Did Microsoft 'Massively Undervalue' Yahoo?

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Includes: MSFT, YHOO
by: Victor Cook

Early Sunday morning, February 10, 2008, Matthew Karnitschnig reported in his Wall Street Journal article that:

Yahoo Inc.'s board plans to reject Microsoft Corp.'s unsolicited $44.6 billion offer to acquire the Web giant, a person familiar with the situation says.

After a series of meetings over the past week, Yahoo's board determined that the $31 per share offer "massively undervalues" Yahoo, the person said.

The article goes on to say that "the company is unlikely to consider any offer below $40 per share …"

SOME BACKGROUND

This is my second post on the Microsoft-Yahoo! deal. The first, Microsoft-Yahoo Deal: A Question of S&M Synergy, published last week, investigated Microsoft's (NASDAQ:MSFT) financial dilemma. Compared with Google (NASDAQ:GOOG) I found that Microsoft was overspending on Selling & Marketing in accordance with Gerstner's Rule in High-Tech Industries: the cost per dollar [CPD] of revenues. I concluded that:

Like Eddie Foy, Jr. sang in the 1954 hit Broadway play The Pajama Game, 7.5¢ doesn't buy a hell of a lot ... neither does 11¢ till you multiple it by MSFT's nearly $58 billion 2007 revenues. That produces an eye-popping net competitive redundancy of $6.367 billion … all of which is associated with MSFT's Selling & Marketing expenses.

This post looks at the proposed deal from the perspective of the Yahoo! (NASDAQ:YHOO) board using a sharper measure of enterprise marketing performance from Chapter 6 "The Rule of Maximum Earnings" of my book Competing for Customers and Capital.

YAHOO! FUNDAMENTALS

This analysis compares Yahoo's actual to its optimal sales, expenses and earnings during the most recent four quarters. The actual values were taken from EDGAR Online I*Metrix reports. Optimal values were calculated from the financial accounting data. These theoretical values occur when a company optimizes expenses by earning exactly what it spent to produce its last dollar of revenue. The costs of producing revenues are described in my audio slide show "Enterprise Marketing Expenses" from Chapter 4 of my book.

There's a huge difference between enterprise Marketing, with a big M, and traditional marketing. In that audio slide show I define enterprise marketing expenses as …

… all the costs of the people and programs that influence how consumers, customers and investors think, act and feel about a company.

The following table reports Yahoo's share of revenue, sales revenue, cost of revenue, enterprise marketing expenses, and earnings in a strategic group with Microsoft and Google. Yahoo! had not yet filed its December 2007 financial statements so its data are for the quarter ending September 2007.

Yahoo's optimal share of group revenues was almost double its actual share: 16.5% compared with 8.4%. Optimal share would have translated into $13.4 billion in sales revenue compared with actual revenue of $6.8 billion.

Generating these additional sales would have required on the order of $2.7 billion in additional cost of revenue. In Yahoo's 2006 financial statement, the management discussion said:

Cost of revenues consists of traffic acquisition costs and other expenses associated with the production and usage of the Yahoo! Properties, including amortization of acquired intellectual property rights and developed technology.

Traffic Acquisition Costs ("TAC"). TAC consists of payments made to affiliates who have integrated our search and/or display advertising offerings into their websites and payments made to companies that direct consumer and business traffic to the Yahoo! Properties (page 39).

This management discussion also reported the cost of revenues in 2006 was $2.676 billion. And TAC were $1.866 billion or 69.7% of revenue costs. This explains why Yahoo's cost of revenue was more than twice those of Microsoft (20.0%). Unlike Microsoft, Yahoo! wholesales its solutions 70% of the time.

The values reported in this table assume the cost of revenue would continue to account for 41.3% of Yahoo's nearly two-fold increase in revenues during the time it took to achieve this optimal level. In addition, to do this the company would have increased enterprise marketing expenses from $3.1 to $6.7 billion or about 115%.

MASSIVELY UNDERVALUED?

Optimal revenues of $13.4 billion would point to a market cap of around $78 billion based on a value/revenue ratio of 5.81. With 1.39 billion shares outstanding this suggests a price in the mid $50 range. This strikes me as far enough above his offer of $31 a share to conclude that Steve Ballmer did indeed "massively undervalue" Yahoo!. What do you think?

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.