Microsoft’s (MSFT) Key Bargaining Chip—Yahoo!’s (YHOO) Earnings

There have been a number of news reports recently saying that Microsoft (MSFT) and Yahoo! are back in the process of negotiating a combination of their search businesses to take on the industry leader, Google (GOOG). Since Microsoft is a distant third in US market share with less than 10% by most measures, it would seem the likely supplicant. Yahoo! has closer to a 20% share although, as the Wall Street Journal recently pointed out, the portal’s deals to be the primary search tool on PCs from companies like Dell (DELL) are lapsing. This dims Yahoo!’s future and gives Microsoft a critical edge in any conversation about the firms combining their search businesses or Microsoft simply buying Yahoo!’s operation outright.

While the perception may be that Microsoft needs Yahoo! more than Yahoo! needs Microsoft, the theory will be tested when both companies release earnings for the calendar first quarter of 2009. Microsoft releases its numbers on April 23 and Yahoo!’s earnings come out on April 21. Microsoft will wait until after the 23rd to enter any serious negotiations with Yahoo! because it can bank on the fact that the smaller company’s numbers will be weak and perhaps weaker than the market expects.

So far this year the news out of large web sites is that display advertising revenue may be off as much as 30% in the first quarter. A large portion of Yahoo!’s revenue comes from search ads which are almost certainly holding up better than display, but the company’s revenue could still drop 15% or more for the period that ended in March.
In the first quarter of 2008, Yahoo! had revenue of $1.817 billion and operating income of $160 million once one-time items were taken out. The most pessimistic analyst estimates are that Yahoo! will suffer a 20% drop-off in revenue for the first quarter of this year and that EPS will be $.06 compared with $.11 in the same period a year ago. If Yahoo! does drop that much revenue, the sole reason that its earnings will merely fall by half is cost cutting. And, there is only so much of that the company can do.

Microsoft’s online business will do worse than Yahoo!’s, but it has the advantage of being part of a much larger company which has tremendous cash flow from its software businesses. In the first calendar quarter of 2008, Microsoft’s online operation lost $200 million on $623 million in revenue. The fall-off in Internet advertising this year is going to make the loss much worse for the quarter that just ended.

If Yahoo! has revenue of under $1.6 billion for the first quarter, its prospects as a viable, independent company are nearly finished. Even if the new CEO Carol Bartz fires another 2,000 people, it buys the firm only a year. A modest rebound of advertising in 2010 will help Yahoo!, but it is unlikely to produce annual operating income of $1 billion a year going forward. With about $3.5 billion in cash and short-term investments in addition to modest earnings, Yahoo! does not have a significant amount of capital for either M&A or R&D activity.

Steve Ballmer, who has done a great deal of damage to Yahoo!’s management and share price in his negotiations with the company so far, knows that the premium that he will have to pay to get control of Yahoo!’s search business drops sharply if Yahoo! hits the low end of earnings expectations for the last quarter and if they have lackluster guidance for the rest of the year. At that point,Yahoo! won’t be left with a single hole card.

Douglas A. McIntyre