Sunday, September 26, 2010


In the August 24 issue, I discussed the history, business climate, and the events that led to Microsoft’s (MSFT) offer to buy Yahoo Inc. (YHOO) in early 2008. In this issue, I plan to briefly discuss the implications of the deal if it had gone through, and what the effects on both companies and the industry would have been.

To begin, many question marks exist concerning the feasibility of the deal. In early 2008, the economy was just beginning to feel the effects of what would become the credit crisis and recession. In late January 2008, MSFT made an initial offer of $31 per share to YHOO management. As I highlighted last time, it was a good opportunity for stockholders that had seen Google (GOOG), Research in Motion, Apple and Amazon soar while YHOO got left behind during the 2000s to cut their losses and walk away. For that reason, many investors, institutions, and hedge funds were pushing for the deal to be consummated. In a clear sign of this, activist investor Carl Icahn took a stake in YHOO and a seat on its board to push for the deal in May, 2008. As far as investors were concerned, there should have been very few hurdles to the deal’s consummation. Obviously, the mandate of any company’s management is to maximize the stock price. YHOO’s management was already engaged in turnaround initiatives, and continually pushed for a better deal because they felt success was just on the horizon. Their overly optimistic projections for the next few years after 2008 were clearly unrealistic, and their unwillingness to bend to MSFT’s advances and the prodding of their own shareholders would prove to be the undoing of the deal.

Looking at the tech industry landscape at the time, an irony of the deal falling through lies in the fact that Microsoft was one of the only, if not the only, suitable partners for Yahoo. To begin, due to the sheer size/market capitalization, there are very few companies within the Internet sector that would have been large enough to acquire Yahoo. Looking at the larger group of companies under the Technology category, if a company such as Hewlett-Packard or Intel was looking to diversify into the internet services sector (an unlikely proposition), then the list can be expanded a bit. Looking at only those firms that were already in the Internet sector, however, MSFT was likely the only one with the financial resources to buy YHOO without using a huge amount of debt, and a small enough Internet search presence that its acquisition of YHOO would not raise the ire of antitrust regulators. As mentioned last time, after the initial YHOO/MSFT proposition fell through, YHOO tried to outsource its search operation to GOOG, immediately triggering the watchful eye of the Justice Department.

Throughout early 2008 and in the two years since, some commentators have suggested that other suitors could have come from private equity and the buyout sector. At the time, this was also an unlikely occurrence. First, in 2008, the LBO sector had just been through a second period of glory, the first of which came during the mid to late 1980s. By early 2008, the broader economy was just beginning to feel the strain from what would become the credit crisis. However, LBO deal volume was already falling as investment banks were already cutting back on lending to their Financial Sponsors clients. That raises the question of whether an LBO could have even been pulled off from the lender’s perspective. Second, from the buy-side perspective, the numbers simply do not add up. Obviously, the private equity firms that would have been able to pull this off either by themselves or as part of a consortium (Blackstone, Texas Pacific, KKR, etc.) are sophisticated investors. Working within reasonable projections for purchase price, debt, and leverage, the prospective returns would likely have not been high enough. With the amount of debt that would have been necessary, YHOO’s cash flow and EBITDA could not have been leveraged enough to make the deal work. Of course, unrealistic projections are not unfamiliar in this case, with YHOO’s management putting forth overly optimistic scenarios at the time of MSFT’s proposition. Either way, in the end the fact that private equity did not get involved could have been due to either the increasing lack of credit, or the conscious decision of such investors to not get involved.

As mentioned, YHOO management was forecasting an overly optimistic scenario going forward due to their still-in-progress turnaround effort that they hoped would come about as a result of these “Panama” initiatives. Their projections were above and beyond what many analysts at the time were projecting. MSFT was well aware of this, and with any merger, this could have led to internal frictions during the integration process. In this case, there may very well have been a higher amount of friction due to the aforementioned factors and another big question mark: the integration of the two companies.

The integration process, if undertaken, would have been very difficult for many reasons. First, the integration of two companies of YHOO and MSFT’s size is a tremendous undertaking. MSFT has nearly 90,000 employees, and YHOO has thousands as well. As is the case with most mergers, there would have been many redundancies on all levels of the company. Second, the integration of the companies’ technologies would have been quite tedious. The “different technologies” were not limited to their Internet search divisions, but everything from advertising systems to HR. This is one point of integration in which the challenges were much deeper than may have initially appeared on the surface.

In addition to the challenges of integration that are seen in any merger, the companies involved here are vastly different in terms of firm culture. Despite the fact that both MSFT and YHOO are relatively young within the grand scheme of the American business landscape (35 and 16 years old, respectively), within the world of computer and Internet technology, this age gap is huge -- MSFT is like a senior citizen while YHOO is middle-aged. As such, both companies have different primary businesses and came of age in very different eras, which translates into a vast difference in corporate culture. While MSFT’s culture is more traditional and formal, YHOO, coming of age during the late 1990s tech boom, embodies the dot-com, Bay Area culture of casual everything from dress codes to intra-office relations. This vast gap would have been very difficult to close during the integration period, and it could have caused difficulties after integration was complete.

Finally, the post-merger company likely would have not affected the overall Internet search landscape very much. Google is still the unquestioned leader in the Internet search category with over 70% of the market. Many commentators have pointed out that MSFT’s Bing will have over 30% of the market once the integration of their search engines is complete. While Bing was gradually eating away at Google’s market share for much of the past year after its initial release, recent figures suggest this may be coming to an end. Either way, it has not made a great difference. For example, I have yet to hear someone say, “I Binged it,” and I’m sure we’ve all said or hear others regularly say, “I Googled it.” As it stands now, MSFT and YHOO’s market share is about 30% and declining. In the event of a full merger, the integration challenges could very well have accelerated that decline.

As of now, it appears that a merger of MSFT and YHOO would not have been a tremendous success for either party, YHOO in particular. For YHOO, while the outcome was not applauded by shareholders at first, the ultimate outsourcing of YHOO search to MSFT’s Bing is a long-term positive for the company. The current search outsourcing deal enables YHOO to focus on its core competencies, while grabbing a healthy percentage of the revenues from MSFT’s Bing search engine. Since YHOO’s stock price declined in 2008 and has remained largely stagnant since, the ultimate outcome of the new arrangement could be a major factor in a future renaissance in the stock price, if other factors come together to make the company successful once again.

Finally, one thing that the deal definitely would not have affected is the M&A market for small tech companies. The large cash reserves of MSFT, YHOO, and GOOG (with MSFT being the only one of the three that pays a dividend), enable all three to be active buyers of small tech companies. A merger between MSFT and YHOO would not have changed that. If anything, it would have made GOOG a bit more aggressive in acquiring small tech firms. The robustness of M&A within the technology sector is perhaps most evident to its being at the forefront of innovation and the evolution of technology as an increasingly important sector of the American economy.

Respectfully Yours,
Matthew R. Green

September 27, 2010