M&A Implications of Microsoft's Yahoo Bid

by: Markos Kaminis

Microsoft's (Nasdaq: MSFT) hostile bid for Yahoo! (Nasdaq: YHOO), announced Friday morning, signals future M&A activity. This holds positive implications for many beaten down firms in the technology, financial and other sectors, and should be a positive earnings driver for the investment banks as well.

Last week, we recommended investors consider the recently beaten down Yahoo!, which we also wrote about before its downward price driving earnings report. Within our prescient pre-earnings article, we said "We would advise long-term investors to take a close look at YHOO on any bad news driven share decline." Then after the report, we told you again you should consider buying YHOO. Friday, the shares received an acquisition offer that conveys a 62% price premium from the cash rich giant genius Microsoft. In other words, we gave you a day-by-day play-by-play forecast.

Implications of the Deal

As much as naive media and early speculators doubt it, we are telling you Yahoo! will not go down easy. At least, it should not if Jerry Yang understands the value of his company. We expect this coveted asset to attract competitive bidders, and we see those potentially coming from companies like Google (Nasdaq: GOOG), General Electric (NYSE: GE), News Corp. (Nasdaq: NWS) and possibly others (although regulators probably wouldn't approve a Google counter bid). For the insightful, this asset has value beyond MSFT's offer price. YHOO is the most trafficked website on the Internet, and for good reason. It holds some of the most useful real estate on the Internet, and I for one can vouch for the widespread usage of its Finance page among both financial professionals and individual investors. For more than a year now, we've been recommending purchase of both Yahoo and Microsoft, and continue to do so now.

What's Next

Yahoo! must of course initially respond that it will consider the offer. At the same time, hungry Internet and media firms and moguls are likely frantically preparing valuation analyses and probably a counter offer or two. We believe YHOO will be acquired on the basis of its assets and not its more recent earnings history. It's true that if you price the stock based on its forward earnings estimates, and use a comparable metric like GOOG's P/E, YHOO could have dropped into the low teens. However, we believe the market understands the value of Internet real estate, and will look at earnings potential, not near-term forecasts. Also, there are specific synergies to be gained by many firms that have been seeking to better leverage the net. There are also competitive risks to allowing another firm to own Yahoo.

We agree that YHOO has to accept a deal, including MSFT's if no counter comes to play. However, certain assets attract values that might not make logical sense by today's standards. We think this is that kind of asset, the kind that is valued on potential that far exceeds expectations for it in '08.

Implications Beyond YHOO

The merger and acquisition market is reborn. Funny, it barely died, but with coveted assets littered across the marketplace at bargain prices, and with the Fed lowering the cost of capital, opportunity suddenly abounds.

In the financial sector, remember that long running trend of consolidation within the banking industry, savvy banks now have the opportunity to buy up peers on the cheap. And guess what, you don't necessarily have to buy poisoned assets. The mayhem has taken down good banks along with the bad. But, those assets are finding recognition now. Just look at Hudson City Bancorp (Nasdaq: HCBK). In July, it was surprisingly much cheaper than it was in early January. Through a series of earnings reports, it conveyed its message as a different kind of bank than the subprime debacle had exposed. Still, there remain other financial sector bargains out there that have been unjustly penalized along with the Countrywide Financials (NYSE: CFC) of the world.

Investment banks like Goldman Sachs (NYSE: GS), Citigroup (NYSE: C), JP Morgan (NYSE: JPM), Morgan Stanley (NYSE: MS), Merrill Lynch (NYSE: MER), Credit Suisse (NYSE: CS) and others should generally benefit from an M&A rebirth, and billions of dollars of sovereign wealth that is actively seeking investment. Thank the Fed my friends.

Coveted Assets

What other coveted assets might exist in the marketplace, on the scale of Yahoo!? We posit there are a few more in the technology space that deserve consideration. Cisco Systems (Nasdaq: CSCO) and Intel (Nasdaq: INTC) have eased off their earnings potential multiples due to nascent economic weakness. Notice, we said earnings potential multiples, not earnings multiples. An asset is coveted for its earnings potential when assets go on a general sale, not on their current earnings. The two companies we just presented are leaders in their respective industries that have gotten cheaper lately. We especially like Cisco because of the broadening of Internet usage that has and should continue with the growth of video on the web.