What's Next For Microsoft and Yahoo?

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By Jason Simpkins
Associate Editor

Shares of Yahoo! Inc. (YHOO) tumbled 15% yesterday (Monday) to close at $24.37 a share as investors responded to Saturday's news that Microsoft Corp. (MSFT) would drop its $47.5 billion dollar bid for the beleaguered search engine firm.

But the tough times are just beginning for Yahoo, which must now prove why it is worth more than the lofty price Microsoft was offering.

"Yahoo is going to be under a lot of pressure," Peter Falvey, managing director at technology-merger adviser Revolution Partners, told Bloomberg News. "A lot of shareholders are going to say, ‘Hmm, maybe we overreached.'"

Microsoft originally offered $31 per share in either cash or Microsoft stock, a 62% premium to Yahoo's Feb. 3 closing price. It boosted the bid to $33 a share, appraising Yahoo at approximately $47.5 billion, but Yahoo refused to accept anything less than $37.

Now, at $24 a share, Yahoo as a company is only worth about $33.5 billion.

That means Jerry Yang, Yahoo's co-founder and chief executive, has the unenviable task of delivering better performance after Yahoo's bold reprisal. In short, he'll have to add at least $14 billion in market value to the company if he's going to justify his decision and prove that rejecting Microsoft's offer was the right move.

And one doesn't have to take a very long look at Yahoo to see Yang has his work cut out for him.

Why Yahoo! Isn't Worth $37 a Share

Last month, Yahoo reported a first-quarter profit of $542 million, or 37 cents per share, up from $142 million, or 10 cents per share last year. It was the company's first profit increase in nine straight quarters (more than two years). But a big reason for the jump was a one-time gain of $401 million – a windfall from the sale of Yahoo's stake in Alibaba.com Ltd.'s (PINK:ALBCF), which came from the Asian Internet company's initial public offering (IPO).

Excluding one-time items, Yahoo reported earnings of 11 cents a share.

Even with the profit increase, the company continued to lose market share to nemesis Google Inc. (GOOG), the leader in Internet search. Yahoo accounts for 21.3 % of all U.S. searches according to comScore Inc.

That compares with a near 60% sway for its rival, Google, which defied Wall Street's first-quarter expectations by expanding its revenue nearly four times faster than Yahoo. While Yahoo's sales climbed 14% last quarter, Google posted a 46% jump in revenue.
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In April, Yahoo all but acknowledged Google's victory by outsourcing a small portion of its search advertising to its competitor on a two-week trial basis. If Yahoo continues using Google's search advertising system, it will be abandoning its own "Panama" ad system. Launched in February, the Panama initiative set the company back millions of dollars. Even so, it continues to lag behind Google's AdSense in terms of revenue per search query.
As it worked to bulk up its search capabilities, Yahoo had earlier shelled out $1.63 billion for Overture Services and $235 million for Inktomi. That's close to $2 billion for search engine service specialists that would for, all intents and purposes, be rendered moot should Yahoo ultimately outsource even more of its search-related business.

While some analysts believe a bigger deal with Google may already be in the works, any serious collaboration between the United States' two largest web portals would very likely run afoul of U.S. antitrust restrictions. Google already places ads on more than 67% of searches. The addition of Yahoo would expand its influence to 89% of searches, according to statistics from Hitwise. Microsoft said last month that Google would command more than 90% of the search advertising market.

"While Yahoo may pursue a Google search partnership as a way to appease shareholders through enhanced cash flow, we believe such a deal would face intense anti-trust scrutiny," Clayton Moran, an analyst with Stanford Group Company, told IDG News Service. "In addition it would cede control of search to Google."

Moran does not believe Yahoo's stock will reach the $37 a share value over the next 12 to 18 months.

There have also been rumors that Yahoo will join forces with Time Warner Inc.'s (TWX) AOL or News Corp.'s (NWS) Fox Interactive Media business units. According to the details that have emerged so far, Time Warner would merge a large portion of AOL's operations with Yahoo and make a cash investment in exchange for a 20% stake in the resulting company. Yahoo would use that cash infusion to buy back some of its own stock.

However, when it comes to Web-search market share, AOL currently ranks fourth, behind Google, Yahoo and Microsoft. So the company that emerged from that combination would be more of a content player than it would be a competitive Web-search firm.

Regardless of what Yahoo does to try to validate its decision to rebuff Microsoft, investors are already working themselves into an apoplectic frenzy over the move. Some Yahoo shareholders had already sued the company's directors even before Microsoft decided to walk.

Enraged Yahoo shareholder Eric Jackson said Sunday that he planned to rally shareholders to withhold their votes from all Yahoo directors at the company's annual meeting, which has not yet been scheduled. Jackson leads a group of about 140 shareholders who together own 2 million Yahoo shares.

"Significant value was left on the table," said Jackson, who heads a group of irate investors who together own about two million Yahoo shares.

Microsoft's Next Move

In an ironic twist, Microsoft – like Yahoo – must now answer to a less-than-thrilled constituency.

Microsoft Chief Executive Steve Ballmer said April 24 that his company was willing and able to walk away from its bid for Yahoo.

"We're prepared to move forward without a merger with Yahoo," Ballmer said at a technology conference in Italy. "We think the best way to move forward quickly is to come together with Yahoo. Hopefully that works. But if it doesn't, we go forward. Time is money."

He lived up to his word Saturday, scrapping his company's a $47.5 billion offer that valued Yahoo shares at a 70% premium to their January value after three agonizing months.

But now the man in charge of Microsoft must explain how the company plans to improve its eroding Internet business – which lost $228 million in the first quarter alone – without Yahoo.

Instead of the stock-price rally that many companies enjoy when they walk away from costly deals, Microsoft's shares closed the day yesterday at $29.08, down 16 cents – hardly the vote of confidence the company would have wanted to see.

Since the company obviously has plenty of cash on hand, it may be a good idea to seek out a more agreeable partner.

"I'm looking for Microsoft to get aggressive with a buying spree," Gartner analyst Allen Weiner told IDG. "I think Microsoft should do something quickly to show the world that [the] Yahoo bid wasn't a setback."

The company could try to strike a deal of its own with Time Warner or News Corp., or perhaps even with the trendy Facebook.com. Other analysts suspect Microsoft may be beckoned back to Yahoo's rescue if the company fails to right its course by year's end.

"Should Yahoo miss expectations in 2008, we would not be surprised to see MSFT come back to the table," RBC Captial analyst Ross Sandler said in a report yesterday morning.

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