Yahoo: Surge or Merge?

Yahoo is writing the book on how not to manage a company in times of adversity. After a year of chaos, it has responded to the recession-led dive in display advertising with a 10% workforce cut. Its planned Google ad alliance to boost sagging revenues is threatened by the lack of regulatory approval.

Yahoo's only short-term salvation could be some kind of deal with Microsoft--until investors realize that any buyout bid that Yahoo's troubled board accepts would be a fraction of the $33-per-share offer it rejected earlier this year. Yahoo appears to have paid its financial advisers $37 million to help them make that decision and fend off activist investor Carl Icahn--comprising the lion's share of the 53% drop in third-quarter operating income to $70 million. Merger integration and advertising recovery will last the same 18 months that a protracted recession could linger, which means Yahoo cannot expect to see better days until sometime in 2010.

So what's Yahoo to do? The answer is as complicated as Yahoo.



Yahoo's business model depends upon maintaining agreements with media, access and advertising partners. It is vulnerable to technology players and other new entrants gaining an unexpected online advertising foothold in an intensely competitive market. The rate of deterioration of its display advertising revenue growth is alarming. Yahoo executives this week declined to elaborate, only generally warning of difficult months ahead and conserving $3 billion-plus cash for now.

Yahoo's $400 million in annualized cost savings tends to blanket the bad news: The significant economy-related deterioration of its overall display business (which accounts for 62% of its domestic net revenues) and a 10% year-ago decline in its largest single revenue stream, affiliate/network marketing. That was offset by a surprising 17% percent increase in paid search on Yahoo's owned-and-operated sites, where display advertising and marketing services each grew 3%.

Yahoo's minority equity investments in Yahoo Japan and Alibaba will be adversely affected by the depreciating U.S. dollar. Although it loses paid search share to Google in the U.S. and worldwide, Yahoo's revenue per domestic search is up 11% from a year ago.

The slicing and dicing of earnings returns and metrics still leaves Wall Street wondering what Yahoo does for a cost-cutting encore in 2009 or the creation of revenue growth in ways other than a merger. In a detailed analysis earlier this month, Bernstein Research's Jeffrey Lindsay concluded that an all-stock deal for AOL would only be accretive to Yahoo for around $3.4 billion (or no more than its own 6.5-times earnings multiple). Time Warner would consider it too low, but some disenchanted investors might not. Any potential upside to AOL or Yahoo depends entirely on cost savings (a 35% reduction in AOL's cost base)--which Yahoo management has been ineffective at implementing in the past, although new hands-on management would likely reside over combined operations.

Any premium paid to Time Warner (possibly seeking $6 billion to $8 billion for AOL) would largely depend upon cost reductions, improved premium display pricing and scale benefits to the network/exchange businesses. The kicker is that an AOL-Yahoo deal could jeopardize AOL's existing paid search agreement with Google, worth $309 million in earnings--which would cancel out most of the cost synergies from the merger. Yahoo executives reiterated during their earnings call this week that they will not consider a "dilutive" deal.

It's worth noting that AOL also continues to deteriorate without a deal.

Lindsay estimates that $1.1 billion of AOL's total $2.6 billion in operating expenses is associated with its search and display businesses, which would be the primary source of cost reductions in a merger of the two companies. AOL's profitable ISP business accounts for about 68% of the company's overall estimates of $1.5 billion in earnings on a total $4.1 billion in revenues this year.

In this volatile environment, a better deal might not come along, which is why Time Warner and Yahoo alternatively could opt for joint ownership of a new Yahoo into which AOL is folded and eliminated as a rival. Although a stronger competitor to Google, a Yahoo-AOL entity would face the same recessionary challenges.

Heavy reductions of headcount and service by both Yahoo and AOL suggest they are gearing up for a deal, while the parties haggle over price, ownership split and cash contributions. Meanwhile, Yahoo's stock price and market cap have declined more than 40% since August.

Which brings us back to the benefits of a Microsoft tie-up. Microsoft CEO Steve Ballmer once again publicly toyed with Yahoo's emotions last week, suggesting that a search partnership between the two companies still "would make economic sense," although no such discussions are planned. With Icahn now on the Yahoo board, there is speculation that he will continue to openly lobby for a Microsoft tie-up, even if Yahoo and AOL combine forces.

Microsoft has plenty of cash to take the entire shooting match as a counter to Google's growing dominance. But what Microsoft really wants is Yahoo's search business, which regulators would likely force to decouple from Google in the event of a Yahoo-AOL merger. The real question: how much competitive ground does Microsoft want to risk losing to Google in a prolonged recession that is sure to devastate online display and traditional forms of advertising? The answer could determine how Microsoft, Yahoo and AOL are positioned when economic recovery comes.

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