Digital Dealmakers Revisit Risk/Reward Options

Yahoo's fate is now all about the rewards for activist investors like Carl Icahn, the risks for Microsoft and the chaotic state of shifting valuations. A proposed Yahoo deal of some kind has become the poster child for the tumultuous forces shaping a tenuous deal market.

Perhaps the most telling development has been reconsideration by Microsoft CEO Steve Ballmer and his board of what Yahoo is worth, and how to structure a deal to minimize risk and maximize return. While the Internet and all things digital continue to provide an opportunity for greater growth and innovation, dealmakers are struggling to accurately project short-term revenue, earnings and market expansion against a backdrop of economic turmoil and logistical unknowns, such as measurement, metrics and pricing.

In an effort to avoid falling victim to inflated valuations, dealmakers are struggling with the qualified cost and value creation estimates for integrating traditional and new media assets, transforming static advertising into interactive e-commerce. Broader crippling economics and the nascent financials of digital conversion are creating tighter money flow, more uncertain projections and changing criteria. Even well-heeled players like Microsoft and Google are more cautious.

The most important development will be establishing a new floor for the valuation of companies and services, on which new deals can be structured. The valuations being projected are as vulnerable to unprecedented external forces of technology and economics as they are to companies' internal realignment. Few of the newer-established combination deals surfacing (Microsoft-Yahoo qualifies as one) are based on rock-solid valuations and projections; they are betting against strategic trends rather than on certain growth.

Microsoft's willingness to reopen talks with Yahoo appears to be motivated by a desire to thwart a Google advertising search deal that would competitively dilute a Micro-Hoo merger or strategic partnership. That is a sweeping action that depends less on the accuracy of fiscal projections that would drive an outright acquisition of Yahoo--something Microsoft has the financial wherewithal to do.

The question for Microsoft--and indeed all buyers of Internet and media companies today--is what are Yahoo's assets and operations worth in a radically changing marketplace? Growth multiples will never be what they were and are changing even now. Large-cap Internet stocks (Google, Yahoo, Amazon, eBay) are trading at an average 12.2 times 2009 earnings multiple that is not wildly ahead of 10 times 2009 earnings multiple average for outdoor, nine times 2009 earnings multiple average for large-cap entertainment (Time Warner, Disney, News Corp., Viacom) as well as for broadcast (CBS and Clear Channel). Newspapers are trading an average 7.7 times 2009 earnings average and cable at six times 2009 earnings multiple average, according to the Lehman Brothers May Data Book.

Not all things Internet are golden.

There are, in fact, wide swings in Internet company performance, valuations and growth projections. Yahoo's return on invested capital and on equity is a mere 1% to 2% compared with Google's 20% to 21%, respectively. Yahoo is expected to have flat earnings and negative 23% free cash flow growth on projected 11% revenue growth in 2008. Google is expected to have 35% free cash flow growth and 34% earnings growth on 39% revenue growth in 2008.

While the size and scope of these two companies is dramatically different (Yahoo has a market cap of $35 billion to Google's $185 billion), they are locked in a battle for online audiences and ad revenues, which is at the heart of Microsoft's pursuit to create a viable competitor to monster Google, especially with total internet ad growth expected to taper off to 13% by 2011.

Microsoft's 9.4% search share and Yahoo's 21.3% domestic search share in March would comprise only half of Google's share of an online search ad market growing 28% to $11.4 billion this year and slowing to a 15% growth rate by 2011, according to Lehman. That is what makes Yahoo's stranglehold on display advertising so important. Overall display advertising, growing at 20% to $8 billion, is nearly one-third of $26 billion--plus in total U.S. online ad spending, which also will slow to 12% growth by 2011.

A mere display advertising and search cooperative between Yahoo and Microsoft would be more difficult to quantify, and therefore justify, due to Microsoft's inability to make the most of integrated resources. As we have seen this year, many external economic factors can impact total online advertising revenues, expected to slow to a 13.7% growth rate to total $41.4 billion by 2011, which will be 12% of the total U.S. advertising market of $344 billion then.

Just as strategically important is Microsoft's need to expand and build its online search and other core businesses on a larger search and online audience base. It must shift its core software business to an online model to keep Google from rifling its dominant applications dominance, especially as Google Search becomes larger and more profitable than Microsoft Windows' share of the operating systems market a year from now.

Indeed, even smaller strategic media deals this year will be plagued by the same uncertainties about general consumer economics, digital logistics and the fiscal realities of trying to combine two different worlds with their contrasting disciplines, cultures and financial frameworks. Microsoft-Yahoo will wrestle with it, as will CBS-CNET and other of the more than $20 billion in old media-new media combination deals that have been announced since News Corp. acquired MySpace several years ago.

Few, if any, have rendered tested benchmark for combined valuations and realistic expectations. If News Corp.'s acquisition of MySpace and others like it have taught us anything, it is that rewards can be very different or emerge more slowly, than initially expected, thus placing a whole new cast on the risk involved.

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