Yahoo: Playing Too Hard to Get

This is the story of a long courtship gone awry, a rebound relationship, and the dashed expectations of those involved with the ill-fated couple. Lest you think you've wandered onto the wrong Web site, we're talking about a couple of companies -- namely Yahoo and Microsoft -- and how Yahoo shareholders have been buffeted by the bizarre merger dance the two have been doing since January of 2007.

That's when Microsoft first turned a longing eye toward Yahoo's Web advertising business, for which Microsoft was willing to pay a premium to compete better against against Google. At one point in May 2008, Microsoft was willing to pay $33 a share, or $47.5 billion, to acquire Yahoo outright -- a 74% premium to the $19 share price commanded by Yahoo when Microsoft publicly opened bidding at $31 a share on January 31 of this year.

Yahoo executives, believing the company worth something more on the order of $37 a share, spurned the May offer, and Microsoft withdrew it, although negotiations continued. Then, on June 12, the bombshell: Talks with Microsoft were over. Instead, Yahoo would partner with Google in a deal that would outsource part of Yahoo's paid search ad business to Google. Yahoo stock (symbol YHOO) plunged 10% as investors mourned the break-up with Microsoft. Yahoo closed at $22.91 on June 18, 30% below Microsoft's highest offer.

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Playing hard to get was a disservice to Yahoo shareholders, says Morningstar analyst Larry Witt. "I really think they had a chance to get at least $33 a share. I don't see anything they can do to make the company worth $33 a share for now. If you're a long-term owner, you'd have a right to be frustrated."

The decoupling of Microsoft and Yahoo occurred despite the matchmaking efforts of shareholder activist Carl Icahn, who took a 4.3% stake in the latter, ostensibly to pressure Yahoo into a deal. Icahn now is waging a proxy fight to oust Yahoo board members, having introduced his own slate of ten nominees. June 18 marks one year to the day chief executive Jerry Yang's returned to Yahoo, the company he founded in 1994 while a graduate student at Stanford University. Now, his hold on the top job is tenuous. Yahoo's annual meeting, delayed from July 3, is scheduled for August 1.

Although Icahn has offered few detailed suggestions about what Yahoo can do to improve its fortunes independently, he was recently quoted by Reuters as saying that he was "continuing to study" the deal with Google "and that it might have some merit."

The deal specifically calls for Yahoo to run ads supplied by Google beside Yahoo search results and on Yahoo Web sites in the U.S. and Canada. Advertisers will pay Google for each click on those ads, and Google will share some of the revenues with Yahoo. Yahoo says the deal represents some $800 million a year in additional revenues and will boost annual cash flow by $250 million to $450 million.

Like most rebound relationships, this partnership is problematic. For one, it will be subject to intense antitrust scrutiny, given Google's already dominant market share in search-related advertising, despite structuring the deal to downplay such concerns. For instance, Yahoo has the option of making similar arrangements with others (like who, skeptics ask) and it will continue developing and marketing its own search-related and display advertising business.

Assuming the deal goes through, Yahoo may be shooting itself in the foot longer-term, says Morningstar's Witt. "If you're an advertiser advertising on both platforms now, but Google starts providing ads to Yahoo, you might not bother placing ads on Yahoo anymore." Fewer advertisers could lower the demand and, hence, the prices for the key words next to which ads are placed, Witt reasons, because prices of those key words are determined by auction.

Analyst Mark May at Needham & Co. minced no words in a recent note to clients: "We believe this deal diminishes Yahoo's relevance among advertisers and strengthens the hand of a key competitor (Google), that this deal could face regulatory headwinds and that there is uncertainty that the target financial gains can be recognized." Having recently upgraded his opinion of the stock on hopes of a deal with Microsoft, May downgraded Yahoo from a "buy" to a "hold" on June 13.

Key Yahoo executives are also giving up on the company, adding fears of a brain drain to other concerns. Recent departures include consumer products chief Jeff Weiner and data strategy guru Usama Fayyad. The husband-and-wife team that co-founded Yahoo's Flickr photo sharing site, Caterina Fake and Stewart Butterfield, are leaving as well.

Indefatigable bulls say Yahoo still has a lot going for it. They say it is a cash cow with little debt, that it is still one of the largest players in an industry that will see robust growth as more and more advertising shifts online, and that its web pages, including Yahoo News, Finance and Sports, are among the most trafficked in the industry.

And a few, including Ben Schachter at UBS Securities, hold out hope that Microsoft will come back. "We continue to believe that, at some point, Microsoft will acquire all of Yahoo," Schachter told clients recently. Eric Jackson, a dissident shareholder who has organized like-minded investors online, says Yahoo "is a broken company with a broken board and a broken senior management team -- but it is salvageable."

Maybe. But for now, the burden of proof -- and almost all of the risk -- is on the bulls. Whether you're already a Yahoo shareholder or someone looking for a tech company for your portfolio, we see better opportunities elsewhere. For starters, you need look no further than Google (GOOG, $562.38) or Microsoft (MSFT, $29.46)