Yahoo: Time for Bold Moves?

To repel Microsoft's takeover bid, the Internet giant's options include outsourcing to Google, finding another buyer, or private equity

by Robert Hof

Let's face it: In all likelihood, Microsoft (MSFT) will end up acquiring Yahoo! (YHOO) for a few billion dollars north of the $44.6 billion the software giant offered in an unsolicited bid on Feb. 1. But it's not a done deal yet. And Yahoo co-founder and Chief Executive Jerry Yang made it very clear in a memo to employees that he's serious about looking at alternatives. "Microsoft's proposal is one of many options that we're evaluating," he wrote shortly after the bid was announced.

Those options clearly won't be as palatable to shareholders as Microsoft's bird in the hand. Some might even provoke lawsuits. But Yahoo's reticence has raised the tantalizing possibility that it might make one of several bold moves to stay independent—or at least extract a little more money from its suitor:

• Outsource search advertising to Google.

Among several admittedly unlikely options, this one has the most credibility. As Google (GOOG) keeps commanding a larger share of the search market, now at 56% or more, rumors have circulated for years that distant No. 2 Yahoo might consider throwing in the towel. Citigroup (C) analyst Mark Mahaney reckons Yahoo could boost its cash flow this year by 25%, or $252 million, if it let Google pay it to handle search results and accompanying ads on Yahoo. Yang has recently considered outsourcing at least Yahoo's European search business to Google, according to published reports. Such a deal might well make Yahoo radioactive to Microsoft. Since the software firm's stated goal in pursuing Yahoo is to keep Google from dominating even more of the Internet, it won't want to be locked into a Yahoo deal that would benefit the search giant.

Yet this would be a bitter concession for Yahoo, which has spent several years building a system for placing ads next to search results called Panama that it launched only a year ago. Ultimately, it also could end up hurting Yahoo's advertising overall, because advertisers ideally want to be able to place search and "banner," or online display ads, using the same system. Although such a move is certainly a long shot, Mahaney adds, "We believe the possibility of this outcome is likely greater than the financial markets believe."

• Find a private equity partner to fund going private.

Yahoo has undeniably valuable assets, from its Internet-leading audience of more than 500 million unique visitors a month worldwide to significant stakes in overseas Internet companies such as Yahoo! Japan, China's Alibaba, and Korea's Gmarket (GMKT). Indeed, analysts think those properties combined are worth at least $10 billion of Yahoo's current $40 billion market capitalization. Combine a sale of those assets with even deeper cuts in personnel and capital spending and outsourcing search to Google, and Stifel Nicolaus (SF) analyst George I. Askew thinks Yahoo could earn $2.6 billion in earnings before interest, taxes, depreciation, and amortization in 2008. That's nearly $700 million higher than in 2007—a potential boost that just may be enough to justify a leveraged buyout of Yahoo.

The biggest knock on this notion, says Askew in a Feb. 4 report analyzing this scenario: "The numbers just don't work." Interest expense on $25 billion in new debt would be $2 billion a year, leaving only $600 million a year in profits. That's well short of the margin private equity firms demand to risk that big an investment. What's more, Askew adds, "Microsoft would likely top any competing bid with its own deep pockets and synergies."