Microsoft-Yahoo: A Reluctant But Necessary Marriage?

Editor’s note: Allan Krans is the Microsoft analyst for Technology Business Research in Hampton, N.H. Even though Yahoo’s board said Saturday that it would reject the Microsoft bid, Krans believes a merger makes sense. This article was written before Yahoo’s rejection.

Following a year of disappointing results and lost ground to Google, Microsoft and Yahoo! may finally be ready to consummate a merger.

Microsoft is again initiating the discussions, while Yahoo! plays the part of reluctant bride, weighing the benefits of a merger versus remaining as a standalone company over the coming years. Although Yahoo! CEO Jerry Yang may be reluctant to embrace Microsoft [and its $40 billion-plus offer], TBR believes the company’s ongoing struggles and uncertain future growth prospects may finally compel him to accept Microsoft’s offer.

TBR believes both companies face a hard uphill battle in the Internet search market whether they merge or not, but a unified front may be the best option to challenge Google’s dominance in the space.

Benefits of Diversification

While Google benefited greatly over the past five years due to economic growth and growing focus on Internet advertising, the company remains solely dependent on one source of revenue: Internet advertising. Yahoo! finds itself in much the same position, making the company vulnerable to any downturn in advertising revenue, which may occur if the economic uncertainty becomes a reality during 2008.

Joining Microsoft, which is currently reporting strong performance in its core OS, Office, and Server & Tools businesses gives Yahoo! the ability to weather economic downturns and continue to invest in the Internet advertising business regardless of economic conditions. In addition to the benefits of added scale, TBR believes joining a diversified company is one of the primary benefits Yahoo! will realize as a result of the merger.

Failed Internal Investment Strategies

Since the two companies discussed a merger last year, both have continued to invest heavily to support their respective Internet advertising strategies Microsoft spent more than $7 billion in its Online Services Business in acquisitions and data center investments, and Yahoo! focused on improving its standing in the market with initiatives such as Project Panama and operational realignments. Microsoft OSB and Yahoo! have not produced substantial improvements in their businesses over the past year, and furthermore, neither is projecting strong improvements during 2008. Microsoft expects the OSB operating losses will continue for the foreseeable future, and Yahoo! CEO Jerry Yang believes the company faces “strong headwinds” in the achievement of its goals.

Yahoo! May Still Be Resistant

Yahoo! walked away from the bargaining table in February of 2007, citing a promising outlook that internal investments would produce a turnaround in the company’s business. Even after a disappointing performance in 2007 and tepid outlook for 2008, TBR believes CEO and co-founder Jerry Yang may still be holding out hope for an internal turnaround. When Yang returned as CEO just six months ago, TBR believes his intention was to orchestrate an internal turnaround of the company, not to position it for sale. However compelling the merger may be, TBR believes that Yang may still be holding out hope of orchestrating an organic improvement in Yahoo!’s business.

Shareholders May Prefer a Bird in Hand

Given the 62% premium over the company’s stock price prior to the merger offer, TBR believes Yahoo! may well face pressure from shareholders to accept Microsoft’s bid. The hard question asked of management will be how Yahoo! intends to match the return represented by the Microsoft bid, and produce a 62% increase in Yahoo!’s stock price.

With the disappointing results posted over the past year, and a less than rosy outlook, TBR believes shareholders will likely prefer a bird in hand, and take the instant return promised by Microsoft over the uncertainty of continued investments. However, considering Yahoo shares were trading above $30 per share just three months ago and that Yahoo believes its unconsolidated assets are worth in excess of $10 per share, TBR believes any eventual agreement may come at a higher price than Microsoft is currently offering.

The Game Isn’t Over, But Its Getting Close

Given Google’s large head start in the market, and Microsoft and Yahoo!’s tepid outlooks, TBR thinks it will be very difficult for either to have a real impact in the online search market during 2008. Over the past year both Microsoft and Yahoo! have lost share in the U.S. search market, while Google increased its dominance of the market. Google’s U.S. Internet search market share increases from 51.7% in 4Q06 to 58.4% during 4Q07, while Yahoo declined from 27.6% to 22.9%, and Microsoft’s share fell from 10.4% to 9.8% according to comScore.

Google is already well on its way to monopolizing the Internet search market, and a combination of Microsoft and Yahoo! may be the only way to present a serious challenge to Google in the Internet search market.