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And the bidding for Yahoo begins


The maneuvering to take control of Yahoo is now underway: according to Bloomberg, private equity firm Silver Lake Partners, in conjunction with Microsoft, the Canada Pension Plan Investment Board, and venture capital firm Andreesson Horowitz have reportedly made a bid to acquire as much as 15 percent of Yahoo for some $16.60 a share, a value about 6 percent higher than Yahoo’s stock price at the close of markets on Tuesday. In all, the transaction would total up to $3 billion, and places the market value of Yahoo at more than $20 billion. Yahoo’s board is meeting today, likely to discuss the offer and other investment or sale possibilities.

If the reports are accurate, the Silver Lake bid does not represent an effort to take over Yahoo in its entirety: instead, Silver Lake and its partners would buy a significant stake in the company and (presumably) get some seats on Yahoo’s board of directors. Yahoo’s board has been widely criticized as one of the least effective in the industry—it’s likely anyone purchasing a minority stake in the company would want representation on the board. Yahoo is also still casting about for a CEO: the company is currently being led by former CFO Tim Morse in an interim capacity since the ouster of Carol Bartz last September—some speculation is looking to Marc Andreesson to step into the board chairmanship, with former OpenTable CEO Jeff Jordan as a candidate for Yahoo CEO.

Silver Lake and its partners aren’t the only potential investors eyeing Yahoo: recent reports have had Thomas H. Lee, Bain Capital, TPG Capital, the Blackstone Group, KKR, and even China’s Alibaba considering significant investments in Yahoo.

What is going on here? As far as most Internet users are concerned, Yahoo lost its luster years ago and all the action has shifted to social networking, online shopping, and mobile—areas where Yahoo has famously failed to execute. What do investors see in Yahoo—and can Yahoo return to its former glory?

Why buy Yahoo?

The basic argument for buying Yahoo is that, despite the fact its days of being a hot Internet-defining brand seem to be long behind it, the company still commands a substantial audience. Some 600 million Internet users still use Yahoo services, whether that’s Yahoo Instant Messenger, setting up custom My Yahoo pages, or using services like Yahoo Mail and Flickr. Yahoo also still has a significant share of the U.S. and worldwide search market: although the back end is powered by Microsoft’s Bing, Yahoo handles ad sales and designs the front end of its own search offering: according to comScore, Yahoo represents 15.2 percent of the U.S. search market, still ahead of Microsoft’s Bing-based offerings with a 14.8 percent share.

All that audience translates to ad impressions, advertising purchases, and search keyword sales—and those are the core of Yahoo’s revenue. Yahoo’s financial results for the third quarter of 2011 (PDF) show display advertising revenue of $502 million for the quarter, with search revenue of $467 million (both using GAAP accounting methods—the results are lower if you figure in money Yahoo spent to acquire traffic). In essence, that means Yahoo quarterly revenue is in the neighborhood of $700 million to $1 billion, with free cash flow in the $250 range—which is enough cash flow to attract a significant number of investors.

And Yahoo does have a few bright spots in its operations: despite the departure of its founders, Yahoo’s Flickr photo-sharing site remains the leading photo community on the Internet, even though Facebook has long since eclipsed it as the largest online photo repository. Millions of people still rely on Yahoo Mail, and Yahoo Shopping has managed to gain some traction.

Yahoo also has a few other assets in its portfolio, including 40 percent stakes in both China’s Alibaba and Yahoo Japan. Although Yahoo’s operation in the United States may not be showing much revenue growth, Alibaba is showing marked success in China—which is both the world’s largest and fastest-growing Internet market. Of course, the downside is that Yahoo’s relationship with Alibaba and its head Jack Ma has often been fractious—nonetheless, those investments currently represent a significant portion of Yahoo’s revenue growth potential, and the only real way for investors to set hands on them is to buy into Yahoo.

Yahoo has repeatedly indicated the company is “not for sale,” but company leadership has been almost flagrantly public about reviewing its options and considering the sale of at least portions of its businesses. In part, exploring sale options is an effort to raise capital and return some value to investors: after all, Yahoo’s stock price has plummeted from a high of $33 a share four years ago to under $15 a share before Thanksgiving—a figure it’s been hovering around for more than two years.

Yahoo’s current strategy seems to be offering a minority stake of just under 20 percent of the company using PIPE transactions—Private Investment in a Public Equity. If Yahoo keeps the proportion of the deal under 20 percent of the company, Yahoo’s board of directors can approve the deal without putting it to a shareholder vote. PIPE transactions are generally considered the province of less-than-reputable companies: they’re essentially a strategy that allows major changes in company ownership without shareholder approval. If Yahoo conducts such a transaction, it’s almost certain to further alienate its investors—unless it can generate tremendous amounts of cash from the sale.

The offer of $16.60 per share for a 15 percent stake in Yahoo from Silver Lake and its partners seems to represent a bet that Yahoo can turn around its core business. Although the investment would likely involve leadership changes and a shakeup of the company’s board—and, likely, pruning of Yahoo’s business—the deal would also deepen Microsoft’s ties with Yahoo. Microsoft is currently the backend operator of Yahoo search, and has been pumping money into Yahoo has part of that deal—last quarter Microsoft paid yahoo $53 million under the terms of their search agreement. However, Microsoft’s total reimbursements to Yahoo for search are capped at $150 million—a limit that has now been reached. Allowing Microsoft to continue pumping money into Yahoo—even indirectly through an investment group—keeps Yahoo’s books in better shape. It also potentially gives Microsoft greater access to Yahoo’s 600 million users—something that may be particularly lucrative as Microsoft works to integrate the Skype VoIP service into its platform and offerings. It’s important to note that Silver Lake—the same group floating this proposed buy-in to Yahoo—is the same company that led the effort to buy Skype from eBay…and then flipped it to Microsoft less than two years later for a very handsome profit.

From an investor’s point of view, however, the $16.60 per share offer from the Silver Lake group has to be a bit underwhelming. It represents only a six percent premium over Yahoo’s share price at the time the deal was made—a figure that doesn’t seem like much of a benefit for selling such a large stake in the company. Moreover, investors who have been looking at Yahoo recently have been hoping for a much larger return on their investment, pending the sale of the entire company or at least Yahoo’s Asian holdings, which should be able to command a premium. The Silver Lake offer does not represent a takeover of the entire company, nor a liquidation of Yahoo’s Asian assets, nor a substantial payday for investors. In short, it could go over like a lead balloon.

Yahoo may have other options. Yesterday, Reuters reported that investment house Thomas H. Lee is considering a leveraged buyout of Yahoo’s U.S. operations. A leveraged buyout would mean going around the board of directors and appealing directly to Yahoo’s shareholders to approve the deal. Although there’s no word on how much Thomas H. Lee might be willing to pay—numbers of $5 to $6 billion have been mentioned— it would have to be an enticing offer to get a majority of Yahoo’s shareholders on board—although perhaps not overly enticing, given that Silver Lake is willing to offer only a six percent premium for a minority stake. Thomas H. Lee’s interest in Yahoo seems to be in managing its U.S. operations similar to the way it handles other media outlets like Clear Channel, Univision, and Nielsen. And, although it’s not clear, such a sale woud presumably leave Yahoo with its international operations, Asian assets, and a heap of cash.

At the same time, Silver Lake may have some competition: venture firm TPG Capital is reportedly considering topping Silver Lake’s offer by $1 a share, implying Yahoo might be able to generate a bidding war for a minority stake.

Another player might be Jack Ma and Alibaba. Last month Jack Ma indicated he might be “very interested” in buying up Yahoo, likely partly due to Yahoo’s enormous range of international properties—that could enable Alibaba to more easily expand to markets outside China. Although Ma’s initial enthusiasm was apparently quickly quelled by U.S. investment regulations that would require a detailed review of the acquisition of a U.S. firm buy a Chinese company—particularly since political relations between the countries are strained—AllThingsD reports Jack Ma is moving forward with working out a deal with Japan’s SoftBank and U.S. private equity firms (perhaps including BlackStone, Bain, and Providence Equity Partners) to make a bid. Ma has indicated his patience with trying to work out a deal for Yahoo is limited, but Alibaba has repeatedly tried to buy out Yahoo’s 40 percent stake in the company—a move Alibaba might be able to force through if Yahoo can’t generate sufficient investor interest from other quarters.

Bottom Line

Yahoo is walking a very fine line: it wants to bring in additional capital and make yet another effort to refocus its business and jumpstart revenue growth—but it wants to do it without sacrificing control of the company, its Asian investments, or selling off any of its crown jewels.

Selling up to a 20 percent stake in the company may be a way for Yahoo to bring in short term cash. However, it may not be much cash unless Yahoo can execute on a solid business plan and break away from the passivity and indecision that seem to have hamstrung Yahoo leadership (and particularly its board) in recent years. Otherwise, Yahoo will likely continue on the same path it’s been following since being sideswiped by Microsoft in 2008: dying by degrees.

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