Microsoft in Perfect Position to Undercut Previous Yahoo Offer

Let me speculate. Microsoft's (MSFT) failure to acquire Yahoo (YHOO) put it in the perfect position to come back at a much lower price.

On a cash flow basis, assuming MSN were profitable equal to the rest of Microsoft's properties (i.e. Office and Windows), it would be valued at roughly $10B to $15B for owning 10% of the search market. That would make Yahoo worth $15B-$22.5B for owning almost 15% of search. Adding a premium that makes sense, lets say it's worth $30B. By my math, at 1.4B shares, that's a ripe offer of $21.42/share, or a rich 38 multiple for a business with relatively meager 10-20% growth rates!

Considering the company only generates cash flow of around $6B for this upcoming year, even a Google-like profit margin of 37% ($7.8B profit on $20B revenues for FY09) provided by market dominance would provide at best $2.2B/year earnings in the most optimistic of circumstances. At nearly $47B for the final offer to buy Yahoo, this means it would take 21 years for the Yahoo investment to pay for itself on a earnings yield basis.

Of course Ballmer's offer, assuming he actually ever wanted to finalize a purchase of Yahoo, pays such a high premium because he is betting on paradigm shift, thinking the sum of Yahoo and MSN will allow Microsoft to become the next Google (GOOG), owning our online lives.

Where in the history of modern business has such a successful acquisition ever occurred to beat a monopoly with these market share numbers (25% total)? Even if MSN+Yahoo immediately became the next Google, $47B right now would buy Google's earnings for 6 years. Why take such large risks for such normal returns? It simply is foolish at best. The intermediate risks are too large.

When in a position to grow organically, as Microsoft is in, why not do it? If creativity lacks, find it.

Unless Carl Icahn and John Paulson have already secretly vetted a deal with Ballmer with a guaranteed sale of shares at a higher price, both they and any Yahoo longs are in for a surprise devaluation if they effectively gain control of the board from Yang and partners. Microsoft has no incentive to come back at these prices. $21-25 is my simplified final Yahoo buyout price target. And it'll take shares coming to $15-$20 to get Microsoft to come back to the table.

I'd also venture to say that Ballmer making 'behind the scenes deals' with the likes of these hedge fund 'arbitreurs' would be foolish at best. To repurchase Yahoo at the same already inflated offer price he had the opportunity to walk away from would call his credibility, management, and bargaining prowess into even more serious question. Without Yahoo accepting this already great deal, Ballmer had the opportunity of a lifetime to rethink and revalue this deal. He would be foolish to pay more than $21-25.

I may be wrong, and these billionaires may have locked into a riskless trade to sell their shares to Ballmer and Co. no matter what. But what if not? Consider big money's track record of late: Bank of America (BAC) with Countrywide (CFC), recently outspoken Ken Griffin of Citadel buying some $2B of E-Trade (ETFC) subprime debt for 27c on the dollar (now trading at 8c), Joseph Lewis on Bear Stearns (BSC), and Dubai on Citigroup (C). The list goes on. Most often, it is nothing but high stakes roulette, no matter how big the bets are. Big bets alone guarantee nothing, nor do they dictate fair value in the long run.

Unless Ballmer is using these hedge fund players as chess pieces, this board maneuvering and shareholder 'activism' spells nothing but gigantic risk for Yahoo shareholders going forward. A perfect sell candidate. And yet, a decent buy at $11.50-$17.00 (20-30% growth for 57c of earnings) when everyone has forgotten about the possibility of a deal.

Disclosure: Author has a short position in YHOO.

Comments

[buzzly]

"..these billionaires may have locked into a riskless trade to sell their shares to Ballmer and Co. no matter what."

Icahn only purchased 9.9 million shares (say $250m total at $25/sh). He purchased 49 m share call option and pocketed the premium by selling 49m share PUT @ $19.5, expirating on Y2010.
His may already have paper profits of $100M on his 49M sh Call due to the est. $2/sh gain since last Monday. ( This is reported in WSJ.)

Icahn has his a$s covered. He is an old pro. I don't think you should worry for him.

[mkreisel]

Why does MSFT have to buy YHOO?

[James Z]

You completely mis-calculated everything. Yahoo has more than just search, let alone all those great investments in Alibaba, Yahoo Japan etc.

Stop publishing stupid article like this one, period.

[pithant]

Concur w/James Z -- If you're going to publish either be informed or honest. YHOO has cash and investments worth some $20B. All your calculations are just pencil whipping without starting there. Then look at who they are. Still the biggest. Excepting GOOG, they are the gold standard of internet companies. Mr Softy is nowhere and sinking. They need YHOO more than the reverse. It's just another version of them bullying their way to dominance and it ain't pretty. 40 is the number they should pay, like they offered before they went hostile.

[Michael B.Krause]

$20B?

Take a look at the latest 10-Q. $10.5B total stockholder equity, 2.2B of that being Alibaba.

www.sec.gov/Archives/e...

My estimate of a $30B offer value on Yahoo is nearly a $10B premium on the cash flow valuation estimate, perfectly making up for these 'assets' you mention. Their interest in Alibaba is worth $2.2B according to their own 10-q.

[Tom S]

I concur with the above. I found a few things I disagree with in this article:
1. I do not follow any of your valuation calculations. You say due to MSN "owning" 10% of the search market, this values MSN at $10-15B? Is this saying that the search market is $100-150B? That practically all of MSN's value is derived from search? (And the same math applied to Yahoo's value?). Regardless of how you got there, I'll give you a value of $21.42/share because that is near where it was at before the offer.
2. I think instead of meaning $6B in Cash Flow, you were referring to $6B in Estimated Revenue? And Yahoo's and Google's margins are different and in this case not comparable. It is pie-in-the-sky to think that Yahoo's estimated Net Profit of $798M will come close to $2.2B. That is 176% higher than expected. And this is why Yahoo has a forward P/E of 48 at the moment and not 21.
3. Based on Google's past growth, it will make $47B in less than 6 years... likely more around 4 years with the forecasts for overall search advertising and the other lines of business it is getting into. This is why it is not foolish for the two to merge--it is riskier not to as Google gobbles up the advertising spend.
4. What incentive would Microsoft have to "come back to the table" when the shares hit 15-20. I think you would mean *Yahoo* will come back based on it being the one to hold out for $37. Microsoft is already "willing" to buy Yahoo at $33 or less...
5. Microsoft's offer to buy at $31 (above your $21-25 target) was generous, not foolish. Microsoft wants to merge Yahoo with good will and retain top talent.

and Buzzly--can you provide a link to the WSJ source? I'm interested in reading more. I have been watching the Calls and Puts and have not seen this volume/trading you are referring to.

[not_yet_bill_gates]

Not sure I understand your comment "Even if MSN+Yahoo immediately became the next Google, $47B right now would buy Google's earnings for 6 years. Why take such large risks for such normal returns?"

You consider that a "normal" return. If you can get cash back in 6 years on a company buy-out, thats absolutely phenomenal. You might not have considered the fact that, the cash flow after 6th year onwards also stays with you only as a buyer and that too for ever. And that is all gravy since you have recovered your investment in 6 years.

[Michael B.Krause]

You are definitely right that 16% earnings yield is not a normal return. You caught my error.

I was a bit sloppy there - I made a causative assumption saying that since their real returns are much weaker (than even 6% earnings yield on such a high multiple that MSFT offered), that the likely result of such a collaboration would at best create normal (somewhere between the 58 multiple MSFT is offering and the best-case multiple of 6) returns for enormously high risk.

[Michael B.Krause]

Tom S:

1) My calculations are based on the assumptions that search market share for MSN (and others: Yahoo, Google, etc) are fairly in line with their revenues. I am making (what some may consider disagreeable) a leap saying that search shares are consistent enough to get a handle on valuation. Is 100% of search worth $150B total? Maybe not search alone: but search, display and everything else that comes with it does come to that. MSN is worth more than search, but so are Yahoo and Google. So for blunt measurements (which are practical for such high multiple stocks), I think its appropriate.

Add up Google, MSN, and Yahoo market caps and you get somewhere close, plus or minus normal volatility (recall GOOG was worth 25% less just a few weeks ago because analysts incorrectly pinned Google's growth curve).

2. I meant revenue when referring to cash flow, not Cash flow on operations.

3. I agree it may not be foolish to merge, but at such a high multiple, all benefits from the merger would be likely forgone with such an overpriced initial transaction. High risk, minimal reward.

Lastly: $47B isn't a merger. Thats a money giveaway.

[buzzly]

It is slow to come out. But here it is link for Ichan's Call/Put options on YHOO


blogs.wsj.com/deals/20...

[Leonard TheMonkey]

Your calculations may not be so relevant but your position on the stock is, even if I don't agree with your reasoning.

The upside in YHOO is capped at $33 and MSFT would be fools to pay that now with the position they are in. Did you see how the board reacted to MSFT's dropped bid? It wasn't just them either the employees were the same way. The cultures of these two companies won't mix. Just ask some of the Yahoos.

Icahn and the rest of them are making a killing and a lot of publicity for themselves while they get even richer as once they are finished pumping they dump their shares into the hype they created.

The risk/reward is very in favor of shorting the shares at the current price near $28. I see 3 up and 8 down.

In full disclosure I have started a short position in YHOO and will be adding to it over $28 if it makes it there.

[User 177483]

I think the SEC should look into articles that are written in a negative manner relating to a stock that the writer is shorting. I have stock in both Msft & Yhoo which I have owned since 1997. Unlike you & many of your posters I own my shares out right. I think the merger is a good thing for both companies, however,I don't think Mr. Icahn is only serving his own well being & he doesn't belong in the middle of Msft & Yhoo

[bill d]

As long as the author divulges I don't see the problem. Even he doesn't it may be sort of unethical but I guess it depends on how much you think their writings influence readers. But here as you read the comments you get both sides of the story (at least). If there were no commnets possible I would agree with you. There are way more significant things the SEC could be looking into than this.
(I have 30 JAN 09 calls on both).