Monday, May 05, 2008

Portfolio: Yahboooooo!

by Kevin Kelleher May 5 2008

Yahoo shareholders are not happy with the failed deal, underscoring that the company has few attractive options. But neither does Microsoft.

No Microhoo? Shareholders of Yahoo are clearly unhappy.

Shares of Yahoo fell as much as 19 percent in early trading today, to a little more than $23, although still above the level they were at before Microsoft made its $31-per-share offer on January 31."

The only question is whether this is really the bottom," says Eric Savitz on the Tech Trader Daily blog.

In lowering his rating on Yahoo shares to "sell," Mark Mahaney, an analyst at Citigroup, wonders why a deal was not forged. Noting that a price of $35-per-share (the midpoint between $33 and $37) amounted to only $3 billion, or 7 percent of the initial bid, "it's surprising that a 7 percent solution couldn't be found."

Henry Blodget on Silicon Alley Insider, says, "Despite Yahoo's suggestion to the contrary, we have yet to hear from a single Yahoo shareholder who publicly supports Yahoo's board's decision to hold fast at $37."Yahoo shares have not been at $37 since January 2006.

Kara Swisher on All Things Digital says that some top Yahoo executives are also dismayed that merger discussions collapsed over the weekend. In particular, the description in the New York Times that some Yahoo executives "were high-fiving each other for defeating Microsoft's bid," caused consternation."That was very telling, if it was true," one executive told Swisher. "It shows a complete lack of connection to the balance of the company."

The proposed merger had drawn its share of critics, who charged that integration and cultural issues would outweigh potential benefits from combining the two. But now that the deal won't happen, the outlook for both companies is as dire as it was three months ago, before the merger was proposed.

"Without Yahoo, Microsoft has no compelling means of becoming the No. 2 player in online advertising," said Sandeep Aggarwal, an analyst at Collins Stewart. "And without Microsoft, Yahoo has no magic wand to lift its stock back above the mid-20s.

"This much is certain: Yahoo's stock will take a hard tumble this week as arbitrageurs and others counting on a Microsoft buyout relinquish their shares at a steep discount to last week's levels.

"The word crater comes to mind," said Rob Enderle, president of tech advisory firm Enderle Group.Yahoo had already been facing at least one shareholder lawsuit after it refused to accept Microsoft's proposal.

It's likely to face more lawsuits, as well as other pressure from activist investors.

One of them, Eric Jackson of Ironfire Capital, is urging Yahoo shareholders to vote against all of the company's board members when they are up for election later this year. Jackson says that he's started hearing from more Yahoo shareholders since Microsoft dropped its bid.

"They're surprised and extremely frustrated," Jackson said. "They were certain a friendly deal was going to happen."

To appease those shareholders, Yahoo needs to improve its financial performance dramatically. The company unveiled a plan in March showing how a new search technology and an open-source approach to software development would help boost its revenue and cash flow. But analysts and investors have signaled that they aren't impressed.

The best short-term hope for Yahoo to increase its cash flow is to ally itself with the very company that has put it in dire straits—Google. Yahoo and Google may enter into a limited ad partnership that will run Google ads on keywords where Yahoo makes less money.

That could help bring Yahoo new revenue in coming quarters. But it could also drive away advertisers who are on Yahoo precisely because its search engine, which is significantly less popular than Google's, charges less for keywords.

Shares of Microsoft are up nearly 3 percent today, and its stock will likely fare much better in the near term. But longer-term threats to its profit growth remain. Vista software sales are slowing; Apple is gaining market share in desktops and laptops; and Google is pushing free versions of office-productivity software, threatening Microsoft Office's cash cow.Microsoft has invested heavily in online advertising, only to see its share of the search market—like Yahoo's—decline steadily. The division that includes Microsoft's online-ad business has posted steadily growing operating losses for nine straight quarters. In aggregate, it's racked up $1.7 billion in losses since early 2006.Such pressures drove Microsoft to pursue Yahoo. The $31-a-share bid that Microsoft made in February offered a 62 percent premium over Yahoo's stock price at the time. But it also discounted 32 percent off the $41-a-share bid that Microsoft had previously made for Yahoo, a bid that was also rebuffed by Yahoo's board.

Last week, Microsoft raised its offer to $33 a share, but Yahoo's board held out for $37."I think Yahoo misread Microsoft," said Enderle. "People usually bid low and then raise their bids. But Microsoft didn't want talks to drag on, so its strategy was to get the deal done as quickly as possible." Yahoo, however, sensed that protracted talks could strengthen its hand, and so it held firm to a higher bid. "Yahoo thought Microsoft was lowballing it," Enderle said, "and they missed the boat."

So, like Yahoo, Microsoft must now scramble. Ballmer has outlined other possible acquisitions it could make if the Yahoo deal fell through: Facebook, Time Warner's AOL, and News Corp.'s MySpace. Facebook is also determined to remain independent, while AOL has talked with Yahoo about a deal. That leaves MySpace as the easiest partner for Microsoft.Or Microsoft could simply bide its time and come back to Yahoo after its shareholders start screaming. In doing so, it would follow Larry Ellison's playbook in Oracle's acquisition of BEA Systems.

Oracle walked away from BEA after its bid was rejected, then talked a lot about how hard it pushed for its bid. Once BEA investors complained, Oracle came back with an additional $1.8 billion and quickly closed a deal."Microsoft can come back again," said Aggarwal, "especially if Yahoo doesn't do very well on its own."

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