The Wall Street Journal-20080202-breakingviews-com - Financial Insight- A Case for Waiting at Yahoo- Microsoft-s Offer May Seem Too Tempting to Pass Up- But Richer Bid Might Be Had

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breakingviews.com / Financial Insight: A Case for Waiting at Yahoo; Microsoft's Offer May Seem Too Tempting to Pass Up, But Richer Bid Might Be Had

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Yahoo shareholders could be forgiven for wanting to swallow Microsoft's $44.6 billion bid in one gulp. Yahoo has been a train wreck. The stock had declined about 45% in the past two years, and despite replacing its chief, the company has shown little sign of getting back on the rails. But Yahoo's board shouldn't cave in just yet.

Sure, the software giant's $31-a-share offer looks astronomical at first blush. That would deliver a paltry return on the investment for Microsoft of just about 3%. Yet Yahoo could be worth more to Microsoft than these metrics suggest.

Strip out the value of Yahoo's stakes in Alibaba and Yahoo Japan, as well as its cash, and the price for Yahoo's core business falls to some $31 billion. On that basis, Microsoft would be paying 23 times Yahoo's earnings before interest, tax, depreciation and amortization after accounting for stock-based compensation. But factor in the $1 billion in cost savings and the multiple comes down to 13 times.

That gives Yahoo room to negotiate a bump. The question is whether it has the leverage to get a big one. In theory, Yahoo could be worth another few dollars a share if its calcified management is willing to outsource its search business. But that's easier said than done. Microsoft is clearly not going to settle for a search deal when it wants to buy the business outright.

That leaves Google, which would love to monetize Yahoo's millions of eyeballs -- either as an owner of Yahoo or search partner. The trouble is that it would hand Google 74% of the U.S. market. That might have flown a year ago, when regulators' knowledge of the business barely would have fit a Wikipedia page. But Google's purchase of DoubleClick and Microsoft's of aQuantive forced them to scrutinize the industry.

Structuring a deal to appease antitrust watchdogs would take time, during which Yahoo would continue to struggle as the industry's mini- me in the capital-expenditure battle that Google and Microsoft are waging. Yahoo should resist folding right away -- but it should make every effort to elicit a higher offer out of the bidder who can make the most of its assets.

Flabbier Google Rival?

Microsoft needs to search for more than size in advertising. Winning Yahoo certainly could help. Both are reeling from competition with Google. Combine them, and the two might prop each other up. The challenge is to avoid creating a lumbering business stuck in a conglomerate quagmire.

The combo would have a third of the U.S. search market. Advertisers are willing to pay more for sites with lots of users, as are publishers. So combining the two might set off a virtuous circle of higher revenue.

Moreover, the two businesses overlap substantially. One could essentially move all of Microsoft's traffic over to Yahoo's more efficient advertising system and cut a lot of operating costs and capital spending. Or, if the company preferred, it could redirect its research effort into developing new services.

The tricky element is managerial skill. Yahoo has looked rudderless, but Microsoft's advertising prowess hasn't looked that much better. Its online-services business steadily burns cash. Its operating loss was $245 million in the past quarter alone, and this includes profits from aQuantive, which it bought last year.

Microsoft is already on the verge of becoming too big to manage effectively. There may be synergies in combining operating systems, office software and games with online advertising.

Yet Microsoft's distant third-place in search suggests these other divisions hamper its online efforts. Unless Microsoft gives this business more freedom -- perhaps even its independence -- it could just create a bigger, flabbier competitor to Google.

-- Rob Cox, Robert Cyran and Jeff Segal

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This column is by breakingviews.com, an online financial commentary site.