Why Weren't Markets More Excited by the Microsoft - Yahoo Deal?

Finally the much awaited search engine deal between Yahoo (YHOO) and Microsoft (MSFT) came through this week. It all started about two years ago when Microsoft gave an offer to acquire Yahoo at ~$47B valuation. With current market cap of Yahoo at ~$21B, that was certainly a good deal for Yahoo shareholders. There were lots of rumors around Microsoft buying Yahoo’s search part only last year as well, but nothing came out of those rumors. Now, Microsoft and Yahoo will actually partner on search engine technology and Yahoo will use Bing as the search engine behind its content and adware. Essentially, Yahoo will come out of search engine development. This may look like a loss for Yahoo on surface but for a company that is rebuilding and re-identifying itself; this may prove to be the medicine that Yahoo needed. There are two main aspects to this deal: strategic focus for Yahoo going forward and financial worth for yahoo search. Let’s look at them.

Strategically, nobody has a doubt that Yahoo did the right thing by going out of search engine space where its chances of winning were slim to none against Google (GOOG) and Microsoft. At this point in US search market, with Google at ~75% market share and Microsoft with another ~8% market share along with a desire to win more, that doesn't leave enough opportunity for any big third vendor. Also, since Yahoo will still keep its sales force, it can re-enter later if required or go with another search engine vendor after 10 years, provided it is still around then. Not only that, but Yahoo will also get to focus more on its core strengths and the market it is leader in, i.e. content provider. Yahoo email, finance and news are the types of areas where it is the best in the world and where it needs to focus more and generate more utility for its customers.

Financially, although it may not sound like the best deal for Yahoo as it didn’t get any upfront payments for getting out of the search engine space, Yahoo will get 88 cents on every dollar of revenue that Yahoo sites will generate for Microsoft's search engine. This is certainly a very nice margin and will result in a highly profitable ongoing revenue stream for Yahoo. Also, Yahoo will have full control over how much search traffic or essentially resulting revenue it can generate without any ongoing research and development costs.

However market reaction to this news was not clearly explainable. This should have been a win-win situation for both Yahoo and Microsoft. If anything, it should actually be a negative thing for Google. Looking at ~ $3.5B stock market loss for Yahoo, it certainly doesn’t look that way. Microsoft actually gained around 40 cents on the announcement date and this is approximately $3.5B gain for Microsoft. The deal is still not through anti-trust clearance but actually nothing was sold or bought in this deal and it is a deal of mostly mutual cooperation and understanding.

To me it looked like an over-reaction by the market without fully understanding the terms of the deal and Yahoo should finally recover from recent stock price losses. Not only that, it should gain some operational efficiencies from getting out of search engine development and focusing on its content customers better than it could now. And, absolutely certainly, this deal is not ~$3.5B value transfer from Yahoo to Microsoft. If anything, Yahoo should gain some value by now strategically focusing more on its core business of content delivery, where it is actually the market leader and being Microsoft's main partner for its search engine traffic generation, one of Microsoft's biggest challenges these days against Google's competition.

Disclosure: Long YHOO

Comments

[User 464152:]

I agree, Yahoo will be more profitable in the long run, if not sooner. The deal has to be explianed in more detail for shareholders to understand, everybody seemed to "panic" and sell Yahoo.. NOW IS THE TIME TO BUY IT!!!

Jul 31 11:12 AM

[jack dee:]

But dont forget it is Yahoo that itself in this spot, where getting out of search looks like a good thing.
the last time I invested in Yahoo I was lucky to get out when I did.
Plus the "boatload" of cash talk / headfake has really put me off this team.

Jul 31 12:46 PM

[wcorowitz:]

This seemed like a retail investor squeeze to take boatloads of money of people who were on margin.

Jul 31 07:26 PM

[Binghoo:]

One area that this article fails to acknowledge is that Yahoo's entire revenue stream is based on Advertising, whether Search or Display. While Yahoo's portal content is certainly core to this strategy, I fail to see how giving up on one primary area of monetization (through Search) is gaining Yahoo anything. Yahoo still had a considerable lead over Microsoft in search share, with roughly a total market share of about 18% in the US. Giving this to MSFT appears to be a total loss for YHOO, and its no wonder that the market has responded negatively, especially in the context of a previous $47 Billion offer for Yahoo by MSFT last year. Who's Yahoo'ing now?

Aug 05 01:13 PM