The Yahoo-Google search test (YHOO) was the most important news in a flurry of Microsoft-Yahoo events last week (MSFT): If the test becomes a full-scale outsourcing deal, most analysts agree that this would drive an immediate, material increase in Yahoo's operating profit, perhaps as much as $500 million a year.

Microsoft immediately responded to the test news by suggesting that a Google-Yahoo partnership (GOOG) was illegal and threatening to use whatever "options" it had at its disposal to block it.

So here are the key questions:

1. Would a Yahoo-Google partnership be illegal? Answer: "Maybe."

2. If it is illegal, would this really matter to the ongoing Microsoft-Yahoo negotiation? Answer: "No." In our opinion, the legality or illegality won't affect the Yahoo-Microsoft negotiations, at least if a deal is concluded within the next few months.

We continue to believe that the Yahoo-Google search test was a smart move that will likely lead to a higher takeout price for Yahoo. We think Microsoft will likely pony up more because:

1. Yahoo will likely be able to demonstrate that its cash flows with Google outsourcing will be higher than they would be without it, and,
2. Microsoft will want to block a Yahoo-Google partnership.

We believe the deal will have these benefits for Yahoo whether or not it is illegal--because even a swift injunction would take several months (more likely, several years), at which point the Microsoft-Yahoo negotiations will be ancient history.

WOULD A YAHOO-GOOGLE SEARCH DEAL BE ILLEGAL?

We spoke to an anti-trust attorney about the legality and practical implications of a Google-Yahoo search deal. (The attorney was NOT a disinterested party, so if others want to question or correct our interpretation, please do so).

Our understanding is this:

If Microsoft, the government, or another party can show that the Google-Yahoo deal represents an agreement between the companies in which Google is effectively paying Yahoo to shut down a competitive service, the deal would be declared illegal under anti-trust law. If, on the other hand, Yahoo can demonstrate that the deal is merely a buy-vs-build decision in which Yahoo is unilaterally choosing to implement Google's AdSense service, then outsourcing would NOT be illegal.

Our source says that an "agreement" in this case does not need to be an explicit contract: It merely needs to be a "meeting of the minds" in which the two largest players agree to do business with each other in order to enhance their businesses.

Google's market share in search, our source believes, exceeds the anti-trust share threshold (70%). The source also believes that the fact that the Google-Yahoo search test is obviously a response to the Microsoft bid, combined with Google's public reaction to the bid and reported offer to help Yahoo resist the bid, would provide plenty of fodder for attorneys to argue that the outsourcing deal represents an "agreement" between Google and Yahoo.

Yahoo and Google, meanwhile, would presumably argue that outsourcing is just a smart business move for Yahoo, one that many Yahoo analysts have been recommending for years. That the move comes in response to Microsoft's bid is irrelevant, the argument will probably go: It's still a unilateral buy versus build decision.

DOES THE LEGALITY OF THIS MOVE MATTER IN THE NEAR-TERM?

Even if a Yahoo-Google search partnership were patently illegal, which we don't believe it is (the arguments seem reasonable on both sides), we believe it would take several months to get a summary judgment and/or injunction. More likely, litigation surrounding the partnership will continue for years, long after any of this matters to the current Microsoft situation.

For practical purposes, Microsoft won't want to take the risk that the Google-Yahoo partnership passes muster with the regulators, so it will likely increase its bid as a way of avoiding this risk.

We therefore continue to believe that the search test is a smart move by Yahoo, one that should lead to a higher takeout price.

See Also: Brilliant Yahoo-Google Test Should Lead to Higher Takeout Price