MS Acquisition 1.0

Since Microsoft’s bold $44 billion bid for Yahoo last weekend, Yahoo has assumed the fairly predictable role of coy mistress. The $31-per-share offer, by the reckoning of Yahoo’s board, is shy by about $9 per share, or around $12 billion total. This is certainly not the first time that a board or management has held out for a better offer or accused an acquirer of taking advantage of low stock valuations to ‘steal’ a company, but what is interesting to me in this case is the timing of the Microsoft offer, which not only caught Yahoo when its stock was reeling, but also caught the company at a time when its strategic direction and future is muddied and not altogether promising.

To most investors Yahoo’s performance over the past 24 to 36 months has all the telltale signs of a company hitting the wall. Three-year earnings-per-share (EPS) growth is negative, but the five-year EPS is still impressive; return on assets and return on investment are below the industry for the trailing twelve months, but comparable over the trailing five years; efficiency scores are similarly trailing the industry average. Yahoo is clearly in trouble and is in need of a major restructuring of its core business, but the recent management shake-up that placed Jerry Yang in the CEO position has yielded nothing but tinkering at the margins.

One area that could rejuvenate Yahoo is the online delivery of digital media, but there is no dearth of competitors across the expanse of that space. Companies as diverse as Amazon and Netflix are all turning the cube in order to figure out the next big thing, and many companies, both larger and smaller than Yahoo, seem to have a better focus on the area. Despite forays into digital media, Yahoo’s main business is still banner ads and the like, and given the lack of strategic direction, it is there that Yahoo will have to excel in order to grow.

But there, too, growth will be difficult. The Google-style text ad – as well as the technology behind it – is now the advertising method of choice for an increasingly large segment of advertisers, so future organic growth of the top line will be somewhat limited. Beyond organic growth Yahoo seems to be too big to ignore, but too small to dominate the field. It is too big because any strategic tie-up – via M&A, joint venture, or alliance – will be heavily scrutinized by antitrust authorities. By the same token the recent performance discussed above does not suggest that Yahoo can grow very quickly moving along in the same ruts. All of this means that Microsoft probably has little to worry about in the form of a competing bid or a strategic tie-up (such as Yahoo outsourcing search functions to Google).

With no competing offers on the table Yahoo’s directors are playing a dangerous game of chicken. Microsoft might raise its offer, but not by $12 billion, and if Yahoo tarries too long, Microsoft might walk away rather than risking a hostile bid that would alienate Yahoo’s engineers and developers who form the core of the company’s value.

At the end of the day the shareholders are the trigger-men here. Rather than a direct hostile bid to replace Yahoo’s board, Microsoft will now likely lean on Yahoo shareholders and seek to sway them against the board. As Seekingalpha.com has pointed out, many of Yahoo’s largest shareholders also own sizeable stakes in Microsoft, so ultimately, look for the shareholders here to either throw a brake on the deal or pressure Yang & Co. to capitulate. The question is simple: If Microsoft walks away, how long will it take for Yahoo’s shares to reach $31? They could be waiting an awfully long time if recent performance is any guide. But Yahoo’s stock valuation is only one part of the story – there might be some Microsoft/Yahoo shareholders who feel that this deal is not in either company’s interest and who would be willing to take a hit on the value of Yahoo in order to save Microsoft from a bad deal. In any event, it will be fun to watch as this one unfolds over the course of 2008.