Microsoft-Yahoo: Motivated Buyer Yet?

With Google and AOL in the picture, Microsoft faces pressure to raise its offer before Yahoo! can seal a deal that spoils Redmond's takeover bid

Yahoo! investor Larry Haverty has newfound respect for the man who runs the company whose shares he owns. Yahoo (YHOO) CEO Jerry Yang earned those props after Apr. 9 reports showed his company has been hard at work crafting alternatives to the Microsoft (MSFT) takeover attempt that it has rebuffed.

In one scenario, Yahoo is testing what it hopes will be a margin-boosting partnership with Google (GOOG). In another, the company is discussing a possible combination (, 4/10/08) with Time Warner's (TWX) AOL.

Haverty doesn't think either plan will keep Yahoo out of Microsoft's clutches. But they will, in Haverty's view, force Microsoft to hike its bid. "I did not know what was in Jerry's playbook and I like the play," says Haverty, a portfolio manager at Gamco Investors (GBL). "At the end of the day, pursuing other deals is how you make the most money for your shareholders."

Sweeter Offer Almost Certain

Analysts and investors had already been speculating that Microsoft CEO Steve Ballmer and his board would be forced to sweeten the company's cash-and-stock offer of $31 a share. The reports that Yahoo has made progress in exploring other options makes it almost certain. "Yahoo is doing the right thing," says Shahid Khan, a partner at Princeton (N.J.)-based IBB Consulting Group, adding that Microsoft is still the best option for investors. "If I were Microsoft, I would increase the bid and make a deal that Yahoo cannot refuse."

Many analysts are now betting that Microsoft could raise its bid to as much as $35 a share. Yang's actions, they say, prove Yahoo had more strategic options than anyone—especially Microsoft—had previously believed. The prospect of a deeper ad-revenue partnership with Google alone is enough to scare a few more dollars from the company, analysts say. "We continue to believe that [a Microsoft-Yahoo] deal is the most likely outcome and continue to believe that it will happen at a higher price than the initial $31 bid," wrote Citigroup (C) analysts Mark Mahaney and Brent Thill in a note to investors.

Microsoft has proved unwilling to up its bid, which was made public Feb. 1. In a public letter to Yahoo's board, released Apr. 5, Ballmer argued that Yahoo's unwillingness to seriously negotiate with Microsoft could ultimately hurt shareholders and result in a lower offer. "By any fair measure, the large premium we offered in January is even more significant today," Ballmer wrote then. "If we are forced to take an offer directly to your shareholders, that action will have an undesirable impact on the value of your company from our perspective which will be reflected in the terms of our proposal."

Putting Pressure on Microsoft

Yang responded in a letter, reiterating that Microsoft's bid was too low. The more meaningful response, of course, came days later when news leaked that Yahoo is discussing a deal involving a cash infusion from Time Warner in exchange for a stake in a combined Yahoo-AOL. Yahoo also said it had agreed on a trial basis to have Google handle sales of a small portion of advertisements for placement on Yahoo's site, an arrangement that could reduce expenses and boost revenue and make Yahoo a more attractive target.

Both proposals are widely considered inferior to the Microsoft offer, and come with respective financial and regulatory hurdles. Still, they put pressure on Microsoft to close the deal quickly before Yahoo can enter into any agreement that would impede Redmond's ability to acquire the company. "The outcome is quite easy to forecast: Microsoft will purchase all or most of Yahoo," says James Owers, professor of corporate finance at Georgia State University's Robinson College of Business, who follows media mergers. "I'm not seeing the kind of value in the AOL deal as in the Microsoft deal." According to a report in The New York Times, Microsoft is in talks to make a joint bid with News Corp. (NWS). Under that scenario, Microsoft would combine its Internet operations with Yahoo and News Corp.'s MySpace social network.

Of course, Microsoft could surprise analysts by withdrawing its offer, even temporarily. In that event, investors hoping for a higher Microsoft bid would likely respond by selling the stock, weakening Yahoo's future bargaining position.

By the same token, the move could push Yahoo further into the arms of Google or AOL. Either scenario could cost Microsoft more in the long run than a few billion dollars now.

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