Yahoo!'s Final Mistake

You blew it, Yahoo! (Nasdaq: YHOO  ) .

Yahoo! is turning down Microsoft's (Nasdaq: MSFT  ) buyout offer -- and this is the end of Yahoo! as we know it.

It doesn't matter that Yahoo! was put into a no-win situation. The bellyaching rings hollow after years of fiscal ineptitude. In fact, it was a lose-lose more situation, and Yahoo! chose the latter, perhaps unaware of the chain of events it's about to unleash. In staying independent, it's practically assuring an executive and boardroom shakeup from incensed investors. In other words, heads at the top are going to roll anyway.

Microsoft's extended hand was cold and clammy, but at least it was an exit strategy. Yahoo! may think the bid was too low, that Microsoft will bid higher, or that Google (Nasdaq: GOOG  ) will save the day, but it's naive on the first two counts and nearsighted on the last one.

The generosity of Microsoft's bid
Yahooligans feeling slighted often point to the company's valuable investment portfolio without realizing that they're making the biggest case in favor of Microsoft's generous offer. Yes, Yahoo! has about $12 per share on its balance sheet in cash and Asian investments, but these have never been hidden assets.

The market has priced Yahoo! accordingly all along. When Yahoo! shares were trading hands at $19 just before Mr. Softy made its bid public, the market was telling you that it felt that Yahoo! -- sans its not-so-hidden assets -- was worth closer to $7 a share. Microsoft's original offer of $31 a share, or $19 a share once you back out the value of Yahoo!'s cash, as well as its stakes in Alibaba, Yahoo! Japan, and Gmarket (Nasdaq: GMKT  ) , was actually nearly triple the $7 price tag that Mr. Market deemed fair.

That's pretty darn generous. As far as premiums go, it's as historical as it is hysterical.

Sweeter offers can turn sour
Rumor has it that Yahoo!'s board is holding out for a bid closer to $40 a share. That's unlikely to come from Microsoft. Keep in mind that if we back out Yahoo!'s cash and stock portfolio, paying $40 a share for Yahoo! would be paying quadruple the market's opinion of what Yahoo! was worth (backing out the $12 a share from both a pie-in-the-sky $40 offer and the $19 pre-deal price).

There are also other reasons why Microsoft is unlikely to outbid itself when it's the only one holding up the bidding card.

Microsoft closed out its latest quarter with $21.1 billion in cash. If Yahoo!'s offer was for $22.3 billion in cash and what was then $22.3 billion worth of its own stock, it can swing the deal without taking on debt, because Yahoo!'s balance sheet brings $2.6 billion in cash and short-term investments to the table.

So what happens if Microsoft has to offer more greenbacks than it currently watches over? It's not a problem at first glance. Microsoft is a cash flow-generating machine. It's also padded with other long-term investments. However, the company is heading into challenging times where even its operating system and applications strongholds will be tested by cheaper, Web-based alternatives. The last thing it needs is to be a debt-saddled sloth.

But the biggest reason it's unlikely to come back with a sweeter offer is that its shareholders are already crying for Microsoft to end its run at Yahoo!. Microsoft's market cap has taken a $38 billion hit since the deal was announced. One can't blame the weak market for the tumble, as the market's 3.5% rock slide is nothing compared to the better-than-12% market cap avalanche at Mount Ballmer.

In a nutshell, even the original $31 offer is off the table. The market has devalued Microsoft to the point where its initial terms are now worth just $29.08 a share, accounting for both stock and cash.

So why should Microsoft sweeten its bid, especially since it knows that it can let Yahoo! dissent run amuck over the next quarter or two and pick up the company from distressed investors for even less later this year?

Microsoft bids alone
No matter what the Yahoo! punch sippers may kid themselves into believing, the porch of gentlemen callers wooing Yahoo! will be a ghost town once Mr. Softy moves on. Well, at least at anything close to the original Microsoft price.

Yahoo! has generated $1.3 billion in free cash flow this past year. No one is going to pay 34 times cash flow for an organically stagnant company (or even 21 times cash flow once you back out Yahoo!'s investments). Microsoft's incentive was that the combined company can cash in on some serious synergies by consolidating its paid search operations and combining its client bases. There is no private equity firm that could cash in on that value. There is no media conglomerate that would go out on such a pricy market cap-obliterating limb.

The offers may come as Yahoo! shares sink deeper, but only at substantially lower price points.

The Google solution
This brings us to Plan B. The only way for Yahoo! to save face is to take Google up on its offer to monetize its gargantuan page views by outsourcing its paid search to Big G. It would be terribly humbling for the company that revolutionized this industry by snapping up Overture to become the most prolific publisher using Google AdSense, but it just makes perfect financial sense for Yahoo! to settle for an 80%-90% cut from Google's ad efforts than to continue to go it alone.

Yahoo!'s operating margins would improve overnight. Overhead would be shaved substantially. Yahoo!'s pages would be populated with a wider variety of higher-paying advertisers, even if it sticks to its own cooking on the display advertising side. AdSense makes sense, but it would also be the ultimate surrender of Google's biggest competitor.

Yahoo! would become less relevant to advertisers, even if selling out would look pretty -- initially, at least -- on the income statement.

This has to be running through Yahoo!'s noggin, because when you turn down your only public suitor, you need to map out your life as an old maid. Turning to Google is one solution. Another solution is to pounce on the chance to be an acquirer itself.

Yahoo! can beef up its page views by snapping up CNET Networks (Nasdaq: CNET  ) . It can drive up its paid search business by buying content companies that toil in lucrative keyword niches like The Knot (Nasdaq: KNOT  ) or Bankrate (Nasdaq: RATE  ) . Yahoo! actually has enough cash to buy all three (before factoring in appropriate premiums), and growing would be the most direct path to win shareholders back.

Yahoo! will have to do something dramatic. It can't just use its greenery to buy back more shares. Nor can it blow everything on pints of ice cream and sniffle on the couch, either. Shareholders will want answers. And if they don't like the answers, shareholders will want blood.

It will be hard to blame those investors. They thought they were handed a parachute a week ago, but it turns out that it was a backpack full of rocks.

For more on the Microhoo relationship:


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