A Yahoo Takeover Trade as Google Partnership Crumbles

Amongst strong objections and threats of legal action from antitrust regulators and customers who believed a Google/Yahoo alliance would have too much power over on-line commerce, Google (GOOG) has scrapped its Internet advertising partnership with rival Yahoo (YHOO). The market has reacted by pushing Google's stock down yesterday, yet Yahoo has seen an 8%+ jump in its share price.

This is purely because the market and a number of analysts believe that Microsoft (MSFT) or another company will make another run at taking over some or all of Yahoo's on-line business. Microsoft (MSFT) had offered $33 per share in May for all of Yahoo, but that offer was rejected by management and the board. With Yahoo now trading at $14 in a depressed on-line and off-line economy, Microsoft can now get a second takeover shot at a much cheaper price. If it thought Yahoo was worth $33 a few months ago, surely it would see it as a bargain at its current price.

How to play this trade

Before discussing potential ways I plan to play this takeover (like my BUD/Inbev arbitrage trade), I must warn that this is a speculative play based on the potential for a takeover and not on fundamentals. If a takeover does not materialize, then it is likely the Yahoo share price will stay flat or fall lower given its eroding on-line market share. So do your own research before jumping in.

That being said, I think Microsoft is desperate to get Yahoo's search engine and advertising platform in order to effectively compete with Google. It also has the cash to buy Yahoo without having to rely on the tight credit markets. There is also the potential for other media companies like AOL/Time Warner (TWX) and News Corp (NWS)to make a play for Yahoo at current prices. Most importantly, frustrated Yahoo shareholders (starting with activist Carl Icahn) have lost confidence in Yahoo management over past deals and so a potential suitor should easily be able to get shareholder approval. Clearly there are a number of catalysts to suggest that Yahoo's days as an independent company are running out.

You can simply play this trade by buying Yahoo shares. For example at the current price of around $15, you would need to spend $1500 to buy 100 shares. If the takeover price is at $20, then you stand to make $500. Not bad. However consider the same play with options, which can provide more exposure and profits for the same cost, albeit with more risk.

Here's the options play. Jan $15 call option contracts are currently selling for about $2. Given each contract consists of 100 shares, for $1400 you can buy 7 contracts. This gives you exposure to 700 shares, compared to 100 shares under the straight stock purchase. Assuming the take over at $20 or more materializes before the call options expire in January, then you could stand to make between $5 and $7 per option contract. This is equivalent to a gain of $2100 to $3500. Much more than just buying the shares. However, the down side with options is much worse too. If the share price stays at $15 or less at option expiry (Jan 17th) you could lose your entire investment. If you had bought the shares, you would only have lost part of your investment.

There you have it. Risk for more reward, or safety for a lower return. The choice is yours, but this is a play worth considering.

Stock position: None.

Comments

[abcde_98:]

MSFT should offer $13 for Yahoo. Why?
1. overall market levels have come down, and any recovery will not be "V" shaped but perhaps "L" shaped

2. pricing in the Search world will probably come down as companies realize they are not getting enough end value (aka click-through all the way to actual sale)

3. Yahoo was counting on revenues from deal with GOOG to help build out additional features/R&D. But now, financial pressures will cause YHOO to slow down such product enhancements (or cause YHOO to take on any deal to accelerate product enhancements)

4. MSFT has the negotiating power/control now, as GOOG is out of the way.

5. Perhaps Jerry Yang's arrogance has abeyed in this economic climate.

6. MSFT may (and should, imo) wait things out to observe the effects of things returning to 'normal' at Yahoo without the GOOG revenue and ultimate effect on Yahoo's market share and revenues (note market share could go up, but ad revenue received per market share unit could decline!). The idea here is to better understand the likely future trends as the economy and operating environments have changed substantially.

2008 Nov 06 07:14 AM

[andyn:]

People are stupid buying YHOO on hope.
Anecdotally, I can tell you of many employees already jumping this sinking ship.

This company is circling the drain and MSFT can afford to wait it out, atleast till 1st quarter of 2009.

Icahn might try to push things but that's what they said when the stock was around $28 not too long ago.

My advice: Buying GOOG below $350 would be the best return for your money over the next year.

2008 Nov 06 09:21 AM

[Jack Walker:]

Andy,

With option implied volatility currently very high have you considered the volatility and time decay risk of a long call option position?

For example the current implied volatility index for the Yahoo calls is 108, while the normalized forecast is between 60-70, having been as high as 140 earlier in the month.

We think there is considerable volatility risk in Yahoo that will likely remain until a final deal is reached.

If you can agree to the downside risk in the event nothing is done, that the stock could go down to 10, then a long 100 share position has about 4 points of risk, or $400.

For $433 a trader could buy 2 long Jan 15 calls YHQAC at 2.165 each, with an implied volatility of 98.19 and assume the risk of a decline in implied volatility and a loss of time decay. If a deal is done the implied volatility will decline rapidly and may approach the forecast range of 60-70 or lower. If a deal is done later in the year or early next year there will also be a loss of time premium at an increasing rate as the expiration date nears.

One way to avoid these risks is by using a bull call spread. This is done by adding a second call position by selling the Jan 17 ½ call at 1.230 each. With this combination we are now long and short January call options and we have offset most of the volatility and time decay risks associated with the long only idea.

In this example we could buy 4 Jan 50/Jan 17 ½ bull call spreads at .935 each for a total of $374. Now our maximum loss has been fixed and defined. Even if there is no deal and the stock declines to something below 10 out risk with this position is still defined and fixed at $374. In addition, if there is a collapse in implied volatility when/if a deal is announced our loss in volatility will be offset leaving us with just the price gain. What we give up for this protection is a cap on the upside. The maximum value of our spread can only rise to 2.50, the difference between the strike prices. In this example it would be $1,000 or 167% of the debit cost. Depending upon when the deal is announced this could still be a very attractive annualized rate of return, but with a now defined and limited downside risk.

Just a thought for your consideration.

Jack

2008 Nov 06 02:00 PM

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2008 Nov 11 08:06 AM