Markets & Finance

Marcial: 'An Excellent Deal' for Yahoo


Carl Icahn says Yahoo couldn't afford to keep competing against Microsoft and Google. But many analysts and investors are skeptical about the search agreement

Activist investor Carl Icahn, who has a pivotal 5% stake in Yahoo! (YHOO), is one of the few fans of the much ballyhooed search agreement that Yahoo signed with Microsoft (MSFT) on July 29. "I think it is an excellent deal, and Yahoo CEO Carol Bartz and her team did an excellent job under the circumstances," says Icahn, who has kept silent about the much criticized search deal until now.

"I agree with [Microsoft CEO Steve] Ballmer that the deal benefits Yahoo in that Yahoo gets 88% of the search revenues under the agreement," said Icahn in a phone interview on the evening of July 31.

The veteran stock activist says he has been "a strong advocate of Yahoo doing a deal with Microsoft on the search business" ever since he bought Yahoo stock a year ago. Icahn was mainly responsible for the ouster of former Yahoo CEO Jerry Yang, who had quibbled and eventually turned down Microsoft's hefty offer in early 2008 to buy all of Yahoo for $45 billion. "But that's now under the bridge," says Icahn, "and now Yahoo had to do a deal with Microsoft."

Cost of Competition

Icahn says that, like Ballmer, he couldn't understand the reasoning behind Wall Street's criticism of the deal. "Yahoo can't afford to continue competing with giants Google (GOOG) and Microsoft," says Icahn. With this deal, "Yahoo will be able to partner with Microsoft against Google, and allow [Yahoo] to focus more and spend more on its content business, which is a tremendous growth area [where] Yahoo has a leg up."

"I am pretty happy that we got a deal with Microsoft," says Icahn, who emphasized that the deal will save Yahoo a lot of money in keeping its foothold in the increasingly competitive search business. The cost of competing with Google and Microsoft in search is tremendous, notes Icahn, and this partnership with Microsoft will greatly benefit Yahoo in that sense alone.

"I believe that the partnership with Microsoft bodes very well for Yahoo's long-term outlook and future," he adds. Some Yahoo bulls believe the Microsoft-Yahoo partnership signals more opportunistic ventures for both companies in the future. "Who knows what else will come in the future because of this partnership," says one big investor in both Yahoo and Microsoft.

Yahoo and Microsoft have agreed to combine their search platforms over a 10-year period, with Yahoo adopting Microsoft's Bing search engine and receiving 88% of revenues from ads sold on its sites for the first five years, with a revenue-per-search guarantee for the first 18 months. With the agreement, Microsoft and Yahoo will have about 30% of the search business, still way behind Google's 65%.

Deal Doubters

Many investors and analysts don't share Icahn's enthusiasm. After the agreement was announced on July 29, Yahoo stock fell from 17.22 on July 28 to 14.32 on July 31. On the other hand, Microsoft's stock stayed firm, at 23.47 on July 28 and 23.52 on July 31.

"The terms of the deal were underwhelming," groused Heath Terry, tech analyst at FBR Capital Markets (FBCM), who reiterated his stock rating of underperform after the deal was announced.

"We are increasingly concerned about the strategic ramifications [of Yahoo] losing the direct relationship with major advertisers in years 5-10 that are necessary to promote a combined search-branded offering," says analyst Marianne Wolk of Susquehanna Financial Group, who maintained a neutral stance on Yahoo.

A leading Internet portal with more than 350 million unique users worldwide, Yahoo offers a one-stop shop for a variety of services, such as e-mail and shopping. The bulk of its revenues come from online advertising, mainly from search, branded ads, and classifieds.

Concerns About Yahoo

The Yahoo-Microsoft marriage "doesn't look as exciting after three years of volatile courtship," says Christa Quarles, Internet services analyst at investment firm Thomas Weisel Partners (TWPG) (which has done business with Yahoo). The stock's recent drop, she argues, might make it appear attractive based on 2010 earnings estimates, but it doesn't mean that investors should rush back into the stock.

Quarles gives two reasons why investors may hesitate before wading back in. First, "there appears to be heightened distrust of management," she explains. After a honeymoon period that included comments by CEO Bartz that it would require "boatloads of cash" for Yahoo to agree to a search deal with Microsoft, she says "investors are feeling slighted at what appears to be a lower deal than that offered by Microsoft in July 2008."

The second reason is "fear of what Yahoo management is seeing in its search business trends," says Quarles. The deal doesn't include an up-front payment to Yahoo, an element of prior proposals, and the lack of such a provision prompted investors to sell the stock, says Quarles.

There is also concern that Yahoo's search business may be weakening. "To switch from a power position in the spring to the defensive deal struck could suggest that Yahoo management believes search is a deteriorating asset," asserts the analyst. In particular, Quarles adds, management posted weak search results in the second quarter. And on its conference call with analysts covering the company's second-quarter performance, Yahoo spent little time discussing its investment in the search business, she recalls.

A Lackluster Stock?

In turn, many analysts believe Yahoo will be a lackluster stock over the next six to 12 months. "We think Yahoo's stock will be range-bound," given investor disappointment about the search deal, warns analyst Justin Post of Bank of America (BAC)/Merrill Lynch in a report titled Dead Money on Deal Fallout. (Bank of America has done banking for Yahoo.) The concern, he says, mainly involves Yahoo's financial performance during the interim period before the deal is fully implemented in early 2010.

Says FBR Capital's Terry: "The current valuation premium relative to its growth rate remains difficult to justify" given the competitive environment among consumer portals. His price target is where the stock is right now: 14.

Analyst Mark May of investment firm Needham says "the negatives outweigh the positives for Yahoo" in its deal with Microsoft. Aside from the lack of an up-front payment to Yahoo, one other negative is that management doesn't expect to see the full benefits of the deal until two years from the time it gets government regulatory approval, he says.

Bank of America's Post, who rates the stock neutral, figures Yahoo is more of a longer-term play, as management is building toward revenue acceleration and margin improvement in 2011 and 2012. He says "Yahoo is currently under-monetizing its user traffic," but that its traffic leadership in several categories "could provide significant value to potential acquirers."

The debate about the Yahoo-Microsoft agreement may linger for some time. In the meantime, investors will have to decide whether Icahn is right, and if Bartz made the best move for Yahoo.


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