The Ball Is Now In Microsoft's Court

The market is always right, goes the adage. In this case, then let’s consider what the market is saying:

Unlike our friends over at Alley Insider who took Microsoft's (MSFT) offer of paying $31 half in cash and half in stock literally, the market is realizing that the baseline for talks in any deal for Yahoo! (YHOO) involves an initial lobby of $44.6B for the company, or $31/share. The stakes have changed a bit, insofar that MSFT was willing to pay $43 back in the day (somewhat irrelevant) and $35/share as recently as January 28th or so, before Yahoo!’s stock tanked after announcing Q4 2007 results.

More importantly and not so surprisingly, as widely held securities, there is a considerable overlap in terms of shareholders who own both YHOO and MSFT. While the uncertainty over this deal is hurting MSFT in the short-term, it is helping YHOO. Long-term, all investors understand that acquiring YHOO would give MSFT as strong of a business in online advertising as it already commands in operating systems and productivity suites.

As well, the fear of YHOO executives fleeing is obviously not seen as a risk. In fact, while few dare say it, the market is clearly suggesting that YHOO’s problem has been execution, and thus its leadership. As the deal edges closer and closer to reality, the market is suggesting that it has more confidence in MSFT’s management to create value with YHOO’s assets that it has had over the past 2 years in YHOO’s people’s ability to create value.

Yesterday, after YHOO rejected MSFT’s initial offer of $31, the market sent YHOO up $0.80 to over $30/share and sent MSFT down $0.35 to $28.20.

Firstly, let’s hope once and for all this kills the argument that YHOO’s offer now sits at below $31/share because of what MSFT’s share price sits at today. That is the problem with analysts taking things literally. As an executive sitting across from Jerry Yang, trust me, the mere suggestion that your offer is now lesser than $31/share because of the market would be a deal killer. If you are MSFT and are this close to owning the best positioned new media company - at a time when online ads in the US in one quarter crossed $7.3B - you don’t even go there.

So what else is the market saying?

• MSFT will acquire YHOO.
• MSFT will probably not go hostile - yet - but it won’t hand over $40/share that easily.
• MSFT will make one more attempt at making this look friendly, by offering $35.91 a share, or roughly $50B for YHOO (as we have been saying all along). This time, the wording will be much stronger and more than insinuate that YHOO’s larger shareholders have already shown a desire to accept MSFT’s offer at $31/share ($44.6B) and MSFT expects any remaining shareholders to frolic at a $50B valuation.
• YHOO will accept the $50B and Jerry Yang will ride into the sunset, with the legend being that he was the CEO who doubled shareholders’ in the 100 days since he took office.

That’s what I think will happen. Will it? Maybe. Microsoft is being coy, repeating “all options are on the table”.

Bear in mind that this storyline has had many surprises starting off with MSFT launching an unsolicited bid that shocked and awed YHOO’s brass. The unthinkable would be for MSFT to unleash a $40/share bid for YHOO. By doing so, there would not be a single shareholder that would hesitate to accept this. This would also make accepting the deal very swiftly because YHOO has wisely or unwisely (time will tell) whispered through to the media that it won’t refuse a deal at that range.

I’ve maintained that the uncertainty over MSFT’s deal is as much of a negative as the premium being paid for YHOO, after all, so long as YHOO and MSFT are dancing, it is not crazy for MSFT shareholders to worry that a white knight will emerge and MSFT will have to pay something obscene like $60B to win over YHOO.

After all, when Doubleclick was first rumored to be in the running, the price tag was $1B. When it was settled, it was $3.1B. aQuantive rose to an even more jaw-dropping $6B price tag.

With Q4 2007 online ads coming in at $7.3B and YHOO so well positioned for display and video advertising, the desperation will only escalate… the sooner MSFT can wrap this up the better.

Microsoft's Drive In Buying Yahoo!

MSFT responds, but the question is: who’s in control of the ball now? I’d say still MSFT.

Logic flows so easily:

• Online advertising in the US alone stood at $25.3B in 2007, with Q4 generating $7.3B
• Quoting Yahoo! CEO Jerry Yang, online advertising in the world is a $40B business, growing to $75B within 2 years, in 2010. Connecting these dots, the US garners $25.3B / $40B = 63.25% of that today, but should shrink over time.
• Today, if MSFT/YHOO merged, they would command 17% net U.S. advertising market share according to IDC.

“If a merger between Microsoft’s new media business and Yahoo! would come to pass, the combined entity would have a net U.S. advertising market share of about 17% based on our 4Q07 data,” says Karsten Weide, program director for IDC’s Digital Marketplace: Media and Entertainment service. “It would not quite bring Microsoft-Yahoo! to where Google is in online advertising in the U. S., but it would give them a much better fighting chance than if they went it alone.”

• Using that very basic argument, if online advertising will become a $80B by 2010, and MSFT/YHOO had a modest 15% of the combined pie, MSFT’s annual revenues from online advertising in the world would be $12B.

Today, MSFT makes a pittance off its MSN.com/Live.com unit. But by comparison, other units make much more:

• Windows desktop client $13 Billion
• Windows Server and development tools $11.5 Billion
• Office - Information Worker - $11.8 Billion
• Home Entertainment Xbox, Zune - $4.3 Billion
• MSN Live Search - $2.3 Billion
• Business Solutions (CRM, ERP) - $900M
• Mobile Embedded Devices (phones) - $400M

Admittedly, these are 2006 figures. 2007 revenue was $51B and 2008 is forecast to come in at $60B. But the point, when you get that big, you need home runs and grand slams, let alone doubles and triples, to keep investors happy.

From 2000 to 2006, MSFT’s share price was in the toilet (hey, just being honest). Bill Gates and Steve Ballmer maintained stuck to their game plan and did not really care about the short term mindset of investors. Eventually, the stock price nudged up from $20 to the high 30’s. Sure, it’s not a Google-esque ascent, but with 9.3B shares outstanding (compared to YHOO’s 1.3B and GOOG’s 312M), it adds plenty of value to the market cap.

The point is, today Microsoft responded to Yahoo!’s “thanks but no thanks” with a “oh really”. Make no mistake about it: MSFT’s go-at-it-alone strategy online are over. aQuantive was the appetizer, Yahoo! is the main meal… once that is down, they’ll wash it down with a tall glass of AOL.

Disclosure: Long YHOO

Comments

[Tom B]

Where's MSFT big shareholders? Surely, they should be asking for Ballmer's head on top of a pointed stick by now? This deal has a 90 plus % chance of bankrupting Mr. Softy when it fails. This is a GOOD thing, obviously, but I'd rather not see them take Yahoo down with them.

[gokou3]

Thomas, I'd really love to see how you determine the 90% figure.. btw, even if the deal closes at $50B it's only about 2 years of MSFT EBIT.

[blah-blah]

It won't bankrupt them, they make way too much money - it's just very wasteful - YHOO is so not worth it