Yahoo!/Microsoft Endgame Might Hinge on Q1 Results

Responding to an ultimatum from Microsoft Corp. (MSFT) giving it three weeks to agree to the software giant's takeover offer, Yahoo! Inc. (YHOO) on Monday reiterated that the $41 billion bid undervalues the company.

In a letter addressed to Microsoft CEO Steven Ballmer, the Internet company also said it does not oppose a deal with Microsoft, although a source representing Yahoo! emphasized that it has never refused to entertain an offer. "While technically we have not said before that we were not opposed to a deal, that's always been the position," the source said, who spoke on condition of anonymity. "We're making it more explicit because Microsoft has been misrepresenting our position that we haven't negotiated with them. The issue here is that their bid undervalues us and does not provide a basis for discussion."

In a letter delivered on April 5, Microsoft claims Yahoo! has not entered "substantive negotiations" on a deal. Mountain View, Calif.-based Yahoo! contends this assertion "mischaracterizes" the nature of discussions between the companies, which Yahoo! said includes integration and regulatory issues. Ballmer also could have taken steps to advance the talks, Yahoo! said.

Microsoft's three-week deadline to reach an agreement concludes just days after Yahoo! reports first-quarter earnings on April 22. A strong performance for the quarter would bolster Yahoo!'s case that Microsoft's $31 per share offer undervalue the company, while weak results would put even more pressure on Yahoo! executives to sell.

"What I think Microsoft is doing is ratcheting up the pressure on Yahoo! on the assumption that Yahoo! is going to come in with a weak quarter," said Jeffrey Lindsay, an analyst with Sanford C. Bernstein & Co. LLC. "Microsoft is probably betting that because they have a good handle on the online advertising themselves."

In its letter Yahoo! reaffirmed that it remains on track to meet previous financial guidance for the first quarter and full year. The company expects first-quarter revenues of $1.28 billion to $1.38 billion, or 8.2% to 16.6% higher than the $1.18 billion reported in the year-ago period. Lindsay said anything less than a double-digit increase would constitute a poor quarter for Yahoo!.

Lindsay also said that if Yahoo!'s results fail to impress, the best it can hope for in a deal with Microsoft would be the original $31 a share cash and stock bid. The offer currently is valued at $29.56 due to a decline in Microsoft's share price since it tabled the offer on Feb. 1.

Jefferies & Co. (JEF) analyst Youssef Squali expects Microsoft's move to force Yahoo!'s hand to work because the target has few other alternatives. In a research note, Squali predicted that Yahoo! shareholders will conclude that Microsoft's bid is a better bet than Yahoo!'s financial forecast. But if Yahoo!'s board shows a willingness to negotiate, avoiding a prolonged proxy fight with the Redmond, Wash., software maker and avoiding an exodus of Yahoo! employees, the Internet company might extract a sweetened bid, he added.

Merrill Lynch & Co. (MER) analyst Justin Post said a deal between the companies remains likely, but not at a higher price. Yahoo!'s "inability to find a credible alternative," along with weakness in Microsoft's stock price since the deal was announced, "make a substantial increase in the offer price much less likely," he said in a research note.

Eric Jackson, who last year led a small group of Yahoo! shareholders in pressing for the resignation of CEO Terry Semel, said he expects a negotiated deal between the two companies to be signed before the end of the three-week deadline and that Microsoft will bump up its bid slightly to avoid the costs and distractions of a proxy fight. "I don't think Yahoo! has handled the process very well--they should have engaged Microsoft more than it appears they have," he said. "It's clear they don't have options, so they're really in a tough spot. Playing hard-to-get makes me a little nervous as a shareholder." -- David Shabelman