Microsoft/Yahoo! Merger Would Benefit Both Companies

Includes: GOOG, MSFT, YHOO
by: Vivek Gupta

The Offer

Microsoft (NASDAQ:MSFT) is offering $41 - $44 billion to acquire internet pioneer Yahoo! (NASDAQ:YHOO) in order to gain a stronger foothold in internet search marketing. Yahoo! currently holds second position in search marketing, behind Google (NASDAQ:GOOG) and ahead of Microsoft, which currently holds fourth place.

Yahoo! Inc.

  • Yahoo! is the one of the biggest & trusted brand name in world of internet.
    • It is the most visited website in world with nearly 500 million users.
    • Sites like Yahoo! Finance, Sports, and News are category leaders and simultaneously hold the number one spot in terms of both audience size and engagement.
    • Yahoo! Mail, the e-mail services of Yahoo! is a worldwide leader for 10 years.

    Despite all of this, Yahoo! is lagging behind in financial growth. The primary reason behind this slow growth is a lack of focus on its most lucrative and popular categories like finance, news, sports, mail and, most importantly, search.

    Strategic shift

    Lack of focus is a thing of past. Currently the company is paying full attention to its most popular categories and is concentrating on enhancing user experience and thereby increasing user engagement on its website and instead of adding new categories company is increasing its offering under same categories.

    The most visible example is its video offering. Instead of offering videos as a totally different category, the company has added category related videos on its each category page. For example, one can find out videos related to various financial news/events on Yahoo! finance page. This simple addition not only enhanced the engagement of user with site but also helps to promote video related category.

    The company has also acquired a more open approach for content offerings. Unlike the earlier, mostly self-contained approach, the company is now offering content from other sites, even from competitors, on its website and thereby offering visitors the most and the best of the web.

    The company's renewed focus on its popular categories is also visible in its recent buyouts. All buyouts that the company had made the last year are related to its most popular categories (finance, news, sports, mail and search).

    Too late ?

    Many people think Yahoo! has already lost the search marketing battle and will never be able to compete with Google. To some extent it seems to be true, but one must consider the fact that the biggest asset of any website is its users and Yahoo! is still number one in this aspect of business. It was just lack of focus which dragged down the fortunes of the company. Now, with the right focus and clear-cut strategy of growing existing strongholds, the company is all set to evolve not only into the biggest online content provider but also as a strong competitor for search leader Google.

    Microsoft and Yahoo Together

    Now the bigger question is why Microsoft is paying seemingly such a huge amount for Yahoo (way above its market cap at the time of offer). First of all, the market value of a company does not always represent its fundamental value or real business value. Second and most important thing is the future potential of search marketing which is expected to rise from $45 billion currently to about $75 billion by 2010.

    Despite all of its attempts, Microsoft is still way behind the Google and Yahoo!. By acquiring Yahoo!, Microsoft will not only get the bigger market share in search marketing but also get access to millions and millions of users which are so far near captive to Yahoo for years!. Moreover Microsoft is also expected to save a great deal by creating synergies between Yahoo! and its own search marketing business and also in product development activities. In addition, Yahoo! messenger and MSN messenger will be able to offer lot more to its user communities.

    Yahoo Valuations

    At $44 billion, Yahoo! is not expensive. At most it's just reasonable and if the deal goes through it will be one of Microsoft's best acquisitions in its history. Why Yahoo! Should Be Valued Above $44 Billion

    • Recent strategic shift is expected to put company back on growth path.
    • Even now, when the company's renewed focus is yet to show results, the company is earning nearly $660 million in yearly profits (FY 2007) which gives it a PE ratio of nearly 66. This is not that high for a pioneer company with a strong base and huge future potential.
    • Company holds nearly 40% equity in Alibaba a China based e-commerce site. Although this is not a core business of the company, it holds a lot of promise for the future and, if sold at the current market price, it will give the company a whopping $5 billion.
    • Currently, the company's 36% equity interest in Yahoo! Japan is valued at $7 billion.
    • If one adjusts the valuations of equity interests and net cash that the company holds (cash and cash equivalents + short-term marketable debt securities - debt) Microsoft is actually buying Yahoo! for $31billion, which is very reasonable considering the company's long term strategic shift of its business focus.
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    Stakeholders Interest

    The possibility of a deal has already benefited the stakeholders due to a rise in price of Yahoo! shares.

    In my view, it will be in best interest stakeholders, Yahoo! and Microsoft itself, if Microsoft treats it as independent listed company rather than merging Yahoo with itself. Microsoft should buy strategic, even majority stack in Yahoo! and work on the strengths of both companies.

    The strength of Yahoo is its user base and its leading position in search marketing, second just to Google. Microsoft can transfer its entire search marketing business to Yahoo! or it can transfer its online content business to Yahoo! and treat it as its online content provider associate or subsidiary, depending on how much Yahoo! stock the company buys.

    Microsoft's strength is its product development capability and it should take over all product development activities from Yahoo!.

    This type of arrangement will be benefit everyone.

    For Yahoo! and its stockholders, it will retain its identity of public traded company and allow the market to judge its true valuation. Moreover it will make Yahoo! much more competitive due to increased scale and synergies.

    For Microsoft it will be a less cash consuming deal as compared to an entire takeover and will also serve its purpose of gaining control of Yahoo! Inc and creating a stronghold in search marketing without initiating a major management reshuffle in Yahoo!. Moreover cash saved can be used to get a good bargain later for any other company because with gloomy outlook of economy much more takeover opportunities are expected to come up in future.

    How Google Will Be Affected

    A deal or merger, whatever happens, will only have negative effect on Google, as it will suddenly find its two nearest competitors merging and competing not only with scale but also with lot more operational efficiency. It may also bring in a new era of scarifying of margins to gain clients as both companies Google and the merged entity (Microsoft/Yahoo!) has enough financial strength to do so.

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