When Will Yahoo Face Up to the Inevitable?

by: Eric Savitz

Yahoo’s (YHOO) management team seems to be working through Elizabeth Kübler-Ross’s five stages of grieving:

      Denial: The initial stage: “It can’t be happening.”
      Anger: “Why me? It’s not fair.”
      Bargaining: “Just let me live to see my children graduate.”
      Depression: “I’m so sad, why bother with anything?”
      Acceptance: “It’s going to be OK.”

    Which stage are we up to right now? Maybe the bargaining stage. But as noted by Bernstein Research analyst Jeffrey Lindsay, from whom I stole the whole idea above (he used the concept in the title of a research note this morning), there aren’t many plausible alternatives right now to simply accepting Microsoft’s (NASDAQ:MSFT) offer to buy the company. And he says the company’s fundamentals are not likely to support a price anywhere close to the current $31 a share offer.

    Lindsay thinks the company will report “another mediocre quarter” when it discloses Q1 results. The company has guided to revenue of $1.28 billion to $1.38 billion and operating cash flow of $400 million to $450 million. He says the midpoint of the guidance yields a valuation that matches his 12-month price target: $24 a share. To reach $31 within 12 months, he says, you need to assume Yahoo can rebuild revenue growth to 20% for the next five years; to reach the $40, he says growth would have to reach a Google-like 24% over five years.

    Alternatively, he says, the company could justify a $31 valuation by doubling operating margins from the current 8% to 16%, and then staying there for five years. For a $40 stock, you could get there with operating margins of at least 26% for the next five years.

    He says neither scenario has a significant probability of happening.

    So if fundamentals can’t drive the stock higher, what about alternative transactions?

    Not likely, he finds.

    • A joint venture with News Corp. (NASDAQ:NWS) in which Yahoo would get MySpace? Such a deal would require additional financing to give both company’s their desired valuation points. Not likely.
    • Buying AOL? Acquiring AOL, he says, would only give the desired valuation is Time Warner took a low price for the assets - and were paid in stock.
    • Outsourcing search to Google (NASDAQ:GOOG)? He actually thinks this is the only option left. With the DoubleClick acquisition closed, he thinks GOOG might consider taking a new look at the idea. He actually thinks this option could get the stock to $31, and with significant staff cuts, could boost the stock to $37. But he’s not betting on it.

    Writes Lindsay: “We ascribe only a low probability to any of the above scenarios and believe that the Microsoft deal will move ahead.” In fact, he thinks MSFT could decide to play hardball and refuse to sweeten the deal, which due to the drop in MSFT’s share price really values the company not at $31 but more like $29 and change. He thinks Microsoft is going to go ahead and propose an alternative slate of directors - and that Microsoft will win.

    In short, Yahoo’s management is heading for the final stage of grief. “We think they will soon be forced to accept reality and sell the company to Microsoft,” he writes.

    Yahoo Thursday is down 37 cents, or 1.3%, at $28.08.