Full Disclosure Finance

By Andrew,

Unless you have been living under a rock for the past 2 weeks you probably have heard about the Microsoft offer for Yahoo!. After what has seemed like endless speculation, Microsoft finally announced that they are officially pursuing a deal for internet conglomerate. The unsolicited offers has Microsoft paying $42 billion dollars or approximately $31 per share for Yahoo!, representing a 62% premium to Yahoo’s previous day closing price. Since the news Yahoo’s share price has risen over 50% to almost $30 while Microsoft’s has fallen nearly 13% to $28.50, Google chimed in playing the anti-competitive card, Yahoo! officially rejected the offer saying that they are being grossly undervalued, and there has been speculation that other potential suitors may want to join in on the party.

In my opinion this has created an excellent buying opportunity in Microsoft. This was a $37 dollar stock as recently as the end of December. At $28 Microsoft is trading at 16x trailing earnings and just 13.5x forward earnings. People seem to forgot that the company absolutely destroyed earnings the previous two quarters. The knock on the proposed merger is that Microsoft may have issues consolidating Yahoo! into its business. Microsoft has been down this road before, maybe not on such a large scale but they know what they are doing. This is what everyone has been expecting them to do…make a move to challenge Google in the internet/search business. The 62% premium may be large but let’s not forget that Yahoo! was trading nearly 40% off its highs from last year. So its not like they swooped in when Yahoo! was at an all time high. Microsoft saw a great, yet poorly managed, franchise at a discounted price and identified an opportunity for them to get into a market that they’ve wanted to get in for a while now. I think this is a great move for Microsoft. When this all gets done, Yahoo! will add a great deal of value to the Microsoft franchise that already is doing very well.

I have been hearing a lot of people recommend buying Yahoo! even after the news of the deal. I don’t agree. To me it seems that an investment in Yahoo! comes with a capped upside and quite a bit of downside. Let’s think about the potential scenarios. The first and most likely scenario is that the deal gets done at somewhere between $34 and $36 per share. In this case your upside is limited between 13 and 20%. Even if the deal gets pushed up to $40, which I think is very unlikely because Yahoo! doesn’t have much leverage in these discussions, the upside is capped at 33%. Now don’t get me wrong, 20% is a great return in a short period of time but this is assuming the deal gets done. If Yahoo! decides to play hard ball and Microsoft walks away, Yahoo! stock falls back to $20 or possibly lower. Same thing if the deal runs into problems with regulatory approval. With Microsoft trading at a 13% discount from when they announced the offer and 23% from the high at the end of December, I think the buy is Microsoft. Even if they walk away from the deal Microsoft is still the company knocked earnings out of the park the past two quarters. When the deal does get done and the Yahoo! synergies start to hit Microsoft’s top and bottom line their share price should follow.

Disclosure: None