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Apr 28, 2009

Analyst changes tune on a Microsoft-Yahoo deal

Stephen Shankland

Updated 10:30 a.m. PDT with comment relating to Yahoo's new management.

Throughout 2008's on-again, off-again talks between Yahoo and Microsoft, many financial analysts declared the belief that some sort of deal--either Microsoft acquiring Yahoo outright or later just its search business--was a matter of when, not if. One report released Tuesday, though, shows at least one change of view.

Jim Friedland of Cowen & Co. said the relative financial results of Yahoo and of Microsoft's online-services business (OSB) gives Microsoft a bad bargaining position. Specifically, he said operating revenue from advertising dropped 16 percent annually for Microsoft in the first quarter of 2009, compared to a 12 percent drop for Yahoo and a 5 percent increase for Google.

"OSB's profitability has deteriorated substantially due to ballooning depreciation from underutilized data center capacity combined with unprofitable ad deals whose already poor performance has been exacerbated by the recession," Friedland said in a research note. "We believe Microsoft's underperformance in the Internet business limits its options in negotiations with Yahoo, and we have updated our view of the likely outcomes: (1) no deal--70 percent probability; (2) a search-only deal--10 percent probability; (3) an exchange of Microsoft OSB and cash for a large stake in Yahoo--15 percent probability; and (4) a purchase of 100 percent of Yahoo--5 percent probability."

Compare that to Friedland's October opinion, which predicted three possible deals: "In our view, Microsoft is unlikely to allow increasing OSB operating losses to continue in perpetuity, and we expect the company to implement one of the following strategies within the next 18 months: (1) the purchase of 100 percent of Yahoo; (2) the purchase of Yahoo's search business; or (3) the exit of its online-ad and access business, potentially by exchanging MSN/Live.com for a minority stake in Yahoo."

In addition, Friedland added in an interview Tuesday, the arrival of Yahoo Chief Executive Carol Bartz also may make things harder for Microsoft.

"The previous management team bungled Microsoft's generous acquisition offer last year. Yahoo's old management may have been more open to a search-only deal to create a near-term value driver for shareholders in order to compensate for its initial mistake," Friedland said.

"We believe that new CEO Carol Bartz will consider all potential transactions. However, Yahoo is in a solid financial position and Bartz is negotiating from a position of strength. Yahoo has a number of competitive challenges, but it doesn't need to do a deal and there are some serious strategic risks to selling its search asset," he added.

Regarding a search-only deal specifically, Friedland was skeptical.

"In order to get a search-only deal done, we think Microsoft would be forced to offer Yahoo high guaranteed minimum payments and pay a high traffic acquisition rate," the ad revenue shared with Yahoo, he said. "We also believe that the integration of the Yahoo-Microsoft search assets could be challenging. Further, a search-only deal could initially result in an increase in Microsoft OSB's operating loss."

What, exactly, is behind Friedland's assessment of Microsoft's online weakness?

"Microsoft OSB generates a run rate operating loss of $2.3 billion and has been unprofitable for the past 13 consecutive quarters due to: (1) the signing of unprofitable ad partner and toolbar distribution deals with companies such as HP, Facebook, and Verizon Wireless; (2) aggressive spending on R&D, which has not yielded any killer apps...; (3) expensive marketing initiatives, like Live Search Cashback, that have not reversed share loss; (4) an aggressive build-out of data centers ahead of demand that has not materialized; and (5) a secular decline in high-margin dial-up revenues."

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