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In the hard-bitten world of mergers and acquisitions, "no" doesn't always mean "no."
Sometimes it means "not yet."
Monday afternoon, Microsoft responded to Yahoo's formal rejection of its acquisition bid in a brief statement, signaling its resolve to pursue the deal.
"It is unfortunate that Yahoo has not embraced our full and fair proposal to combine our companies," Microsoft said in a statement. The company reiterated its belief that the merger would be in the best interest for shareholders of both companies.
"The Yahoo response does not change our belief in the strategic and financial merits of our proposal," Microsoft added, noting that it "reserves the right to pursue all necessary steps" to complete the transaction.
Monday morning, Yahoo's board of directors said Microsoft's offer of $31 per share "substantially undervalues" the company in light of its prospects for future growth, recent investments in its advertising technology and other financial indicators.
In a company-wide e-mail, CEO Jerry Yang told employees that Microsoft's offer also marginalized the value of the Yahoo brand, and its position as one of the most trafficked portals on the Web.
Microsoft's half-cash, half-equity offer represented a 62 percent premium over the closing price of Yahoo's shares on January 31. In the time since, Yahoo's shares have risen more than 50 percent, while Microsoft's have dropped slightly.
The dip in Microsoft's stock reduces the value of the equity portion of the offer, which now stands at about $42 billion, down from the $44.6 billion based on the values at the close of trading on January 31.
In its response, Microsoft restated its assertion that acquiring Yahoo would improve competition in the Internet search and advertising markets overwhelmingly led by Google.
In the fourth quarter of 2007, research firm IDC reported that Google commanded 24 percent of the U.S. online advertising market. The combined market share of Microsoft and Yahoo was 17 percent in the same period.
"[A merger] would not quite bring Microsoft-Yahoo to where Google is in online advertising in the U.S., but it would give them a much better fighting chance than if they went it alone," IDC analyst Karsten Weide wrote.
Microsoft's next move
So what does Microsoft do now?
While the language of Microsoft's response suggests that it might stand by its original offer and go hostile in its bid, Yahoo's rejection could have simply been part of the game.
And Microsoft will likely come back with a higher offer, according to Richard Rafferty, a corporate and securities attorney and partner with the Texas-based firm of Strasburger and Price.
"Given that Yahoo's board is under fiduciary duty to get the best possible value for its shareholders, I would have been very surprised if they accepted the first offer," Price
Any scenario in which Microsoft would go hostile with its bid would be problematic, Rafferty said.
Yahoo has a "poison pill" mechanism in place that could effectively block a takeover if Microsoft were to make a tender offer directly to the shareholders.
Alternatively, Microsoft could nominate its own roster of candidates to replace Yahoo's 10-member board at the annual shareholder meeting in the spring. But Rafferty warns that such a strategy risks torpedoing any chances for a harmonious integration of the two companies' operations.
A more benign approach would have Microsoft reaching out to Yahoo's biggest institutional investors in an attempt to put pressure on the board to accept its offer. Microsoft would try to keep any such back-channel overtures very quiet, acting as an unseen hand to make Yahoo's eventual acceptance appear as organic as possible.
Spokesmen for Yahoo and Microsoft declined to comment on the acquisition bid, referring to the two companies' public statements.
Citigroup analyst Mark Mahaney has been handicapping the great spectator sport that this acquisition has become. In a recent research note, he attached a 55 percent likelihood to the scenario of Microsoft increasing its bid to a level that Yahoo would accept.
"We did not view the Yahoo board rejection as surprising," Mahaney and two other Citigroup analysts wrote. "But given the lack of alternative bidders, Yahoo's limited strategic options and our view that buying Yahoo may be Microsoft's ONLY game-changing option in online advertising, we believe this is the most likely scenario."
Mahaney noted that Microsoft's online advertising initiative has foundered over the last three to four years while Google has steadily gained market share. Yahoo might be the only company that could deliver the scale needed to compete in the current market, so Microsoft is not going to let it go quickly, Mahaney noted.
Finessing the deal
He shares Rafferty's concern that a direct tender offer to the shareholders or other hostile advances could poison the culture of the combined company, and lead to an "exodus" of key Yahoo employees.
Seeing Yahoo's top engineering talent walk out the door would be a blow to Microsoft, and would run counter to its goal of improving its competitive position vis-Ă -vis Google.
After all, Mountain View is only three miles up the road from Sunnyvale.
IDC's Weide looks for Microsoft to sweeten its offer, but only slightly.
Without naming an exact figure, Weide said that Microsoft's new offer will be well under the $40 per share that Yahoo is reportedly seeking. There could be some negotiation, Weide expects, but ultimately Yahoo will be forced to accept the offer because its options are limited.
"Essentially, the question is who calls the shots. It's not Jerry Yang, and it's not the board," Weide "Ultimately, it's the shareholders."
To placate those shareholders, Yang will need to present a dramatic strategic shift that could drive value beyond what Microsoft offers.
The other possible scenario would be a "white knight" bidder emerging with an offer to counter Microsoft's.
The list of companies that would benefit from acquiring Yahoo enough to justify taking a run at the portal giant is short one—News Corp., AT&T and Time Warner have been floated. None has stepped forward, and News Corp. has explicitly said that it is not interested.
Mahaney gives this scenario a 5 percent probability.
Gartner analyst David Smith raised the idea that a private equity investment group could step forward, possibly from overseas, with an offer to buy a controlling share of Yahoo. But he admitted that it was unlikely.
AOL Still in Play?
The rumor that Yahoo is considering a merger with AOL also surfaced this week. Time Warner CEO Jeffrey Bewkes said last week that he planned to split AOL into two units, one centered on advertising and free Web content, with the other operating the business's dial-up Internet service.
It remains far from clear if Bewkes's announcement was meant to improve AOL's curb appeal for potential purchasers or if it's a straightforward move to formally separate the unit's divergent operations.
Even if AOL is for sale, Yahoo might have a hard time financing a purchase, and the combination of the two portals seems unlikely to resolve the problems that have weighed on Yahoo's competitive position—particularly in the area of search.
Then there's the possibility that Yahoo could outsource its search and advertising technologies to Google.
To Mahaney, this is the second-most likely outcome behind Yahoo accepting Microsoft's bid—at some price. Weide said that such a move would be "admitting defeat," but it has the appealing feature of preserving Yahoo's independence—at least nominally.
In spite of the improvements made through Panama, Yahoo's highly touted ad-platform overhaul, Google still monetizes search far more effectively.
Citigroup reported that Google banks an average of nearly 9 cents per search query, compared with less than 4 cents for Yahoo. Mahaney gave the Google-outsourcing scenario a 30 percent probability.
At this stage it is difficult to say whether Yahoo's rejection of the offer signifies the company is unwilling to sell out to Microsoft at any price, or whether it is simply looking for more money, said Gartner's Smith.
"One thing is certain, though. The days of an independent Yahoo are numbered one way or another," he "It's a question of when and who and at what price."
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