What Now For Microsoft?

We sold our shares of Yahoo the week before last when the price hit our safety stop, which we were forced to place by the uncertainty surrounding a deal with Microsoft.

Microsoft CFO Chris Liddell said in the April 24 conference call: “Our initial offer was an extremely generous [one]…. The strongest argument that I’ve heard on why we should increase our bid, simply that we can afford to, is not one that I favor. We’ve yet to see tangible evidence that our bid substantially undervalues the company.”

In response to Mr. Liddell’s comments, I sent to subscribers last Sunday:

You can see why investors began thinking that maybe Microsoft will walk away from the deal with Yahoo.

Walking away now doesn’t mean walking away forever, by the way. Remember that Microsoft tried to get Yahoo a year ago. That didn’t work, so it waited a year and tried again. Maybe it won’t work this time, either, but we could see it come back in six months when Yahoo’s share price is $17 and shareholders have so pressured Jerry Yang for missing the chance to get $31 that the deal can happen at, say, $25.

We’re at the end of Microsoft’s deadline, so it has to decide soon whether to up the offer, launch a hostile proxy battle, or walk away.

It has said it doesn’t want to up the offer because there is no reason to do so. It believes its offer is full and fair. Raising the offer now would be odd, and would leave Mr. Liddell with some explaining to do after his comments in last week’s conference call.

A proxy battle looks senseless. It would drag on for months and the very talent that Microsoft seeks to get with Yahoo would flee the situation in droves, going to the open arms of internet firms around Silicon Valley. Both Microsoft and Yahoo would be distracted from their businesses while Google continues going to town.

That leaves walking away looking like a good option.

Should Microsoft cancel the offer and we see YHOO drop like a rock, there’s a small chance we’ll re-invest at lower prices if the partnership with Google looks like it might become something and/or a later offer by Microsoft appears likely.

Despite Mr. Liddell’s saying that Microsoft’s initial offer was “extremely generous,” it got even more generous. On Friday, Microsoft upped its offer from $31 to $33 and it appeared that we’d made a mistake to have sold YHOO the week prior. Then, late last night, Microsoft withdrew its offer entirely.

Steve Ballmer said, “Despite our best efforts, including raising our bid by roughly $5 billion, Yahoo has not moved toward accepting our offer. After careful consideration, we believe the economics demanded by Yahoo do not make sense for us, and it is in the best interests of Microsoft stockholders, employees and other stakeholders to withdraw our proposal.”

Jerry Yang wrote, “This process has underscored our unique and valuable strategic position. With the distraction of Microsoft’s unsolicited proposal now behind us, we will be able to focus all of our energies on executing the most important transition in our history…”

Soleil Securities analyst Laura Martin said she expects shares of YHOO to fall $8 on Monday. Other analysts have predicted a swift return to $19, which would represent a 36% drop from their Friday after-hours price of $29.70.

What now?

Of course, we’re glad to be out of YHOO shares. That’s the immediate reason to raise a glass. Longer term, I continue to think this near match-up between Microsoft and Yahoo makes it clear that Google is the place for online investment dollars. It’s the company that Yahoo is turning to for help in its comeback, and it’s the company that scared Microsoft into offering more than $40 billion for Yahoo.

I think this saga isn’t over yet. I think we’ll see Yahoo struggle for a while longer and I hope very much that it succeeds. Our belief that it could was our reason for investing in the first place. However, Jerry Yang’s 100 days for a turnaround ended a long time ago and we haven’t seen much. The increased shareholder pressure now that the deal with Microsoft is off might light a fire under Mr. Yang — or burn him out of his position entirely.

Regardless, if Yahoo gets back on its feet, it appears that it will do so with the help of Google. That will benefit Google. If Yahoo fails, I imagine that Microsoft will show up again with a lower bid for Yahoo and that it will succeed because Yahoo shareholders won’t let it pass by again.

Through all this, Google’s search share will grow, its progress with gDocs will move closer to offering an alternative to Microsoft Office, and we may even see a downloadable internet-based operating system from Google as the first potential threat to the Windows franchise.

Before the hate mail comes pouring in, realize that I do not expect Google to displace Microsoft before summer is out. That’s not what I’m calling here. What I’m observing is that the Microsoft/Yahoo drama illustrates that the old guard is in a precarious position against the new, and that it gets even more precarious with each passing month.

Clearly, the old guard itself realizes that as well. If Microsoft is to remain a necessary part of computing, it’s going to have to get online applications figured out quickly, build hooks to its online properties into its online applications, and hope that an integrated Microsoft web search capability from within its online application family can gain it some of Google’s growing market share — and the advertising revenue that goes with it.

Microsoft is now facing a future where more is done online than off, and where it has a spotty track record in the areas that matter. It had hoped that Yahoo could help it catch up. With that hope gone, it had better begin reconfiguring itself soon.

With an extra $40 billion in its wallet, the possibilities are tantalizing.

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