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Microsoft-Yahoo Saga: To Be Continued

The deal’s dead, but its revival is possible.

At its annual meeting Aug. 1, Yahoo will have to address how it plans to mollify frustrated shareholders in the wake of dead-end buyout talks Microsoft.

What seemed like a game-changing deal with activist shareholder Carl Icahn has been quickly overshadowed by the discontent of two other major shareholders; one, T. Boone Pickens, sold his stake ahead of the meeting, while the other, is reportedly set to express his lack of confidence in the company’s leadership at the meeting.

With all the moving parts involved, predicting the outcome is tricky, especially since there are good arguments for either scenario. Here's how they play out.

Why the Deal Seems Dead

The agreement between Yahoo and Icahn that placed him and two new, Icahn-recommended directors on its board seemed to throw the prospects of a Microsoft-Yahoo deal into disarray. Icahn, after all, was the most vocal champion of a buyout, so much that he wanted to take control of Yahoo’s board.

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By eliminating the threat of a proxy fight, Yahoo reaffirmed its stance against a deal, at least in the short term. Since rebuffing Microsoft’s overtures, Yahoo’s management has maintained the company is best served going it alone. Derek Brown, an analyst at Cantor Fitzgerald, notes that the company is unlikely to stray from that stance at its annual meeting.

Activities from the Microsoft front also indicate a dead deal. Kevin Johnson, who led the company’s bid to buy Yahoo, left his post as president of Microsoft’s platforms and services division. Microsoft announced a reorganization of that business unit, splitting online services from its Windows platform business. Also, Microsoft Chief Executive Steve Ballmer confirmed during last week’s analyst meeting that all talks with Yahoo were "done."

Microsoft has already begun making moves to grow its floundering online services business. Last week, it expanded its relationship with Facebook to bring Web search and search ads to the online social network. And in lieu of a Yahoo deal, there has been talk of the company pursuing Time Warner’s AOL unit.

“It’s necessary for Microsoft to make bigger moves in online services,” says Kevin Buttigieg, analyst at the Stanford Group. “Google is growing much more rapidly on a larger base of business. For Microsoft to not do anything is just as risky as pursuing a large transaction. It needs to do something.”

Why the Deal Isn’t Dead

Although Icahn didn’t carry out his threat of taking over Yahoo’s board, he is now a company insider. And if he continues to push for a deal with Microsoft, it may yet happen.

Furthermore, it appears that at least one large investor plans to air his displeasure with the way Yahoo handled negotiations with Microsoft. Gordon Crawford of Capital Research and Management is considering withholding votes for Yahoo Chairman Roy Bostock and Chief Executive Jerry Yang at Friday’s annual meeting, according to a New York Post report. A Capital Research spokesman declined to comment.

Because the proxy contest between Yahoo and Icahn has been resolved, shareholders won’t be able to vote out board members. But even a symbolic no-confidence gesture by Crawford could help revive interest in a deal.

“Yahoo’s board and management team seem attached to a certain value,” says Troy Mastin, analyst at William Blair & Co. “I don’t know what it was, but it was higher than $31 a share. But now, market realities, the economic slowdown and a revamped board can result in a willingness to make a deal at terms more favorable to Microsoft.”

But Mastin points out that a deal for Yahoo’s search business would have to be worth more than the agreement the company struck with Google in June. Yahoo estimates that deal can generate $800 million in annual revenue.

Also noteworthy is that Yahoo shares are down 10 percent this year and back near the four-year low touched right before MIcrosoft made its offer. Despite maintaining a position that its best chances for growth are without a Microsoft deal, the company hasn’t given any details of its strategy so far.

“Outside of a Microsoft deal, there’s no near-term catalyst for the stock,” says Brown, who holds a $25 price target for Yahoo.

From Microsoft’s perspective, Ballmer did leave open the possibility that the companies could return to the negotiating table. In his most recent comments, he said "there's nothing under discussion," which, though true at the time, doesn't necessarily rule out another time. Without a major deal, Microsoft will have to revamp the unit on its own. Such a move would take years to complete while Google continues to grow.

Since making its initial bid for Yahoo on Jan. 31, Microsoft’s shares have dropped 19 percent (vs. about 10 percent for the Dow Industrials). Apprehension that a Yahoo deal would be dilutive to Microsoft’s earnings is part of the reason, analysts say. But if Microsoft is to gain the scale necessary to compete with Google, Yahoo appears to be the best option.

“Having a deal done can be a positive for the stock because it removes the uncertainty,” says Buttigieg, who maintains a $37 price target on Microsoft. “Microsoft is losing money heavily in online services. Yahoo, for all its troubles, is profitable.”

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