Why it’s still too early for Yahoo shareholders to count their chickens

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Wall Street may be irrational, but it isn’t that irrational.

It’s been clear since Google walked that a search deal with Microsoft is the only way for Yahoo to make a meaningful difference to its performance in the short- or medium-term (notwithstanding the swingeing job cuts that took effect today.)

Nor is Microsoft hiding its intentions: after the last debacle, Steve Ballmer has, rightly, decided to be perfectly direct about his continuing interest, while at the same time stopping short of applying the thumb-screws to Yahoo again – at least for now.

Today, Ivory Investment Management, a hedge fund with a 1.5 per cent stake in Yahoo, called on the company to just get on with it and do the deal, arguing that it could push the Yahoo share price to $24, or even to $29 if Yahoo uses some of the extra cash to buy back stock.

Ivory’s back-of-the-envelope calculation: Microsoft can afford to pay $15bn upfront without diluting its own earnings, which would be worth $9bn to Yahoo after tax. Also, with a share of future revenues from the search traffic Yahoo sends Microsoft’s way and with cost savings, Yahoo could see its earnings (in ebitda terms) rise by $500m a year.

If so, then why are Yahoo’s shares changing hands for only $13.40, even after the 10 per cent bump they got today (itself irrational, since Ivory does not have the influence to force Yahoo’s hand)? Clearly, Ivory has every interest in talking the share price up, but here are a few good reasons to discount its case:

Market share and monetisation. If Yahoo throws its lot in with Microsoft, it will be entirely dependent on the software company to maintain a competitive search engine and search advertising system. The Ivory calculation assumes Microsoft would actually generate 20 per cent higher revenue per search than Yahoo has managed on its own. Failure would undermine Yahoo’s future income from search, and Yahoo would be tied at the hip to Microsoft and unable to shop its business around (i.e. to Google), so it makes sense to apply some sort of discount to these assumptions.

Bargaining power. Why should Microsoft pay $15bn when there are no other buyers? Since May, when Microsoft last proposed a search deal, the bargaining power has shifted dramatically, even if Microsoft’s long-term strategic need is the same.

Yahoo’s new CEO. It’s hard to imagine Yahoo resisting a serious offer for its search business. Still, the company seems intent on hiring a new CEO quickly, and that person will have a big say in where it goes from here.

A search deal with Microsoft is still the most likely outcome. It’s just that the messy history between these companies and the shift in bargaining power make Wall Street’s continued caution the most rational stance.

Update: To settle litigation from some of its shareholders, Yahoo has amended a controversial severance plan for executives that had been criticised as a “poison pill.” The original plan could have made it more expensive for opponents to mount proxy battles against the company. (The changes are discussed in this transcript of a teleconference held earlier this week by the Delaware judge overseeing the case.)

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