“We believe Microsofts proposal substantially undervalues Yahoo.”–former Yahoo CEO Jerry Yang, in a letter to employees on Feb. 11, 2008 about Microsofts $41.6 billion unsolicited bid for Yahoo.
Yahoo will sell its search capabilities to Microsoft, “if there’s boatloads of money and the right technology involved.”–Carol Bartz, Yahoo chief executive, in an interview at the All Things Digital Conference on May 27.
As far as we’re concerned, the boatload of cash is preserving our revenue Having an upfront payment didn’t really help us from an operating standpoint.”–Bartz, in a conference call with analysts, announcing the deal on Wednesday.
Let us be clear: Yahoo has squandered many chances to generate huge value for its shareholders in its three-year dance with Microsoft. First and foremost, it turned down Microsofts bid to buy the entire company for $41.6 billion last winter. Today, Yahoo has a market value of $24 billion.
But the past is the past. Looking ahead, there may be a good case for buying Yahoo now that it has outsourced much of its search business to Microsoft. It isn’t a blockbuster deal, but the move makes strategic sense for Yahoo.
Here is the play: Yahoos shares are taking a beating today, falling 11%, or $1.90 to $15.30 in midday trading. Investors are unhappy that the search deal didnt include any “boatloads of cash” from Microsoft. Analysts had been expecting at least $1 billion. Investors also may be selling on the news that the on-again, off-again negotiations between the two companies are finally over.
The bears aren’t buying that the search deal will create value for Yahoo over the long term. But the bull case is worth considering. The deal enables Yahoo to tap into Microsofts Bing search technology, which has been rolled out with some success in recent months. Yahoo also will reap 88% of the combined search revenue, an increase from the 85% share that Microsoft offered when it first proposed a search deal last summer. Under that proposal, Yahoo’s take went down to 70% after three years.
For Yahoo, this adds up to $275 million in additional earnings before interest, taxes, depreciation and amortization annually, largely from cost savings on research and development and infrastructure costs associated with the search business. That translates into approximately $1 a share more of enterprise value, says Christa Quarles, of Thomas Weisel Partners, referring to a measure of the total value of a business, with debt and cash factored in. Yahoo’s 2008 Ebitda was $1.8 billion.
If you add in the roughly $200 million a year it won’t be shelling out now for large capital expenditures on the search business, the rise in enterprise value approach $2 a share, Quarles says. According to Yahoo Finance, Yahoo has an enterprise value of $20.56 billion.
Quarles has a “hold” rating on Yahoo, but she admits that todays sell-off makes the stock look attractive. “People have gotten emotional around the selling and any time that happens, there can be buying opportunity around that,” she said.
To be sure, there are a lot of pitfalls to the search deal and few guarantees for Yahoo. Unlike a similar Google-AOL search deal that gave AOL guarantees on search pricing over the life of the pact, Yahoo is entitled to only 18 months of pricing guarantees in its 10-year deal with Microsoft. After that, Yahoo will be at the mercy of Microsofts technology to maximize searches.
It is worth noting that Google invested $1 billion in AOL, giving it more skin in the game than Microsoft, which has paid nothing upfront. But AOL’s parent, Time Warner, recently bought out Google’s investment for $283 million. Microsoft avoids such a risk in its deal with Yahoo.
The bears may be too angry about Yahoos long history of lost opportunity to focus on the positives of the search deal. “But I think Yahoo gets to have its cake and eat it too,” says Sandeep Aggarwal, an analyst at Collins Stewart. Wall Street may have been expected too much, but Yahoo is a net gainer here.”