Yahoo says no to Microsoft

By Elizabeth Strott

Yahoo (YHOO, news, msgs) isn't biting.

The Internet company this morning rejected Microsoft's (MSFT, news, msgs) $31-per-share bid to buy the company.

Yahoo's board met over the weekend and concluded that the $44.6 billion offer from Microsoft "substantially undervalues" the company and "is not in the best interests" of the company and its shareholders. (Microsoft is the publisher of MSN Money.)

Yahoo shares rose 67 cents, or 2.3%, to $29.87 this afternoon; Microsoft shares fell 35 cents, or 1.2%, to $28.21.

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"The Board of Directors is continually evaluating all of its strategic options in the context of the rapidly evolving industry environment and we remain committed to pursuing initiatives that maximize value for all stockholders," Yahoo's press release said.

Microsoft late Monday responded by stating that it is "unfortunate" that Yahoo hasn't "embraced our full and fair proposal."

Microsoft said that the offer is in the best interests of both companies and reiterated its position that it "reserves the right to pursue all necessary steps to ensure that Yahoo's shareholders are provided with the opportunity to realize the value inherent in our proposal."

Two strikes for Microsoft?

Microsoft launched its unsolicited bid for Yahoo on Feb. 1, with an offer that represented a 62% premium over Yahoo's previous closing price of $19.18.

The software company has been circling Yahoo for months. Talks between the two fueled rumors of a possible merger last May. Shares of Yahoo jumped 10% on May 4, when The New York Post reported that Microsoft had asked Yahoo to enter formal negotiations about a merger. The Wall Street Journal later reported that any talk of a merger had been put off.

Yahoo did not state an acceptable price in its press release, but there have been reports that Microsoft suggested a price of $40 a share during the earlier discussions. Over the weekend there were reports that $40 is the minimum price the Yahoo board will now consider.

Yahoo's share price is now about the same as it was at this time last year. But it is up almost 50% over the past week on the strength of the new offer from Microsoft.

• Talk back: What do you think of Microsoft's bid for Yahoo?

Prior to the new offer, the stock had lost 32% from the time the earlier offer was declined by former Chief Executive Officer Terry Semel. Shares are down 14.5% over the past three years.

Microsoft's next move

Most analysts speculate that Microsoft could sweeten its bid to $35 per share, but whether Microsoft will pay $40 per share is questionable. The last time Yahoo shares traded at that price was in January 2006. Microsoft's CEO Steve Ballmer "is tenacious," said Jeffrey Sonnenfeld, senior associate dean of Yale School of Management, in an interview with CNBC this morning. Ballmer sees the deal as key part of Microsoft's future, Sonnenfeld said.

Yahoo's board "right now is confused because they revere (Yahoo founder) Jerry Yang," Sonnenfeld added. He speculated that Yang opposes the deal for reasons that are largely emotional. Yang is one of the two founders of Yahoo.

Microsoft has said that it will borrow money for the first time for this merger.

Microsoft shares have lost $4.04, or 12%, since the company made the offer, as of Friday's closing price. That means a whopping $38 billion has been wiped off the company's market capitalization.

Microsoft said it would allow Yahoo investors to choose stock or cash, provided about half are paid in stock and half in cash. That element of the deal links the worth of the offer to Microsoft's share price. The decline in the share price has shaved roughly $3 billion off the offer price.

Microsoft was downgraded to "sector perform" from "outperform" at RBC Capital this morning.

If Microsoft raises the offer to $40 per share, it will cost the tech giant another $12 billion.

Now one of the key questions for the markets is whether Microsoft will go hostile and proceed with its effort despite the official rejection from Yahoo's board. Yahoo has put in place a poison-pill defense -- a strategy to discourage a hostile takeover by diluting the value of any stake accumulated by an unfriendly suitor.

• Video: More on Yahoo's rejection

"A lot of this is gamesmanship on the part of Yahoo," Scott Kessler, an analyst at Standard & Poor's, said to Bloomberg News. "Microsoft is well aware that Yahoo doesn't have any other options. What this is about is how much Microsoft wants Yahoo and how much time they're willing to wait to get this deal done."

The rejection is "part of a negotiation process to fetch a higher bid," S&P analyst Jim Yin wrote in a note to clients this morning. "Although Microsoft could raise its offer, we think it is unlikely the bid would reach $40. We believe Microsoft will either sweeten its offer or try to bolster its case by appealing to shareholders at the next Yahoo shareholder meeting."

Global Crown Capital analyst Martin Pyykkonen agreed that $40 is too high. "Yahoo is playing a situation where they have someone who really wants them," Pvykkonen said on CNBC this morning. A proxy fight is unlikely, but the longer it takes for this to go through, the better it is for Google, Pvyykkonen added.

Ballmer's offer letter to Yahoo stated that Microsoft "reserves the right to pursue all necessary steps."

Meanwhile, Yahoo shareholder Eric Jackson says he wants to negotiate with Microsoft himself.

"We have no desire to see Yahoo! continue independently with the current board and management team in place. We believe that is a recipe for a $17 stock price," Jackson's blog stated.

• Read the group's blog

Jackson wants other shareholders to "band together as a group and agree to sell our Yahoo! shares to the highest bidder."

The yin to Yahoo's Yang?

While Yahoo's decision to decline the Microsoft offer may have some employees cheering Yang, that decision doesn't do much to address Yahoo's problems. Yang, who founded Yahoo in 1994 with fellow Stanford University graduate student David Filo, resumed control of operations with the departure of Semel but so far has made little progress with results. The company has reported profit declines for the past eight quarters.

Yahoo most recently reported a 23% drop in 2007 fourth-quarter profit and gave a sales forecast for 2008 that was lower than analysts had expected. The company also announced the "realignment" of 1,000 jobs.

Yahoo has also been struggling with executive departures, low employee morale and continued market-share loss to rival Google (GOOG, news, msgs).

One option Yahoo has to fend off Microsoft is to build partnerships. The Times of London is reporting that Yahoo wants to restart talks with Time Warner's (TWX, news, msgs) AOL. Yahoo is also considering the idea of partnering with Walt Disney (DIS, news, msgs) as well as with Google.

Don't forget about Google

Google has dominated the online search market, with both Yahoo and Microsoft trailing badly: Google has about 58% of the market, Yahoo has nearly 23%, and Microsoft has 10%, according to comScore. A combined Microsoft-Yahoo would help produce a stronger rival to Google. Bank of America (BAC, news, msgs) analyst Brian Pitz speculated that Yahoo could become the target of a bidding war.

"While it's difficult to raise debt in the current market environment, we believe a rival bid from a private equity consortium is also possible," Pitz wrote in a note to clients last week.

Google's only response to the Microsoft offer was a post on its Web site suggesting there are antitrust issues.

"Proposed mergers like this at least in the first instance (are) anti-innovation and therefore bad for the public interest," University of Georgia law professor Jim Ponsoldt said when the bid was first announced. Ponsoldt, who specializes in antitrust, said "Microsoft should be programmed for internal growth, not growth through acquisition."

Google CEO Eric Schmidt has offered a search advertising partnership with Yahoo, according to published reports. But a Yahoo partnership with Google would almost certainly face antitrust hurdles.