Where To Now for Yahoo?

Unless you have been living under a rock somewhere, you have probably heard that Microsoft pulled out of the negotiations to acquire Yahoo! this past weekend.

All along, Steve Ballmer, CEO of Microsoft, had said that he had a maximum price that he would pay for Yahoo! Apparently this price was $33 per share.

When Microsoft first made an overture to buy Yahoo!, Yahoo! was trading at $19.18 per share. The company was flailing around with no apparent direction, seemingly losing market share to Google on a monthly basis. Yahoo! had replaced its CEO about nine months back, bringing on Jerry Yang to try and steer his company out of the doldrums it had found itself in.

Microsoft's deal made sense for both companies. By combining Microsoft and Yahoo's search engine numbers, you would finally had a real and substantial competitor to Google. Separately, both companies are losing ground, but together, it seemed as though a combined entity might have what it takes to compete with Google.

The problem was that Yahoo's management was demanding $37 per share from Microsoft, almost a full 100% higher than Yahoo's closing price before Microsoft made its unsolicited bid. Microsoft felt that this was too high of a price to pay and walked away. They were prepared to offer $33 per share as recently as this weekend, but Yang and David Filo flew to Seattle to inform Microsoft management that they would not sell for less than $37 per share. Upon hearing this news, Microsoft quickly pulled out of the negotiations.

So the question is: what happens now?

After the news hit the market that Microsoft had pulled out of the negotiations, Yahoo opened down about $5 1/2 dollars, and ended up closing on Monday at $24.37. Many were expecting that Yahoo would drop all the way back to its pre-bid price of approximately $19 per share, but this didn't happen. Clearly many think that the talks are truly not over.

Many Yahoo shareholders wanted the deal to go through at $33 per share, and have stated that they will be filing lawsuits against Yahoo. There will be an annual shareholders meeting for Yahoo sometime before July, and it will be interesting to see what transpires in this meeting. There are many shareholders that are clearly angry with the management of Yahoo.

There are three things that could happen at this point. They are:

1. Business as usual. Yahoo! decides to go it alone and continue to operate as it had before the unsolicited bid. The problem with this is that the company's shareholders are fractured now - business as usual does not seem to be a valid option at this point. The company does not seem to have a winning strategy for gaining ground against Google, and I'm not sure that Yang could stave off angry shareholders for long enough to keep his job. Sure, this was the company that he founded, but that doesn't mean that he has a guaranteed job as the CEO of the company. If Yahoo continues to struggle, Yang will have an almost impossible task of convincing shareholders that his long-term vision for the company will work. What happens if the stock drifts back into the teens? Will Yang still have the support of the majority of shareholders then? Doubtful. I think that this is the least likely of the three scenarios.

2. A different business combination. Many have talked about a proposed deal with Google, that would see Yahoo outsource its paid advertising business to Google. There are reasons why this makes sense - the two have worked together before, and Google has a much superior advertising back-end and a much richer client list. This would be a shot in the arm to Yahoo's revenues, and would clearly make sense for both sides.

There are reasons why this deal wouldn't work. First off, Yahoo would basically be admitting that its paid advertising backend was inferior to Google's. Secondly, this deal would likely never pass an antitrust review - the two combined search entities would control around 80% of the total search market. This would be a tough sell to antitrust regulators. A Google / Yahoo deal would be nearly impossible to push through.

Other options? Tie-ups with Myspace or AOL are possible, but would certainly lack the pop of a Google partnership. Mark Mahaney, Internet Analyst at Citigroup, estimates that an outsourcing of their search technology to Google would yield over one billion dollars in incremental cash flow to Yahoo, which would add $6 of value to the stock. Again, this is a very valid option to a MSFT / YHOO merger, but it seems very unlikely given the antitrust issues.

3. Microsoft / Yahoo return to the table and do a deal. This likely will not happen over the near-term. This will be a gradual occurrence over the next year or so. Here are the things that will likely have to happen for this deal to fall into place again:

a. Extreme shareholder pressure on Jerry Yang, resulting in him being replaced as CEO or relenting and listening to his shareholders.

b. Lack of significant progress in terms of Yahoo building out its business and making a dent into Google's marketshare

c. continued willingness on the side of Microsoft to make this deal happen

Number three is not an issue. I believe that Microsoft desperately wants to take on Google, and firmly believes that acquiring Yahoo! is the only way to do it.

Number two is a bit of a question mark. I can't see Yahoo! making significant strides over the next year or so - I think it is more likely that the company will continue to move sideways while Google increases its market share.

Number one is the trickiest scenario. How many people are actually willing to put pressure on Jerry Yang? The problem is that many people still believe that Microsoft is going to return to the bargaining table at some point. If they truly believed that the deal was lost, then likely they would be calling for Yang's head. But with the market still factoring in a "deal premium", many potentially angry shareholders are going to simply sit on the sidelines, likely figuring in their head's that a deal will eventually get done. The only thing that will truly turn Yahoo shareholders into an angry mob is if this deal has still not been consummated in a year or more, and Yahoo's business seems to still be stagnant. Then the pitchforks will come out. Until then though, I only see moderate pressure on Yang.

I must say that I was surprised that Yahoo's management was so stubborn as to their final asking price. When Microsoft offered $33 per share, I was sure that a deal was going to get done. You can't really blame Microsoft for walking away - I believe that they offered a fair price, and Yahoo didn't show much willingness to negotiate. There is only so much that Microsoft can pay for Yahoo so that a deal will still make sense.

There are two scenarios that, in my opinion, WILL NOT happen.

1. Hostile takeover of Yahoo by Microsoft. Yang has already indicated that he will make a hostile takeover as "unattractive" as possible for Microsoft. Microsoft only wants to buy Yahoo if they have the full support of Yahoo management. A hostile takeover would end up being a huge integration headache for Microsoft, and they definitely don't want that.

2. Someone else buying Yahoo. Not going to happen. Google? No way, would never pass an antitrust review. News Corp? Nope, they pulled out of acquisition talks long ago. Who else is left that makes sense? Nobody.

I think that at the end of the day, this deal will still happen. It will likely be months from now, maybe even a year, but Microsoft and Yahoo will end up tying the knot and going forward as a combined entity. At the end of the day, these two companies need each other to take on Google. I believe that a deal will eventually get done in the $32 - $34 range.

Google, which had been vehemently opposed to this deal from Day One, was especially glad to see Microsoft walk away from the bargaining table. They are likely to do nothing, as their hands are tied. They can't buy Yahoo themselves, and they will find it very hard to execute any kind of a business partnership with Yahoo for the same reason - antitrust concerns.

Microsoft will likely continue to make their case for a Yahoo / Microsoft merger through the press, hoping to convince Yahoo shareholders that their deal makes the most sense for the company. If Yahoo's share price falls off over the next few months, they won't have too much trouble convincing on-the-fence YHOO shareholders.

At the end of the day, the final chapter in this story has not been written yet - far from it.

Sources:

Techcrunch - Citi's Mahaney Says Microsoft / Yahoo Merger Still 15% Likely

Businessweek - Will Yahoo's Stock Plunge Send Yang Crawling Back to Microsoft?

Filed under: Internet Companies