Yahoo, Microsoft: Either Make Nice or Lose Big

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Includes: AABA, MSFT
by: Diane Mermigas

Whoever thought that playing well with others would be the primary prerequisite for sealing a deal that advances business in a depressed economy and realizes sizable shareholder gains? Sadly, dysfunctional sandbox dynamics, as much as price, is at the heart of the ongoing Yahoo (YHOO) - Microsoft (NASDAQ:MSFT) fiasco.

"There won't be a deal. There are bad personal feelings. In six months, Microsoft walks away," Rupert Murdoch says, pulling his own News Corp. (NASDAQ:NWS) out of the equation — at least, for now. It is what principal players' body language and words have relayed all along: The biggest impediment to a partial or complete buyout is that leading executives and investors at Yahoo and Microsoft hate each other.

Somewhere in their B-school training — Yahoo's founding CEO Jerry Yang and Microsoft CEO Steve Ballmer are Stanford-bred billionaire entrepreneurs — surely would have learned that the art of sealing the deal is to put personality aside. Forget your feelings; do what's best for business. Then again, they may subscribe to Michael Corleone's famous dictum: "All business is personal."

It's not clear what Capital Research senior vice president Gordon Crawford was doing (with a 6% investment in Microsoft and more than 11% investment in Yahoo) when the companies were arm-wrestling over nearly $35 a share earlier this year. Now, Crawford and other institutional investors are complaining about the remote chance that a deal could still take place $25 a share, rather than the $33 a share they have been demanding.

In fact, any deal fashioned now for and by Yahoo will fall short of the nearly $47 billion merger and $12 billion in new value (from synergies and new revenues) that would have been created by Microsoft's original stock and cash offer, according to Citigroup analyst Jason Bazinet.

A Yahoo-AOL (NYSE:TWX) merger — which some insist is in the works — would generate a potential $8 billion in new value, based on such factors as an estimated $900 million in annual synergies and a sizable gain in display advertising. It also makes sense for Yahoo to sell its increasingly weak search business to Microsoft under some minimally taxable arrangement. Alternatively, they could agree to some outsourcing arrangement. Or, Microsoft could make a big enough equity investment in Yahoo to take effective control of its search operations if the parties can agree on a valuation. Not likely.

Several weeks ago, in an open letter to shareholders, Yang disclosed Microsoft recently offered $1 billion for Yahoo's search business and a share of search ad revenues in exchange for an $8 billion investment and a 10-year exclusive arrangement. Microsoft's analysts generally agree that Yahoo's international holdings (including Alibaba) comprise about half of its market cap, of which search is only part of the operations — although search-related earnings are the most valuable.

There are widely diverse economic circumstances under which Microsoft still could have some interest in Yahoo to secure the scale, traffic and community it needs to more effectively compete with Google. They all pivot on the same fragile element of personal politics. The latest swipe was Microsoft conveying that it would be willing to re-entertain the notion of a complete buyout if it could negotiate the deal with the proposed replacement board offered by Icahn. That's not exactly the way to make friends and influence people.

Even under the best circumstances, a lot of time, money and effort have been squandered fighting a war that Yahoo already has lost. When Yahoo reports its latest quarterly earnings July 22, it is expected to deliver more bad news about meeting this year's projections. Yang insists his position and actions are driven by a desire to remain autonomous, but he forfeited the option when he failed to deliver on his short and long-term objectives to turn around the company and fashion partnerships that advance Yahoo-save outsourcing to Google, if the deal flies.

No matter how many more structural and organizational changes Yang makes, Yahoo has limited options. Those became even more limited when Murdoch pulled News Corp. out of the running. Murdoch is smart enough to return to the fray when he can decisively leverage his MySpace and Fox Interactive Media assets.

Everything is on hold until Yahoo's Aug. 1 shareholder meeting and open proxy war with Carl Icahn, and Microsoft's July 24 annual meeting with financial analysts.

If Icahn and other activist investors get their way, Yahoo could be led by a new executive team that would reinstate the company's diluted entrepreneurial MO, stop the exodus of key talent and begin constructively negotiating with interested players. Former AOL CEO Jonathan Miller and former Fox Interactive Media CEO Ross Levinsohn, now co-CEOs of Velocity venture capital, would be Icahn's pick for interim, peacemaker co-CEOs to negotiate with Microsoft. Why? Because they know how best to leverage assets and strengths-especially in tough times.

But facts become secondary during a personality meltdown — think Redstone and Diller, Diller and Malone, Jobs and Gates. It could be that high-powered egos and pocketbooks go hand-in-hand. But in these perilous times, when disaster and opportunity walk a tightrope over unstable economics, there is little prudence in a street fight. Someone could get hurt.

Disclosure: I own no media, entertainment or internet-related stocks.