Microsoft and Yahoo: the ten-year search agreement

Two days ago MSFT and YHOO announced an agreement to pool their web search resources for ten years.  In general terms, MSFT will provide the search technology through its Bing search engine, YHOO will sell the service to potential advertisers.  At the end of the first five years, the terms of the deal are subject to a reset, but the companies didn’t say by how much or at whose option.

YHOO expects to have extra cash flow of $275 million a year from the deal.  MSFT said little other than it expects to spend several hundred million dollars in the initial years.  Let’s say this means $2.75 billion (around $2 a share) for YHOO and that MSFT breaks even for the decade-long partnership.

Several aspects of the deal and its announcement are worthy of note:

The most obvious is that this is a far cry from the $40+ billion offer MSFT made for YHOO less than two years ago–and that YHOO rejected as being too low!  This implies a drastic reassessment of their futures by both sides.

The announcement itself was very unusual.  Typically, corporate announcements to the investing world have a large dose of factual information and a smaller, usually very restrained, effort to persuade Wall Street that it is finding out about something good.  Not in this case.  I can’t recall having seen an announcement more heavily tilted toward marketing and away from numbers than this one.

Carol Bartz, the new CEO of YHOO, did add some humor to the proceedings.  She had recently said she would not do a search deal with MSFT unless YHOO got “boatloads of cash” upfront.  She is now saying instead that YHOO is receiving “boatloads of value” from MSFT.  She acknowledges that there is a difference between the two formulations.  But she explained that in her view brokerage house analysts don’t have the cognitive resources to understand a complex business deal, and she was trying to, in effect, dumb it down to terms they would have a chance at grasping.  I’m sure that won her a lot of new friends.

When a material event occurs for a company, like an important new contract that investors and the SEC should know about, the firm is required to file a form 8-K with the SEC.  It has four business days to do this.  YHOO filed one on Wednesday.  So far, MSFT hasn’t.  Assuming, as I do, that they won’t, the message from MSFT must be that this is not a big deal for them.

Since the deal’s announcement, MSFT is basically unchanged in a market that’s up about a percent.  YHOO, however, is down about 15% on 4x-5x normal volume.

As I see it, the market reaction in YHOO’s case is sensible, despite the comments from Mr. Ballmer to the contrary.  Any lingering hopes that YHOO would be taken over have been dashed.  And the search business has shown itself to be worth far less than the market (abetted by the MSFT bid) had thought.

The MSFT case is more complicated, I think.  There must be some relief that the company is not going to make an expensive acquisition.   On the other hand, MSFT might well have been able to buy at $20 a share a firm it was willing to pay $30+ for in 2008.  Did MSFT very badly misanalyze the YHOO business last year?  Has it deteriorated in a way that MSFT hadn’t anticipated, so that it is thanking its lucky stars it couldn’t pull the takeover trigger?

The other possibility is that it is MSFT’s assessment of its own position that has changed, that it no longer feels it has the luxury of spending, say, $25 billion to acquire YHOO  ..or that it can’t afford the disruptions that integrating YHOO could cause.  After all, two years ago netbooks were a curiosity, GOOG hadn’t announced its Chrome operating system, smartphones weren’t so dominant.  Now they’re big threats.

The cliche would be to say that the truth is somewhere in the middle.  As an investor, though, in order to want to hold MSFT it”s the second issue–that MSFT is worried it might need the money–that you have to come to terms with.  No one seems to be worried about this, which makes it doubly threatening (since it’s not yet incorporated into the stock price).

I have no opinion.  That’s enough to keep me on the sidelines.

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