Monday, February 25, 2008

MS-HOO – GOOG Likely to Gain

According to Marianne Wolk of Susquehanna Financial Group, there remains a possibility that MSFT & YHOO might ultimately agree to combine Microsoft’s OBS with Yahoo! into an independent entity that Microsoft could own, all or in part (and possibly trade as YHOO).

Microsoft could potentially go down the path of a proxy fight, proposing its own slate of YHOO Directors. While some experts say Microsoft is prepared to authorize a proxy fight, others opine that the company has hired proxy solicitation group Innisfree M&A Inc. If true, Microsoft needs to file its slate of director nominations with Yahoo!'s company secretary by March 14th. Microsoft has been reportedly approaching prominent Silicon Valley insiders to join its proposed slate of new Directors. Yahoo! does not have a staggered Board, and its Bylaws suggest only a plurality of votes is required to win in a contested election. Microsoft is likely to win a proxy fight, if one is waged, as much of the shareholder base seems to have shifted toward speculators and arbitrageurs that would vote for the Microsoft slate of Directors. To ward off a hostile acquisition by Microsoft (and retain employees), Yahoo!’s Directors voted to award rich severance packages to employees terminated without cause within two years of completion of any merger. This move was aimed at thwarting a proxy fight, making it challenging for Microsoft to achieve its target of $1 bln in synergies in the first year of an acquisition.

Other, less likely, alternative offers for Yahoo! could emerge from News Corp., Time Warner, and private equity (in conjunction with Dan Rosensweig, Yahoo!’s former COO). However, a transaction with Google is ruled out.

While outsourcing search advertising to Google would add immediately to Yahoo!’s bottom-line – perhaps as much as 20% (raising revenue per query by 30-50% and reducing operating and capital expenditures), this would cede Yahoo!’s key advertiser relationships to Google. Long term, outsourcing search ad sales to Google would damage Yahoo!’s branded advertising franchise, because it would: (a) provide Google with meaningful insight to Yahoo!’s user base, their behavior and proprietary company data; and (b) enable Google to target Yahoo!’s users anywhere on the web with its own branded advertising, potentially cannibalizing the premium Yahoo! receives for aggregating significant pools of targetable users on its home page and other high-scale destinations. If Yahoo! proceeds in this direction, it would be mandatory for Yahoo! to invest more significantly into media and content, knowing that it has relinquished its position as an advertising technology and marketing company. Any partnership between Google and Yahoo! is likely to face significant regulatory scrutiny. Together, Google and Yahoo!’s sites generated more than 75% share of worldwide queries (comScore, December 2007), and Goo-Hoo! sold 95% of all search advertising in 2007 (for owned and partner sites). If Google had sold search ads for Yahoo! in 2007, it would have meant Google sold more than 50% of all online advertising that year.

YHOO could persist as a stand-alone company, but if so, might face litigation. If the acquisition does not go through, Yahoo! is likely to see its turnaround plan delayed and even damaged by the Microsoft merger proposal. This is because; Yahoo! is likely to lose critical management focus, momentum, and personnel during this process. Already, the Yahoo! Board has been sued by the Wayne County Employees’ Retirement System and two Detroit public pension funds (Detroit’s Police and Fire Retirement System and General Retirement System) for failing to negotiate in good faith with Microsoft regarding its merger proposal. If no deal takes place – with Microsoft or a White Knight – litigation could become more widespread.

In the interim, many predict disarray at Microsoft OSB and Yahoo! Since the deal was first announced, experts have suggested a growing fear of layoffs. To stave off these concerns, a memo issued by Kevin Johnson (President of Microsoft’s Platforms and Services Division) indicates plans by the merged company to maintain teams in both Redmond and Silicon Valley. While meant to comfort Microsoft’s employees, the fact that the strategic direction for the merger proposal is now led by the Platform and Services Division cannot be lost on Microsoft’s Internet team, which recently experienced a management shake-up (and loss of autonomy). The deal has distracted the engineers at both companies, likely diverting Microsoft OSB from its goals for adCenter, and slowing Yahoo!’s progress in key development areas, such as (a) monetization improvements at Panama; (b) development of an off-site branded ad-serving capability to support its emerging branded ad network; and (c) improved scale and targeting for Right Media. Net, Yahoo! is likely to report weaker than expected Q1 results due to the distractions of the merger.

Due to all these, Google is expected to benefit over the next 18-24 months, providing it a major opportunity to advance in branded advertising. Microsoft expects the transaction with Yahoo! to close in the second half of 2008, assuming an imminent agreement from Yahoo! and regulatory approval. If instead Microsoft is forced to acquire Yahoo! via a proxy fight, it would mean a more protracted closing process. In this instance, Microsoft will have to wait for the annual shareholder meeting in June to elect its slate of Directors and push for merger approval. Then, the transaction might not close until early 2009, when it would begin the complex integration of Yahoo!’s 14,300 employees, multiple advertising platforms, technology infrastructures, content sites, culture, etc. Thus, Google may not face a more competitive Microsoft-Yahoo! until 2010. While its competitors get sidetracked, Google should see: (a) increased success in hiring top engineers from Microsoft and Yahoo!, as they fear for their jobs in a consolidation; (b) strong gains in search traffic partners (on the heels of 4Q07’s win with Orange/Wanadoo) from both new wins and renewals as publishers seek to optimize near-term monetization; (c) a near-clear period to extend its lead in search monetization; (d) a major lead in emerging growth areas, such as video advertising, mobile, and local advertising; and (e) a window of opportunity to expand its role in display advertising (buoyed by its likely 2Q08 acquisition of DoubleClick), while its two leading competitors are in disarray.
Thanks Marianne Wolk, Susquehanna Financial Group, February 2008