• by Diane Mermigas , May 6, 2008

The issues and deficiencies that propelled Microsoft to bid for Yahoo are even more urgent after three months of futile negotiations. They will continue to spur the companies to salvage their competitive stance in social networking, online advertising and e-commerce.

The consequences of doing nothing--or making a wrong move--could be dire. Microsoft likely will make another run at Yahoo with News Corp. as an ally. There also are dozens of smaller deals that Microsoft and Yahoo could do, but they would cost them as much value as they would hope to create. Yahoo's board could be facing a proxy fight by activist investors.

Yahoo may have cunningly played the scorched card to thwart Microsoft's unsolicited takeover by threatening to alter the value of its assets through a potential search alliance with Google. Microsoft may have demonstrated financial discipline against upwardly bidding against itself in a potential no-win situation. Sadly, both companies have failed to deliver on clear strategies, while dominant Google and the rest of the Internet world have raced past them. Microsoft would need to renew its pursuit sooner rather than later--at a justifiably lower price if Yahoo's stock plummets--to stem losses in online advertising, search and sales of software applications. Yahoo must execute just the right partnerships and acquisitions to avert a shareholder revolt and shore up its balance sheet.

Despite its costly development of the Panama advertising system, Yahoo needs a strong, well-funded partner to bolster utilization of its user base to improve its search and advertising, socialization and overall profits. Institutional investors will pressure management to do a deal with Microsoft, since the payoff would be immediate--even though the price could be less than the $33-per-share, $47 billion it was last willing to pay. News Corp. entering the fray as an equity partner could contribute all or part of MySpace, a much-needed and under-monetized, social networking component.

Weak second-quarter results will push Yahoo over the edge. Yahoo shares were down sharply by as much as 19% Monday, paving the way for shareholder lawsuits over a lack of fiduciary responsibility and an alternative slate of Yahoo directors who could negotiate a strategic deal.

A regulatory-friendly, open-system search deal with Google would generate an incremental $500 million in cash flow for Yahoo in 2009 and potentially add $6 billion in enterprise, driving the company's target valuation to $32 per share, according to RBC Capital Markets analyst Ross Sandler. Much will depend on the number of years committed to a Google pact (allowing for Microsoft to reenter), or whether a Google alliance would receive regulatory approval (which many experts think is unlikely). The threat of a Google deal and its potential corrosion to Yahoo assets was the deal-breaker for Microsoft, sources say.

A joint venture with AOL would give Yahoo more heft, but could cause more grief, given AOL's complex transformation and loss of free cash flow. Without some kind of deal--either with Microsoft, Google, AOL or private equity--it will be difficult for Yahoo to achieve much more with its current assets, operating performance and strategy. CEO Jerry Yang must quickly demonstrate that Yahoo is worth the $37 a share he was insisting from Microsoft, before its stock reverts to $19 a share.

Microsoft still lacks a multi-pronged online strategy to quickly execute: a strong partner or acquisition to immediately become a major online advertising player and an interactive transformation plan for its weakening core applications and software businesses. The Yahoo bid was Microsoft's way of saying it is imperative to pair its portfolio technologies "with greater traffic through acquisitions and organic initiatives," said Bernstein Research analyst Charles DiBona II.

Cash-rich Microsoft and Yahoo both need a stronger social-networking component, which could prompt each to pursue Facebook or MySpace, each valued at $10 billion-plus. Or they could offer Time Warner $10 billion or an equity stake in their business for AOL and its pending acquisition of the social network Bebo. Or, they could buy any of the interactive assets being spun off by Barry Diller's InterActiveCorp.

Microsoft's pursuit of Yahoo is part of a necessary strategy to compete with Google and the most efficient option to fulfill its goal of 25% digital advertising revenues. Alternatively, it could cobble together $40 billion worth of smaller acquisitions--which could collectively provide the same scale as Yahoo, but create bigger integration problems. "Microsoft's core long-term growth potential will ultimately be determined by the success or failure of its various online initiatives," Di Bona observes.

The fundamental math behind Microsoft withdrawing its offer: the return on investment was in line with its cost of capital for its improved $33-per-share bid, but well below its cost of capital in the case of Yahoo's demanded $37 per share. While Yahoo's overall standing eventually would be bolstered by a Microsoft deal, some of Yahoo's minority investments, such as Alibaba, continue to underperform.

Google will be the primary benefactor from all the disarray. A regulatory-friendly outsourcing arrangement with Yahoo would give it access to 90% of search advertising. Google could gain nearly $1 billion in new revenues and boost earnings 7%, according to Goldman Sachs analyst James Mitchell. Google could pick up $300 million in net revenue from Yahoo's own searches and $600 million from capturing Yahoo's current search affiliates--many of which would defect to Google, reducing Yahoo's revenue gains from the pact by $480 million.

In a weekend letter to Yang explaining reasons for withdrawing its buyout offer, Microsoft CEO Steve Ballmer warned that a Google alliance will fragment Yahoo's search and display advertising strategies and "undermine the reliance on your display advertising business to fuel future growth." In other words, a search alliance is as good as Yahoo selling its soul to Google--for a whole lot less than $47 billion.