Why The Investor Proposed Search Deal Is Problematic

Ivory Management, owner of 1.5% or 21.4 million shares of Yahoo, sent a letter to Yahoo’s board of directors suggesting that they sell Yahoo’s search business to Microsoft. In the letter, the firm accuses Yahoo’s board of: 1) failure to maximize shareholder value, 2) mis-executing operationally, and 3) mishandling an offer from Microsoft to acquire the company for $31 per share. They believe a search deal would value Yahoo at between $24-$29 per share. In addition, Ivory believes that buying AOL would not increase shareholder value.

Details of Their Proposal:
• Microsoft acquires all of Yahoo!’s search assets and enter into a perpetual agreement for Microsoft to be the search provider for all Yahoo properties
• Yahoo becomes an affiliate that retains 80% of the revenues generated on their own sites
• Microsoft would become the search engine of Yahoo’s affiliates
• $800mn of duplicate costs would be eliminated
• Potential monetization increase is greater than 47%
• Yahoo receives $15bn in upfront payment from Microsoft
• Yahoo increases its EBITDA by $500mn per annum
• Yahoo losses $1.7bn from its own sites and $450mn from its affiliate sites
• However, it would offset that with $1.6bn in annual TAC from Microsoft
• Yahoo eliminates $1bn in annual costs related to search
• Microsoft increases net search revenues by $1bn per annum, consisting of $100mn of revenue synergies from its estimated $500mn of search revenue, and over $400mn from the retained 20% share of Yahoo search arrangement, and $540mn from Yahoo affiliates
• To achieve these revenues, Microsoft would have to spend an additional $200mn per annum, resulting in a $800mn pre-tax profit to Microsoft
• On an after-tax basis, the $15bn payment would add $9bn to Yahoo’s coffers, leaving Yahoo with $21.2bn in cash and investments and annual EBITDA of $2.4bn, up from $1.9bn today
• Applying a 5x multiple to Yahoo’s EBITDA would result in a $24 share price
• If Yahoo uses to $9bn to repurchase shares at $16, it would reduce the share count by 40%, leaving the remaining shareholders with a share price approaching $30 per share.
• Buying AOL would not enhance shareholder value

This is off course a well thought out proposal that has been supported by most Wall Street analysts following Yahoo and presumably Steve Ballmer himself. This is essentially analogous to a sale-lease back that is common in most business practices and it would avoid any anti-trust issues that may surface with combining the full company (email, IM, etc.) Shareholder activism has worked in the Internet space in the past - with CNET, which ultimately sold out to CBS. I largely agree with the central thoughts of this proposal but have a number of reservations about it.

Here are the problems with the investor’s approach:

1. It leaves Yahoo with a shell business similar to AOL, which the investor called a “declining business”, so ultimately Yahoo’s shareholders do not benefit, unless Yahoo uses the cash to return it to shareholders

2. The latter takes me to my second point, in which the investor states that Yahoo could buy the shares back at $16. If such a deal does come to pass, the shares, as they indicated, would be valued up to $24. Thus, Yahoo won’t have the opportunity to buy back at $16 and won’t shrink the float as much as indicated.

3. Further, the $15bn upfront payment to Yahoo seems like a very aggressive assumption given that Yahoo has a market cap ~$19bn, an adjusted enterprise value of $9bn, and that search is only one half the business.

4. Separating search and display at Yahoo would leave Yahoo at a competitive disadvantage given that advertisers are increasingly looking for holistic solutions and that Google is looking to offer both search and display as a one-stop-shop option to advertisers. Further, Yahoo would not have the in-house engineering talent that it would need/leverage to grow the other remaining parts of its business. It would be tough to operate this way particularly in this economy.

5. I believe that most of the affiliate contracts have change of control provisions that would allow them to get out of the affiliate deals with Yahoo. Thus, most of them would head over to Google given the significantly higher monetization potential. It would just be an economic decision. So a large slice of the $540mn estimate by the investor would disappear, making the deal less valuable. Arguably, this may also happen with a full acquisition of Yahoo.

6. To that point, Microsoft could enter into bidding wars with Google for the affiliates, but that again would be value destructive to Microsoft and make the deal less appealing.

7. I agree that a combined market share would increase the number of advertisers bidding on key words, which would have the net effect of driving up monetization. However, the problem with both companies, relative to Google, is volume. As a combined “search” company, they would still be faced with the problem of taking query share from Google. This transaction doesn’t solve that for either of them. This is the biggest problem.

8. Ichan recently said he was against splitting the company

Given the complexities of such a proposal and that longer-term Yahoo and its shareholders would be at a disadvantage, my view is that Yahoo and Microsoft should go back to the table and discuss a full acquisition.

Full Disclosure: I am neither long nor short Yahoo shares.