Yahoo's High-Stakes 'No Thanks'

Whether Yang & Co. want to stay independent or are holding out for a higher bid, their rejection of Microsoft's offer is fraught with risk
A Yahoo billboard on Sixth Street in San Francisco. David Paul Morris/Getty Images

Web pioneer Yahoo (YHOO) has resisted the urge to merge with Microsoft (MSFT) for more than a year. But with its latest refusal Yahoo is playing a dangerous game.

Founder and Chief Executive Jerry Yang says that Microsoft's Jan. 31 bid, worth $44.6 billion at the time, "substantially undervalues" Yahoo. In a statement released Feb. 11, Yahoo's board cited the company's "global brand, large worldwide audience, significant recent investments in advertising platforms and future growth prospects, free cash flow and earnings potential, as well as our substantial unconsolidated investments." Microsoft, the argument goes, is seizing on the drop in Yahoo's stock to buy the company on the cheap.

Yang and Yahoo are hoping Microsoft will sweeten a bid that was 62% higher than Yahoo's Jan. 31 stock price. But a backfire in the gamesmanship could lead to a phalanx of shareholder lawsuits arguing the board is placing its interests ahead of those of investors. Typically, shareholder suits argue, in part, that directors prefer independence to protect their well-paying board seats.

In fact, the legal battle has already begun. When Microsoft made its public bid for Yahoo, CEO Steven Ballmer disclosed that he had proposed acquiring the company more than a year earlier, only to be rebuffed. That disclosure triggered a shareholder lawsuit last week in Santa Clara County (Calif.) Superior Court that accused Yahoo directors of failing to negotiate with Microsoft, and of entrenching themselves in order to continue to receive their board compensation.

Would Microsoft Offer More?

To be sure, Yang's letter is certainly part of the ritualistic mating dance common to unsolicited takeover bids. But in this case, it's also a high-stakes gamble. By all accounts, Yahoo has no other suitors, certainly none at Microsoft's lofty valuation. If Microsoft were to walk away, rather than increase its bid, Yahoo's share price would inevitably drop back from the 29.20 it closed at on Feb. 8 into the high-teens, where it traded before the offer. That would set off an avalanche of lawsuits with far more meat than the recently filed Santa Clara County case.

What's more, Yang & Co. also have to worry about the state of the U.S. economy, which seems to be spiraling toward a recession. That would likely dampen online advertising prospects, which would hinder Yahoo's hopes to rebound on its own. In the most recent quarter, Yahoo's profits fell 23%. Yang may believe he can keep the company independent. But it's just as likely that he's hoping for Microsoft to boost its bid. Microsoft is a moneymaking machine, adding more than $1 billion a month to its cash holdings, which hit $21.1 billion Dec. 31, from its twin dominant Windows and Office software properties. And while Microsoft plans to borrow funds to close the deal—a first for the company—its credit quality is presumably so strong that the debt won't be particularly costly. Moreover, when Ballmer announced the deal, he also stressed the importance of closing quickly, with search leader Google (GOOG) getting stronger by the day. That, too, may argue for bumping up the offer.

How high could Microsoft go? Some analysts have speculated that Microsoft is prepared to bid into the mid-30s, though Yahoo could be seeking as much as $40 a share. That would be a nearly one-third bump over Microsoft's initial bid. With Microsoft's stock sliding 12% since making the offer, to 28.56 on Feb. 8, it's hard to imagine the company boosting its cash-and-stock offer by that much. Microsoft didn't immediately comment on Yahoo's rejection.

Yahoo doesn't set a minimum price in the letter, but the board clearly is mindful of recent investments that include last year's purchase of the outstanding shares of Right Media, which handles Web-ad placement, and the March, 2005 acquisition of popular photo-sharing site Flickr. Yahoo and analysts have valued the company's holdings in China's Alibaba, Yahoo Japan, and Gmarket in Korea alone at about $10 a share.

Proxy Fight Ahead?

Microsoft's other alternative is to play hardball and take its case directly to shareholders. Microsoft is no stranger to playing rough. Indeed, making its bid public, even in the polite tones of Ballmer's letter, was an aggressive tack that forced Yang into a corner.

Consider the threat Ballmer laid out in his Jan. 31 letter to Yang. "Depending on the nature of your response," he wrote, "Microsoft reserves the right to pursue all necessary steps to ensure that Yahoo's shareholders are provided with the opportunity to realize the value inherent in our proposal."

What steps? The most likely is Microsoft nominating a slate of directors to Yahoo's board who would be partial to its bid. And the timing of the offer suggests that Microsoft is preparing to do just that. That's because, according to Yahoo's bylaws, shareholders have a 30-day window, starting Feb. 13, to nominate candidates for election to the company's board at the annual meeting. It's a powerful option since all 10 of Yahoo's directors are up for election this year; Microsoft could take control of the company through a proxy fight.

State of the Shares

The outcome of such a battle, of course, depends on shareholder sentiment. But there are already signs that Yahoo investors are weary of the company's sagging fortunes on Wall Street and are keen to taking Microsoft's money. Eric Jackson, a management consultant, launched a small but well-covered "Yahoo Plan B" last year that sought, in part, to oust former CEO Terry Semel. He has just launched a new campaign calling for shareholders to negotiate with Microsoft directly. "This board is playing chicken with our shares," he says. "We're not going to sit back and watch the stock price crater to $17."

Jackson is but one voice, and it is unclear how many shares he represents. But Microsoft would likely find support elsewhere, particularly from hedge fund managers who presumably have jumped into Yahoo shares since Microsoft made its public bid. About half of Yahoo's shares have turned over since the offer, and it's a fair assumption that much of that comes from speculators looking to arbitrage. If so, those aren't investors planning to hold the shares long-term, betting on Yahoo's independence.

Yang is fighting Microsoft's courtship. But it appears less and less likely that he'll keep Microsoft at bay.

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