Microsoft or Bust for Yahoo!

Last month, I wrote about the five reasons why Microsoft (Nasdaq: MSFT  ) should buy Yahoo! (Nasdaq: YHOO  ) . This morning, Microsoft provided a sixth reason: Because it can.

This morning's buyout proposal is huge. Microsoft is offering to put Yahoo! out of its misery at $31 a share in cash and stock. Yahoo! will carefully consider the offer, but it would be nuts to rebuff a bid that values the company at a 62% premium to yesterday's close.

Even if Yahoo! were trading near its floor -- with cash and Asian investments valued at roughly $12 a share -- it probably wouldn't climb as high as Microsoft's offer on its own. The Panama upgrade to its paid-search product is a flop. The company's presence through third-party publishers is shrinking. And every passing quarter finds Google (Nasdaq: GOOG  ) pulling further away, a sorry combination of Google's pedal to the metal and Yahoo!'s fundamentals stuck being in reverse.

Yahoo! could probably set things right in a few years, but shareholders shouldn't have to wait that long. The problem right now is that Yahoo! has no near-term savior other than Microsoft. The catalysts aren't coming, and neither are rival suitors. Google would get laughed out of antitrust proceedings if it were to raise a bidding card, and no public company would risk its market value by overbidding for a dot-com stalwart. Private equity is the only other viable alternative, but even that would be a long shot. Only Microsoft holds the key to cost savings through synergy.

Cry all you want, Yahoo!, but it's Mr. Softy or bust.

Exit strategy, stage right
There are no regulatory concerns here. If Microsoft had been angling to buy a software company like Linux-enabler Red Hat (NYSE: RHT  ) or even the publishing-happy Adobe (Nasdaq: ADBE  ) , furrowed eyebrows would follow.

But a Microsoft-Yahoo! marriage would barely put a ripple in the competitive waters. Yahoo! occupies the online space, where Microsoft is an unprofitable laggard. Even with Yahoo! standing on Mr. Softy's shoulders, the pair would still only come up to about Google's waistband in terms of domestic search-engine market share.

Even the typically pesky European regulators would have to stand down, since Microsoft is even less of a speck in the global search marketplace.

December Worldwide Market Share

Google

62.4%

Yahoo!

12.8%

Baidu (Nasdaq: BIDU  )

5.2%

Microsoft

2.9%

Everyone Else

16.7%

Source: comScore qSearch 2.0.

Yes, Yahoo! would actually raise more scrutiny if it hooked up with Baidu.com than with the distant fourth-place competitor. That's the global reality. Ultimately, though, as long as Google isn't involved, regulators are most likely to greet any deal with a dismissive pat on the head, and tell the two participants to run along and play.

Buy, sell, or mold?
What's a Yahoo! investor to do? Taking today's profit and running out the door isn't an unreasonable strategy. A day ago, Yahoo! lay bloodied on the floor. With its shares opening 50% higher this morning at $28.70, it's now pressed up against the ceiling.

A lot could go wrong at this point, though. Yahoo! could get cocky and refuse the deal, with no Plan B in sight. Or, although it's extremely unlikely, regulators could kill the deal, even if Yahoo! nods accordingly. That would send Yahoo!'s shares crashing back down.

Since Microsoft is committing only enough cash to pay for half of the shares, the value of the deal will also change if investors sour on Microsoft's pricey purchase. In fact, the deal is already worth less than the original $31-per-share price Microsoft offered this morning.

The stock-swap part of the deal calls for half of the Yahoo! shares to be exchanged for 0.9509 shares of Microsoft. With Microsoft's shares opening lower this morning, at $31.10, the exchange ratio means that half of the Yahoo! shares will receive $29.57 a share worth of Microsoft's stock. That value will fluctuate with every uptick or downtick, but when you blend that $31 in cash and $29.57 in stock based on this morning's open, the $31-per-share deal is worth more like $30.29.

Microsoft's stock can go the other way, of course. The deal may wind up being worth more than $31 a stub if market forces shine kindly on Mr. Softy. Then again, if you see it that way, why not just buy Microsoft, rather than anchor yourself to the fixed-cash portion of the deal?

You'll be hearing plenty about this deal in the coming hours, days, and weeks. If I'm a Microsoft investor, I'm not overly concerned about it, beyond knowing that the cash portion of the deal will eat away most of the company's balance-sheet greenery. Otherwise, the synergies make sense, and the resulting partnership is really the only way the companies can even pretend to compete against Google in a wired world.

If I'm a Yahoo! investor, sticking around doesn't make a lot of sense. You've tasted the floor, but don't get greedy at the ceiling. Helium fades.

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