers, including third-place Microsoft (MSFT).

Not everyone is convinced, though – notably advertisers. The Association of National Advertisers (ANA), the Association of Canadian Advertisers, and the World Federation of Advertisers have all written regulators to voice opposition. In the letter from the ANA – a 375-company association with a board that includes members from Wal-Mart, Sears, and McDonald’s – CEO Bob Liodice writes that his group “is aware of only one advertiser/marketer that does not object to the Google-Yahoo collaboration.” (Liodice wouldn’t identify the exception.)

MICROSOFT GETS SUSPICIOUS

One big problem for Yahoo may be an astounding comment allegedly made by its own CEO, Jerry Yang, during negotiations with Microsoft in a San Jose airplane hangar on June 8, just three days before the Google-Yahoo pact was unveiled. (Google offered Yahoo the ad deal in an apparent effort to keep it out of the hands of Microsoft, which had offered to buy Yahoo at a 75% stock premium.)

According to testimony that Microsoft general counsel Brad Smith later gave to the Senate Judiciary Committee, Yang peered across a conference table and said, “Look, the search market today is basically a bipolar market…. On one pole, there’s Google, and on the other pole, there are Yahoo and Microsoft…. If we do this deal with Google, Yahoo will become part of Google’s pole.” Smith and his Microsoft colleagues were dumbstruck. Smith testified that during a break a few minutes after Yang’s comment, Microsoft CEO Steve Ballmer cracked, “[Yang] said there’s only going to be one pole in the market. I guess that would be a ‘mono-pole,’ wouldn’t it?”

When stunned Senators demanded that Yahoo general counsel Michael Callahan, who had also been present at the June 8 meeting, give his account of what Yang had said, Callahan repeatedly refused until, when pressed, he finally said, “I don’t recall that comment.”

Even putting aside the disputed remark, there are plenty of reasons to be skeptical about those reassurances from Yahoo and Google. For example, consider Yahoo’s claim that the deal will enable it to compete harder in the search business. The company has told shareholders that it hopes to make $800 million a year from its pact with Google – money that, as Yahoo president Sue Decker has written on a company blog, will be plowed back into R&D “to help us become a stronger competitor in all aspects of online advertising,” including paid searches. Yahoo has an incentive to do so, the company says, because it keeps all the revenue from its own ads but only a portion from Google’s.

Hmm. What portion will Yahoo keep when it uses a Google ad? That’s not public. But according to a lawyer close to the Google-Yahoo camp, Google’s ad deals with web publishers large and small-from the New York Times website to GPSworld.com -typically leave the publisher with “the lion’s share” of the revenue. Accordingly, when Yahoo runs an ad delivered by Google, we’re probably not talking about a 50-50 split; it’s more like 90-10, with 90% staying with Yahoo. So if Yahoo can make 90% of what Google’s superior mousetrap currently yields while incurring no research expenditures, how great is its incentive to keep dumping hundreds of millions into R&D for its own clunkier mousetrap? Plus, if Google really thought the deal would help Yahoo build a more competitive paid-search program, would Google be doing the deal? Concern about the deal’s sapping Yahoo’s long-term incentive to compete is presumably a key factor spurring EU regulators to nose around, notwithstanding its ostensible geographical limitation to the U.S. and Canada.

THE PRICE PROBLEM

Then there’s the price-fixing issue. Nobody’s price fixing, Google and Yahoo insist, because ad prices will continue to be set by separate auctions. That’s true. But part of the idea with this alliance is to replace some Yahoo ads on Yahoo search screens with Google ads, when the Google ads will fetch more revenue. Here is an oversimplified hypothetical example: Suppose you’re an auto parts dealer trying to drum up some business with search ads. You bid for the query “spark plugs Dallas Texas” on both the Yahoo auction and the Google auction-and learn that the going rates on Yahoo and Google, respectively, are $0.80 per click and $1.20 per click. Google reaches more users – hence the higher bids – but you decide to go for the $0.80 ad on Yahoo.

Guess what? You’ll need to pay the $1.20 anyway. Why? Remember that with the Google alliance, Yahoo now has the choice of going with ads delivered through its own system or through Google’s. Yahoo, of course, is going to run the ad that makes the most money – the ad from Google. In fact, Yahoo would never run its own ads if they were priced more cheaply than an available, comparable Google ad. In that sense the Google ad prices, though set by auction, would effectively set a floor for the prices of comparable ads displayed on Yahoo. Price floors constitute illegal price fixing.

Yahoo and Google respond that Yahoo won’t have the real-time pricing information about Google’s ads it would need to make instantaneous price comparisons to Yahoo ads. Still, Yahoo obviously thinks it has some way to compare the relative prices of Google and Yahoo ads – how else will it know when to replace a Yahoo ad with a Google ad?

Which is not to say that the search giants’ formidable teams of lawyers won’t eventually win Justice’s blessing for the deal. Clearly, though, those lawyers still have some serious work to do.

[CLARIFICATION: A spokesperson for Yahoo says that the way I've described the "$800 million" annual revenue figure above is inaccurate. To be clear, what Yahoo said in its announcement and SEC filing was this: "Yahoo! believes that this agreement will enable the Company to better monetize Yahoo!'s search inventory in the United States and Canada. At current monetization rates, this is an approximately $800 million annual revenue opportunity. In the first 12 months following implementation, Yahoo! expects the agreement to generate an estimated $250 million to $450 million in incremental operating cash flow." What Yahoo president Sue Decker said during the June 12 teleconference call was this: "In the first 12 months following implementation, we expect this agreement to generate $250 million to $450 million in incremental operating cash flow. Over the longer term, Yahoo! believes this agreement enables the company to better monetize Yahoo!'s search inventory. At the current monetization rate, we believe there is an approximate $800 million in annual revenue opportunity in the U.S. and Canada on those queries where monetization upside exists. This revenue opportunity could be achieved either from this arrangement with Google, which includes both search and nonsearch elements, or from other enhancements to our search capability, or a combination of them." -- RHP]

Yahoo’s ad alliance with Google seems like a great deal to Messrs. Brin, Page, and Yang. Now they just have to win over the Justice Department.

Google and Yahoo had hoped to have it all up and running by now. As you may recall, the two Internet giants announced an alliance last June in which Google would supply Yahoo with search ads to supplement Yahoo’s own. Google would get a big new customer for its ad-delivery service, while Yahoo would get a new source of revenue – and best of all, they’d keep Microsoft from swallowing Yahoo.

Then Washington got in the way. Due to pushback from antitrust regulators, in early October, Google (GOOG) and Yahoo (YHOO) put off the launch to give the Justice Department more time to chew on it. In September, Justice reportedly hired veteran antitrust litigator (and former Walt Disney vice chairman) Sandy Litvack to help review the deal, and soon thereafter Canadian authorities hired an outside lawyer too. The European Union is also taking a hard look.

What’s the hang-up? Well, there are three basic concerns about just what this alliance really amounts to. First, if it had been a merger between Google, with 70% share in the paid-search market, and Yahoo, with the next 20%, it would clearly violate antitrust laws by creating a monopoly. (Paid-search ads are the ones that show up near the top of a search-result screen or off to the side, under the rubric “sponsored links.”) Second, if Google were paying Yahoo to exit the paid-search arena, that would be an illegal agreement between competitors to allocate markets. Third, if Google and Yahoo were agreeing to set a price floor for the two companies’ paid-search offerings, that would be illegal price-fixing.

The actual deal being proposed looks something like a slow-motion version of the first two scenarios, and it might constitute an immediate realization of the third.

Google and Yahoo have tried to placate skeptics with a raft of reassurances: They’re not merging; Yahoo will continue to compete in paid searches; ad prices will continue to be set by auction, with each company’s auctions operating independently; Yahoo will only run Google ads to the extent it chooses; and Yahoo is still free to display ads from other paid-search providers, including third-place Microsoft (MSFT).

Not everyone is convinced, though – notably advertisers. The Association of National Advertisers (ANA), the Association of Canadian Advertisers, and the World Federation of Advertisers have all written regulators to voice opposition. In the letter from the ANA – a 375-company association with a board that includes members from Wal-Mart, Sears, and McDonald’s – CEO Bob Liodice writes that his group “is aware of only one advertiser/marketer that does not object to the Google-Yahoo collaboration.” (Liodice wouldn’t identify the exception.)

MICROSOFT GETS SUSPICIOUS

One big problem for Yahoo may be an astounding comment allegedly made by its own CEO, Jerry Yang, during negotiations with Microsoft in a San Jose airplane hangar on June 8, just three days before the Google-Yahoo pact was unveiled. (Google offered Yahoo the ad deal in an apparent effort to keep it out of the hands of Microsoft, which had offered to buy Yahoo at a 75% stock premium.)

According to testimony that Microsoft general counsel Brad Smith later gave to the Senate Judiciary Committee, Yang peered across a conference table and said, “Look, the search market today is basically a bipolar market…. On one pole, there’s Google, and on the other pole, there are Yahoo and Microsoft…. If we do this deal with Google, Yahoo will become part of Google’s pole.” Smith and his Microsoft colleagues were dumbstruck. Smith testified that during a break a few minutes after Yang’s comment, Microsoft CEO Steve Ballmer cracked, “[Yang] said there’s only going to be one pole in the market. I guess that would be a ‘mono-pole,’ wouldn’t it?”

When stunned Senators demanded that Yahoo general counsel Michael Callahan, who had also been present at the June 8 meeting, give his account of what Yang had said, Callahan repeatedly refused until, when pressed, he finally said, “I don’t recall that comment.”

Even putting aside the disputed remark, there are plenty of reasons to be skeptical about those reassurances from Yahoo and Google. For example, consider Yahoo’s claim that the deal will enable it to compete harder in the search business. The company has told shareholders that it hopes to make $800 million a year from its pact with Google – money that, as Yahoo president Sue Decker has written on a company blog, will be plowed back into R&D “to help us become a stronger competitor in all aspects of online advertising,” including paid searches. Yahoo has an incentive to do so, the company says, because it keeps all the revenue from its own ads but only a portion from Google’s.

Hmm. What portion will Yahoo keep when it uses a Google ad? That’s not public. But according to a lawyer close to the Google-Yahoo camp, Google’s ad deals with web publishers large and small-from the New York Times website to GPSworld.com -typically leave the publisher with “the lion’s share” of the revenue. Accordingly, when Yahoo runs an ad delivered by Google, we’re probably not talking about a 50-50 split; it’s more like 90-10, with 90% staying with Yahoo. So if Yahoo can make 90% of what Google’s superior mousetrap currently yields while incurring no research expenditures, how great is its incentive to keep dumping hundreds of millions into R&D for its own clunkier mousetrap? Plus, if Google really thought the deal would help Yahoo build a more competitive paid-search program, would Google be doing the deal? Concern about the deal’s sapping Yahoo’s long-term incentive to compete is presumably a key factor spurring EU regulators to nose around, notwithstanding its ostensible geographical limitation to the U.S. and Canada.

THE PRICE PROBLEM

Then there’s the price-fixing issue. Nobody’s price fixing, Google and Yahoo insist, because ad prices will continue to be set by separate auctions. That’s true. But part of the idea with this alliance is to replace some Yahoo ads on Yahoo search screens with Google ads, when the Google ads will fetch more revenue. Here is an oversimplified hypothetical example: Suppose you’re an auto parts dealer trying to drum up some business with search ads. You bid for the query “spark plugs Dallas Texas” on both the Yahoo auction and the Google auction-and learn that the going rates on Yahoo and Google, respectively, are $0.80 per click and $1.20 per click. Google reaches more users – hence the higher bids – but you decide to go for the $0.80 ad on Yahoo.

Guess what? You’ll need to pay the $1.20 anyway. Why? Remember that with the Google alliance, Yahoo now has the choice of going with ads delivered through its own system or through Google’s. Yahoo, of course, is going to run the ad that makes the most money – the ad from Google. In fact, Yahoo would never run its own ads if they were priced more cheaply than an available, comparable Google ad. In that sense the Google ad prices, though set by auction, would effectively set a floor for the prices of comparable ads displayed on Yahoo. Price floors constitute illegal price fixing.

Yahoo and Google respond that Yahoo won’t have the real-time pricing information about Google’s ads it would need to make instantaneous price comparisons to Yahoo ads. Still, Yahoo obviously thinks it has some way to compare the relative prices of Google and Yahoo ads – how else will it know when to replace a Yahoo ad with a Google ad?

Which is not to say that the search giants’ formidable teams of lawyers won’t eventually win Justice’s blessing for the deal. Clearly, though, those lawyers still have some serious work to do.

[CLARIFICATION: A spokesperson for Yahoo says that the way I've described the "$800 million" annual revenue figure above is inaccurate. To be clear, what Yahoo said in its announcement and SEC filing was this: "Yahoo! believes that this agreement will enable the Company to better monetize Yahoo!'s search inventory in the United States and Canada. At current monetization rates, this is an approximately $800 million annual revenue opportunity. In the first 12 months following implementation, Yahoo! expects the agreement to generate an estimated $250 million to $450 million in incremental operating cash flow." What Yahoo president Sue Decker said during the June 12 teleconference call was this: "In the first 12 months following implementation, we expect this agreement to generate $250 million to $450 million in incremental operating cash flow. Over the longer term, Yahoo! believes this agreement enables the company to better monetize Yahoo!'s search inventory. At the current monetization rate, we believe there is an approximate $800 million in annual revenue opportunity in the U.S. and Canada on those queries where monetization upside exists. This revenue opportunity could be achieved either from this arrangement with Google, which includes both search and nonsearch elements, or from other enhancements to our search capability, or a combination of them." -- RHP]

CARLSBAD, Calif. – Barry Diller defines the calm, cool, collected CEO. At least on stage, when he’s on his best behavior. He called his recent (successful) litigation with partner Liberty Media a wrenching three-month distraction. Come Aug. 1, he says, IAC (IACI) will complete its split into five companies, including the “new” IAC, a pure Web company.

Diller was more interesting about other people’s businesses than his own. About Hollywood, which he knows well, he said: “It’s a community that’s so inbred it’s a wonder the children have any teeth.” His point is that other than theatrical talent there’s no creativity coming out of Southern California. He expressed dismay that Yahoo (YHOO) let Microsoft (MSFT) walk away and implied that the only way he would have turned down such an offer would be if he knew – and not simply desired – that his business plan would produce a better return.

Diller has been around, so his thoughts on management are illuminating. He said the reason for breaking up IAC is that its more than 50 brands are too much for one company to handle. There’s always trouble somewhere with that many brands, he said. And as a manager, “what you tend to do is go where the trouble is,” as opposed to making trouble, which is far more enjoyable and profitable. Asked his opinion of the digital prowess of the major media conglomerates, he praised only one, News Corp. (NWS)

How do you define Dell (DELL) these days? Listening to Michael Dell speak, I have no idea. Dell himself noted that the company’s former “monolithic” strategy – its famous direct-to-customer manufacturing technique – didn’t work so well toward the end of its run. He cited five areas where Dell missed the boat: consumers, emerging markets, notebook computers, data centers and small- and medium-sized businesses. (Dell is the leader in PC sales to large businesses.) So instead Dell now emphasizes all those things, or at least is trying to. It dabbles in retail. It targets smaller businesses. Its growth has been impressive, but is that over a weak base, what Wall Streeters call an “easy compare?” Perhaps Dell eventually will do many things as well as it used to do one thing. For now, it’s a still a computer maker that spends a tiny percentage of its revenues on R&D ($600 million out of $65 billion in sales) and therefore sells me-too products, though often more efficiently than the competition.

It’s being widely reported that Yahoo (YHOO) and News Corp. (NWS) are back in talks to combine Yahoo with MySpace and other properties that make up Fox Interactive Media, News Corp.’s online arm. The companies held what I’m told were very preliminary talks along a similar vein last year. The deal would have three main components: 1) News Corp. would contribute FIM to Yahoo; 2) News Corp. would invest in Yahoo; 3) a private-equity partner would inject yet more cash into Yahoo. The goal, in theory, would be to raise Yahoo’s value with the cash investments, thus obviating the need for Yahoo to sell to Microsoft (MSFT).

Here’s the problem. Or, rather, the problems. It’s going to be tricky to value MySpace, which will be the linchpin of the value of what News Corp. is contributing. If whatever News and Yahoo were to assemble didn’t add up to Microsoft’s current offer ($31), or counter-offer, the board of directors at Yahoo would be in a pickle.

Couldn’t they just accept a lower bid with the argument that Yahoo is worth more independent than selling out? Sure. Then they’d get sued. They’ve got to be able to best Microsoft’s offer in a reasonable timeframe, or they’re not doing their fiduciary duty.

There’s more. In a note to clients Wednesday, UBS analyst Ben Schachter (who had a buy rating on Yahoo at $19, when many of his competitors had lost faith, because he figured Yahoo’s falling price would provoke a sale, or at least a bid) reasons that the only way for a YahooSpace to achieve necessary profits would be do a search outsourcing deal with Google (GOOG). That’d bring the companies back to the same regulatory conundrum they’ve already been grappling with: Google’s search share is too big. There’s also the question of whether Yahoo needs MySpace. After all, “Yahoo’s problem has not been a lack of inventory, ” writes Schacter, meaning that it already has a huge audience. It’s problem, he writes is “its poor execution on optimizing monetization.” That means Yahoo isn’t so good at making money from its 500-million-plus audience. Schacter has a $34 price target on Yahoo because he thinks Microsoft will raise its bid.

So is Yahoo wasting its time talking to News Corp.? Of course not. Its stock traded over $30 Wednesday, closing at $29.88. To the point of my earlier post, that’s a sign investors expect a higher bid from Microsoft, not that it’s overly impressed with a News Corp.-Yahoo tie-up.

My friend, the Newsweek columnist Daniel Gross, posted an entertaining and informative column this week on Slate about what he sees happening next in the Microsoft-Yahoo merger. Like everything Dan writes, this column is worth reading, partly because it’s delightful and also because he does a great job of explaining how these catfights typically work. I agree with everything he wrote — except his conclusion.

To boil down his wonderful words, Dan believes that because Yahoo’s (YHOO) stock price hovers around $29.50, where it’s been more or less since Microsoft (MSFT) offered on Feb. 1 to buy the company for $31 a share, Wall Street is signaling its belief the deal will collapse. He reasons that if investors believed a higher bid was coming, the stock would trade higher. The fact that no private-equity or sovereign-wealth firm has materialized to bid for Yahoo is further proof that no one wants it and that Microsoft won’t fight.

I beg to differ, and not just because I wrote in the current issue of Fortune that a Microsoft acquisition of Yahoo is inevitable. First, Yahoo’s stock price is held back in part because Microsoft’s stock price is down, and half its offer is in stock. Second, if the market really believed that Yahoo will succeed in telling Microsoft to buzz off, the stock wouldn’t be at $29 and change. It would have plunged back toward $19, the sorry level to which it had fallen just before Microsoft dropped its bomb.

Yes, Yahoo traded for $31 not so very long ago. But that was before investors realized how little was going on inside the company, that CEO Jerry Yang was taking his sweet time to clean house, that Yahoo continued to poorly articulate its growth strategy and, perhaps most importantly, that the company faces “headwinds” in its core business, online display ads. Those realities haven’t changed since Microsoft offered to buy the company.

As for another bidder materializing, the fact that nobody — not a phone company, not another media company and certainly not a private-equity shop — has stepped forward tells you something about how the world outside Redmond, Wash., and Sunnyvale, Calif., views Yahoo’s valuation. A financial buyer simply can’t make the numbers work; Only Microsoft can.

But can’t Yahoo simply say no? Sure it can. But if Wall Street really believes no means no, you’ll see a stock drop and lawsuits fly. “We do not believe that Yahoo’s board will be able to turn down a mid-$30s bid without another offer in hand,” RBC Capital Markets analyst Jordan Rohan wrote to clients this week. “Yahoo management has already exhausted the patience of its largest, longest-suffering shareholders and Microsoft’s offer allows them to save some face.” Rohan then reports something I haven’t seen elsewhere: “Microsoft held several meetings last week with some of Yahoo’s largest shareholders. Ultimately, since there is only one class of stock, if those shareholders band together behind the likely-future-revised Microsoft bid, the deal will eventually get done.”Already, that’s beginning to happen. T. Rowe Price and Legg Mason, two large Yahoo shareholders, have gone public with their support for the Microsoft offer.

What this means is that it’s likely wrong to interpret Microsoft’s lack of a higher bid so far as an unwillingness to raise its offer. Instead, think of Microsoft’s behavior as a pause, an opportunity to make Yahoo sweat — or at least get an earful from its own shareholders. Of course Microsoft will raise. But only after Yahoo has the time to consider the meaning of Microsoft not raising.

A few more things to consider, at least for readers not caught up in the mind-messing media games that get played by all sides in this circus. The Wall Street Journalis reporting in Wednesday’s editions that Google (GOOG) is no longer overly interested in pursuing a revenue-sharing deal with Yahoo for search ads. It sources are “people familiar with the matter.” I haven’t checked, but I’m guessing that the Journal, citing “people familiar with the matter,” first broke the news that Google was interested in pursuing a revenue-sharing deal with Yahoo for search ads. Gold star for anyone who can guess where that information started and ended.

Similarly, the conventional wisdom for why Microsoft won’t actually mount a hostile takeover bid, a term of art that is different from the public “bear hug” it currently is pursuing, is that it would scare away Yahoo’s best people. What’s odd about that is that the conventional wisdom up until earlier this month was that most folks you’d want to retain at Yahoo already had left. Conventional wisdom’s a funny thing.

A final thought, and not a happy one for Microsoft, but even less so for Yahoo. Yahoo undoubtedly will draw this process out for a bit. Who knows, they may even force Microsoft to mount a proxy fight, though I doubt it. But let’s say it’s three months before Yahoo acquiesces and another nine months before U.S. and European regulators approve a Yahoo acquisition. Google likely will complete its long delayed DoubleClick purchase this spring. Under this scenario, it would then have a year’s headstart against MSN-Yahoo, which will be the mother of all integration challenges. Neither Yahoo nor Microsoft and the ad businesses it acquired when it bought aQuantive last year will stand still, of course. But talk about distractions.

What with all the exciting stuff going on in the Web world of late — Google (GOOG) laying a rare earnings turd, Facebook becoming the next Google, Yahoo (YHOO) losing altitude fast — a morsel from eBay’s (EBAY) earnings call last week was undereported. CEO Meg Whitman, vowing to rejuvenate eBay.com’s core listings, promised to market more offline. She also commented briefly on eBay’s recent spat with Google. Consider this from the New York Times:

Last month, eBay temporarily stopped buying keyword advertising on Google, the Web’s largest search engine. EBay said the suspension did not have had significant effect on its bottom line. “We learned a great deal from that test,” Ms. Whitman said. “It actually had no impact on the financials of the quarter, and we learned a lot about where we want to spend money and where we think we can save money on Internet marketing.”

Think about that. eBay, once and perhaps still Google’s largest advertiser, saying that perhaps online advertising isn’t all it’s cracked up to be anymore. That’d be fine, say, if Procter & Gamble (PG) decided it had had enough of this newfangled form of advertising. But not eBay, an Internet pioneer. Internet advertising taking a back seat to offline marketing? The horror, the horror.

My former boss Eric Pooley published a juicy, access-laden cover story about Rupert Murdoch in the current issue of Time Magazine. There’s a small amount of news, like Murdoch confirming that he discussed combining MySpace with Yahoo (YHOO), a conversation he had with former CEO Terry Semel. Pooley also describes how Murdoch threatened to walk away if the Bancrofts didn’t submit a more reasonable response to his $5-billion bid to buy the Wall Street Journal. Murdoch also voices support for newly installed Journal managing editor Marcus Brauchli. All in all, it’s a good read, with the cover line “The Last Tycoon”, after the Fitzgerald novel.

There’s also an intriguing throwaway line from Murdoch deep in the story, regarding MySpace. “It was an education for me, the way it took off,” Murdoch tells Pooley. “It was the cool young site. Now the average age is climbing.”

What’s intriguing about Murdoch’s point is that MySpace CEO Chris DeWolfe went out of his way to make a similar point to me Wednesday morning over breakfast in San Francisco. He told me 40% of MySpace’s audience is 35 years or older. The reason for stressing this is to counter the assumption that rival site Facebook has a better plan for growing beyond its youthful audience. I don’t doubt that more older people are using MySpace, and Facebook, for that matter. When I asked DeWolfe, however, what percentage of time spent on MySpace is attributed to the 35-year-old-plus crowd, he said he didn’t know but agreed with my assumption that the figure would be well below 40%.

I still doubt that adults, the kinds with careers to build and families to raise, will spend much time on sites like MySpace and Facebook in years to come. The owners of those sites disagree, of course. Their businesses depend on it.

I mentioned this topic in my article Tuesday after Jerry Yang’s appointment as CEO of Yahoo (YHOO), and the The New York Times devoted a considerable amount of ink to it the next day. This is a bit of an arcane topic to people who aren’t in the biz, but an extremely important one. It essentially suggests that Yahoo should stop investing in its search-advertising platform because it has been such a laggard and instead outsource the function to Google (GOOG). That’s what Yahoo used to do, and there’s widespread agreement that Google is and always will be superior at this to everyone else.

In fact, it’s a classic business-case problem. Should Yahoo let the fact that it has spent billions of dollars buying Inktomi and Overture and investing in its Project Panama stand in the way of making the right financial call? Unemotional business theory suggests that you can’t let past poor decisions stand in the way of good decisions today. Then again, if search advertising is central to what Yahoo does — and that has been management’s position to date — then they simply can’t give up.

I’ve had two interesting responses to my article in the last couple days from executives who think about his stuff all day long. One thinks Yahoo’s preparing to sell itself. The other sees plenty of opportunity. “A CEO who has never run anything large and a president who hasn’t either and came from Wall Street,” wrote one. “Can this truly be anything other than Yahoo pursuing ’strategic options?’” Said the other: ” There are a lot of people who think that search is still relatively early and that there’s a whole lot of ad technology left to be built in years ahead and that Google, Microsoft (MSFT), AOL and others are going to be investing heavily. Jerry seems to be the kind of guy to lead a similar effort for Yahoo.”

What do you think? Tell me below or in this poll.

David Kirkpatrick and I have been having a cordial argument about Facebook. He thinks it’s going to be the next big thing. I think it’s really annoying. He likes to send me messages through Facebook, which then notifies me, by email, that I have a message on Facebook from David. I ask him to send me emails instead. I just can’t see myself ever spending significant amounts of time on Facebook. It’s cute and all, but, well, I don’t know, it’s just not my thing.

That got me thinking about just how difficult it is to change one’s behavior online. I believe that kids use Facebook and love it, and I’m sure many will keep using it when they grow up. Most, however, will have to attend meetings and do actual work during the day — unless, of course, they become journalists — and therefore won’t have the time to see who is “poking” them on Facebook.

Similarly, I was stunned by news that Google (GOOG) now has 56% of the U.S. search market, up from 49% a year ago. Then again, I’m sort of surprised anyone doesn’t use Google. I keep meaning to spend a whole day using Ask.com’s search. (Jim: LOVE the new commercials.) But then I forget, so ingrained is Google in my search psyche. (The IAC (IAC) unit also didn’t do as good a job of helping me find a news story about search marketshare as Google did.) Then there’s Google Finance, which is doing some really neat stuff — and has started a new blog (Katie, you’re a blogger!). I like Google Finance. But I rarely use it. Yahoo (YHOO) Finance has been my browser home page for about … forever. I just can’t conceive of not seeing Yahoo Finance when I go online.

What will it take to change that?

Mike Volpi has been on the job as CEO of Joost, the new online video network, for a few weeks. But already he’s got his mission statement down better than Terry Semel ever did at Yahoo (YHOO). (See this interview I did last summer with Semel to get a sense of what I mean.) “We want to transform the way people entertain themselves,” Volpi said last night at a party at the Academy of Television Arts & Sciences in North Hollywood, Calif. (A fairly serious guy, Volpi also began his remarks with a pitch-perfect zinger: “My staff has told me this will be my only opportunity ever to say, ‘I’d like to thank the Academy …’”)

If you know anything at all about Joost, you know it doesn’t suffer from ambition. Founded by the two guys who started Kazaa and Skype, Joost is one of scores of companies that are trying to be the next YouTube. And yet it’s gotten a higher profile than the others, even before officially starting its service. That’s due in part to its founders and partly to early investors like Skype funder Index Ventures (hey Danny!), CBS (CBS), Google (GOOG) and YouTube investor Sequoia Capital. Nabbing Volpi added yet more cred to Joost. He was a Cisco (CSCO) bigshot for years. (Read David Kirkpatrick’s overview of Joost on the day Volpi’s hiring was announced.)

Okay, so how is Joost doing? Well, it’s hard to say. The company is still in its testing phase. Volpi told me 700,000 users have downloaded the company’s player, a piece of software to watch videos on your computer. It has signed all sorts of deals with creative types — which is why it threw a party in La-La Land. And it’s working with Interpublic Group’s (IPG) Emerging Media Lab to let IPG’s advertising clients test how Joost slices and dices both programming and user data. In short, well-funded Joost basically isn’t going for the hard sell yet, either with advertisers (whom it’s charging only nominally) or with users, while it’s trying to see if they actually like the experience Joost is pushing.

Watching Joost must be what it was like when the cable networks got going: a new video experience with a splotchy menu of shows that only a few people were experiencing. Will it break out of the pack? Way too early to tell. At least Joost seems to know where it wants to go.

I posted an article this morning on CNNMoney.com suggesting that investors were perhaps a wee bit too exuberant about Terry Semel’s exit from the scene at Yahoo (YHOO). The stock rose 3% during the day Monday and added another 5% after the market closed. Today’s a different story. The stock has given back nearly everything it took Monday, trading down about 1% from Monday’s close. By late morning, Yahoo changed hands at $27.84, just 50 cents or so above where it ended last week.

Semel’s exit was the non-surprise surprise. Marketplace radio’s Kai Ryssdal found me on the freeway in Silicon Valley yesterday about twenty minutes before air time to talk about the news. (The text and audio of the interview are posted here.) My insta-analysis: Yahoo’s failure is all about Google (GOOG) and simply getting rid of Mr. Hollywood doesn’t change things much.

Investors also completely ignored Yahoo’s downbeat earnings commentary yesterday, though they’ve wised up today. Shares of mighty Goog, by the way, are practically unchanged today.

Microsoft (MSFT) needs to be a company of “multiple muscles,” says Steve Ballmer, the company’s unusually calm CEO. In a genial interview with the Wall Street Journal’s Walt Mossberg Wednesday morning, Ballmer presented a picture of a plodding, predictable, unexciting company. He couldn’t quite say when Microsoft will make some progress against Google (GOOG) in its weak share in Internet search. He couldn’t say why exactly the new Vista operating system was overly complex when it was released. He didn’t particularly enlighten the audience on just why Microsoft is paying $6 billion to buy online ad agency aQuantive (AQNT). By the way, Ballmer won’t mention Google’s name, referring to it merely as “the market leader;” He is willing say the word Yahoo (YHOO), but Mossberg didn’t ask him if Microsoft would like to buy Yahoo.

Microsoft has 78,000 employees today, and Ballmer acknowledged that getting things to happen outside of the “central planning committee” is a major challenge. Listen carefully, and Microsoft has become a company of excuses. If Zune isn’t so hot right now, Ballmer implies, it’s just a beginning. As for why it’s brown: “It’s the color that all the dirt bike riders really want.” (Read Brent Schlender’s biting critique of Zune, along with Apple’s (AAPL) Apple TV, here.)

As for those multiple muscles, Ballmer points out that just as Microsoft added selling to big businesses to its original business of selling sofware only to computer makers, today it’s trying hard to add two new business models: consumer electronics and advertising. “We’re going to keep coming and coming and coming and coming, just as we did in the enterprise, and just as did in phase one,”he said.

Trying, trying, trying. You almost feel sorry for Microsoft.

I didn’t attend Zuckfest in San Francisco Thursday. (I was busy, not uniterested.) But I did read David Kirkpatrick’s comprehensive report on what Facebook is up to with its new platform concept, as well as a whole bunch of other descriptions of the attempt by CEO Mark Zuckerberg – whom I’ll always remember for his one-of-a-kind business card – to create Macworld-like drama the way Apple (AAPL) CEO Steve Jobs does. (Particularly worth reading is a contrarian take by paidContent.org that throws a fair amount of cold water on Facebook’s dramatic announcement.)

What interests me here is whether anyone over about 25 will really use Facebook, including folks who use it in college and then go out into the real world. Last fall, when Facebook started expanding to allow corporate e-mails to be used to establish accounts (around the same time the company reportedly turned down a billion-dollar offer to be bought by Yahoo (YHOO)), I asked Facebook to start one for Fortune’s editorial employees. I then invited everyone on staff to be my “friends.” Three accepted, and I’m not naming names, nor did I take the rejection personally. It was more that no one seemed to care. Since then I’ve been steadily getting invitations from all over the place for people to be my “friends,” many from people I’ve never met or met only once. My hunch is that adults are finding out about Facebook and then inviting everybody they can think of. But will they actually visit the site and see who is “poking” them? I seriously doubt it. I don’t use LinkedIn much either, but I know that lots of people do, and I understand why: It’s got content that helps them do their job. And even then, it’s not like you’re going to spend a ton of time on LinkedIn, the main premise behind Facebook and News Corp.’s (NWS) MySpace. Professionals get in and get out. They’re too busy to do otherwise.

(Will adults use Facebook? Have your say in this poll.)

Take that Google (GOOG). After losing out on nearly every major deal imaginable, Microsoft (MSFT) finally has landed a counterpunch to Google, and a pricey one at that, by buying online ad agency AQuantive (AQNT). Google bested Microsoft in the high-priced competition to supply Time Warner’s (TWX) AOL with search advertising. It trumped Mr. Softee again when it paid $900 million for News Corp.’s search business that included serving search to MySpace. And it snatched DoubleClick from Microsoft’s grasp too.

Buying AQuantive for $6 billion is a massive move for Microsoft. If it can integrate its Seattle neighbor well, the AQuantive purchase will be a jumpstart for Microsoft’s MSN business. Then again, it could be a costly waste, a too-late, too-timid move where the far more expensive purchase of Yahoo (YHOO) truly would have made Microsoft a player in the online world. Microsoft has a history of unsuccessfully tossing around big bucks to “get into the game.” Think: WebTV (1997), LinkExchange (1998) and CompareNet (1999). LinkExchange, for those who don’t remember, was an online advertising network. Um, that’s in large part what’s relevant about AQuantive’s business. Oh well. (In fairness, a really good get-into-the-game and extremely expensive acquisition: 1998’s Hotmail.)

It’s also something to see all of the late 1990s online ad flameouts – DoubleClick, AQuantive, and 24/7 (TFSM), which WPP Group (WPPGY) bought yesterday – getting snapped up. Even the formerly disastrous Snowball.com, later re-named IGN, is now a robust part of the growing Fox Interactive Media empire. What a time to be in online media.

The writing was on the wall for this one since the moment last October that Google (GOOG) agreed to buy YouTube. Jennifer Feikin, the director and chief businesswoman of Google Video, is leaving the company. I’ve wondered ever since the deal was announced how Google Video and YouTube would co-exist inside the same company. YouTube so thoroughly vanquished Google Video, an also-ran product in terms of traffic, that Google was compelled to buy YouTube, if only to keep it out of the hands of Yahoo (YHOO), Microsoft (MSFT) or one of the several broadcast networks that should have bought it. Feikin, at least, has something of an answer to the question: She’s not sticking around to find out.

A four-year-veteran at Google (yes, typical stock-option grants take four years to vest), Feikin was cut from a different cloth than other Googlers. Her glittering resume includes stints at Time Warner’s AOL unit (TWX), News Corp.’s (NWS) 20th Century Fox and the consulting giant McKinsey. (No slouch: She’s Harvard Law and Duke undergrad to boot.) Google Video’s relative lack of traction compared with YouTube shows that on the Internet even a well funded product guided by an experienced and savvy strategist doesn’t always win.

In an email to her peeps Feikin reflected on her “amazing years” at Google, which included the “launch and phenomenal growth of a once-tiny product called Google Video.” She said she’s leaving for “new adventures.” She shouldn’t have any trouble finding them.

At first glance, there’s not much new about today’s report in the New York Post that Microsoft (MSFT) has formally re-approached Yahoo (YHOO) about a merger. The article reads like banker talk: Investment bankers on one side or the other (or, better, a banker who couldn’t get a seat at the table) chatting up a deal to get things moving. It’s also not new news. A desperation merger between the two weaker online advertising players has been in the rumor mill for more than a year. Tim Arango and I speculated on such a move (among others) last October, for example, and UBS analyst Ben Schacter has justified a bullish call on Yahoo’s stock for quite a while predicated on Microsoft buying Yahoo if it got too cheap.

Does a deal make sense? Absolutely. Yahoo effectively could become MSN on steroids. The two search-advertising also-rans finally would be able to push serious traffic through their ad-search delivery platforms. Microsoft would bring major financial resources to Yahoo, which because of its underperformance in search has been cost-cutting elsewhere. (An Internet business cost-cutting during an advertising boom is a sad thing to see.) A tie-up also might explain why Yahoo CEO Terry Semel is still around. Everyone assumed he’d be gone by now. But Semel is a dealmaker, and this is an enormous deal.

Having said that, every time I’ve discussed a Microsoft-Yahoo merger with people who know the two companies well, they remark on what a disaster it would be. Those ad-search platforms, for example: each company has spent a fortune developing their own. It’d be a bitter pill to ditch one. Microsoft remains light years behind in truly understanding the Internet, at least compared with Google’s mastery. Google (GOOG) would love this deal, at least for a couple years, in the same way Dell (DELL) was ecstatic when HP (HPQ) bought Compaq. (Dell squandered an opportunity by not taking that deal seriously enough, but I digress.)

The market, of course, takes this report extremely seriously. Investors don’t care if a banker is trying to pump up a deal or if this talk is old or new. Yahoo’s stock was up 19% by late morning. Like the response to News Corp.’s (NWS) bid for Dow Jones (DJ) , the market’s reaction might make this deal a reality.

Since Google (GOOG) announced its proposed $3.1 billion acquisition of DoubleClick earlier this month, Microsoft (MSFT) general counsel Brad Smith has been one of the most outspoken in urging antitrust regulators to closely scrutinize it. AT&T (T) has also publicly expressed concern, and the deal is also understood to be of great interest to Time Warner (TWX), (the parent company of Fortune’s publisher), Yahoo (YHOO), and nearly every big web publisher and advertising agency.

Obviously, the role of antitrust enforcement watchdog is a new one for Smith and for Microsoft, but such ironies won’t blunt the impact of any meritorious argument they might raise. I interviewed him last week about his perspectives on the deal. Below are excerpts. (I’ve edited my questions to make them sound more articulate than they really were. Also, I wasn’t taping, so Smith’s answers are just captured here as best I could using pen-and-paper notetaking.)

Q. For the time being, no one is asking outright that the deal be blocked. Instead, they’re just urging antitrust regulators to make a “second request.” [A second request for information indicates that the antitrust authority--either the Department of Justice or Federal Trade commission--has decided to initiate a full-bore, analysis that will probably take six to nine months to complete. The second request will come, if it comes, in mid-May.] Are people just being conservative?

A. Mostly, they’re probably being conservative. These questions are very novel. Before anybody tries to come to a conclusion, it would make sense to learn a lot more, in terms of having a data-driven analysis. It may well be, after learning more, we’ll be saying it should be blocked.

Q. I’ve heard people say that there’s no problem here, because Google and DoubleClick aren’t direct competitors. [Google's biggest business is in the market for paid-search ads, which are the text ads that show up alongside search results. According to eMarketer, Google held 75.6% of the U.S. paid-search market as of February 2007. Google also posts contextual ads on third-party sites, where the ad is targeted to relate to the content running near the ad space. DoubleClick, on the other hand, is the leader in providing Web services that advertisers and publishers use to post and manage display ads, including rich media and video. Compared to Google's contextual ads, these are typically higher-end ads, running on higher-end sites, touting higher-end brands.]

A. The law is opposed to two companies coming together if it’s going to acquire market power that would enable them to raise prices. So a big part of this question is, are they part of the same market and, if so, will they be in a position to raise prices?

Companies typically defend in a merger analysis by saying either, “No, we’re in two different markets,” or “Yes, we’re in the same market, but we don’t have a significant share of it.”

So the threshold question is: What is the market? To answer that you ask: Are two products substitutable for each other. If you raise the price on product A, will they shift to product B. If so, they’re substitutable, and are in the same market. I think [the argument that display ads, which DoubleClick brokers, and contextual ads, which Google handles, are in different markets] is very unlikely to sway regulators.

The thing that differentiates the two is the way they’re generated. A contextual ad scans the context of a page, and then chooses and serves up an ad related to that context. If it sees that the content is about Ford Motor earnings, it might serve an automobile ad.

With a display ad, they look at it through cookies generated when someone goes to other pages. You may be writing this article about Google, but the reader thirty minutes ago went to a Ford automobile page, so it might serve up an ad for a competing automobile.

Web sites rely on both. Are display ads and contextual ads substitutes for each other? They look the same, and they serve the same purpose.

Q. Do they look the same though? I thought contextual ads were typically much simpler than display ads.

A. Nothing in the technology requires that they be simpler. . . . Are they in the same market? It’s a very objective question. If the price of one goes up, will publishers switch to the other? We think the answer’s yes. If these two companies come together, they’ll have 85% of this market place. They’re the two principal competitors. One has the lion’s share of contextual; the other has the lion’s share of display.

Two other questions then need to be considered. How broadly should the market be defined. The narrowest would be by segment: display is one market, contextual is one market. At the other extreme, there’s [what Google CEO Eric Schmidt was reported as saying at the Web 2.0 Expo conference on April 17, which is that advertising is a trillion dollar business and that a post-acquisition Google would only have about one percent of it.] He wants to include all advertising on the planet. That would be the first time regulators have ever defined a trillion-dollar market, except maybe in the oil industry. Is a Web site publisher going to use newspaper ads [as a substitute for display ads]? I don’t see how that would work. [At the conference, eWeek.com also quoted Schmidt as having said: "This is an emergent business with lots of choices: customers have lots of choices, end users have choices and advertisers have choices. These are people [Microsoft and AT&T] who were involved in acquisition reviews as best I can tell and who lost.” -RP]

The last step, once you define the market and figure out the market shares, is you ask, what are the barriers to entry [by new competitors]? Even if the merged company has 85% of the market, if the barriers to entry are low, the regulators might say, we’re not going to worry [because new entrants to the market will prevent the merged company from raising prices to anticompetitive levels]. This is something the regulators need to study. This is a a market where there are very strong network effects with significant barriers to entry.

Q. What are the network effects here? ["Network effects" were famously a factor in the Justice Department's monopolization suit against Microsoft in the late 1990s. The argument there was that it would have been extremely difficult for a new competitor to enter the market for operating systems when so many thousands of existing applications had already been written to work only on Windows. Few people would want a new operating system, because few applications would exist to run on it.]

A. Everyone [gauges their success in this business] by measuring revenue per something. Revenues per ad impression. Revenues per search. Revenues per click-through. RP-something. What you see today is, Google’s revenue per search or revenue per ad are way higher than its competitors’. They’re double Yahoo’s, and even more compared to Microsoft’s. The reason? It’s how much personal information their sites collect and use. . . . It’s based on how much information you have on users. That’s attractive to advertisers. They keep aggregating [data on] all the searches you do, all the web sites you visit, and use all that data to serve up an ad. That generates more revenue per search. That makes it harder for other people to break into the market. Whereas in the 1990s, people focused on the applications barrier to entry, this is basically the privacy barrier to entry, or the advertising barrier to entry, or something. Within the next six months, I guarantee you a new term will emerge for how difficult it is to enter when you have somebody with economies of scale from owning so much of the personal information on the Internet.

If the kinds of factors I’ve described are real, what you’ll probably see with consolidation is the profitability of the company that serves the ad will continue to go up at the expense of the the Web site publishers on the one hand and the ad agencies on the other. The company in the middle will own all the personal information and derive all benefits. Talk to ad agencies, publishers, content creators. This is why they’re worried.

Well, readers? Do you find Smith’s arguments convincing?