Having Fun Yet?

I know I'm not. And if you think the market is getting it wrong, consider that MSFT was previously expected to make $2.09 per share in FY09. At a semi-reasonable 18X multiple, that would have generated a target price for the stock of around $37.62. Now, consider that some - notably Bernstein - think the YHOO deal could be .32 dilutive to that FY09 EPS target alone. In other words, it could drop to $1.77. If the multiple stayed the same, that would take the target down to $31.86. Which, not coincidentally, is virtually identical to what Canaccord provided today as they downgraded MSFT:

Canaccord Adams downgraded MSFT as they believe shares will come under pressure if the company raises its bid for YHOO. Note that the firm upgraded YHOO to Buy from Hold. Target to $32.00 from $40.00.

But wait, it gets worse. See, with all the extra risk and uncertainty, there's no particular reason to think the market will still award an 18X multiple. I'll leave you to do the math if it dropped to say 16X, or - God forbid - 12X. Additionally, no one knows exactly how dilutive this deal will be. That's because it's half cash, half stock. Now in theory, as MSFT shares continue to decline, so too does the value of the offer. There's just one problem: even if YHOO management decide to accept the deal (and their options are pretty limited), they're very likely to insist that MSFT get it back up to at least the original $31/share level (some are saying $36-$40 might even be required).

Since Ballmer appears to be intent on doing this deal (irrespective of the strong feedback shareholders whom he is meant to represent and work for are giving him), that would leave two choices: adjust the share multiplier higher (from its current .9509 of a MSFT share) - thereby resulting in even more shares being minted, further dilution for us, more downward pressure on future EPS, and a larger ongoing dividend obligation for the company - or change the 50:50 cash/stock balance to favor more cash which, since MSFT doesn't have it, would require taking on even more debt. And the more MSFT shareholders bail, the lower the stock goes, and the worse this non-virtuous failure loop becomes. Neat, huh?

Then there's the fact that while Dumb and Dumber say this deal will be breakeven or better within two full fiscal years after the deal closes, they also said that was excluding various charges. In other words, don't count on EPS after charges - or final EPS - to be breakeven, even through FY10. Related, there is no way that YHOO on paper is going to be worth this price. So at some future point, MSFT is going to have to take a huge charge to write down the "goodwill" difference between what they paid, versus what YHOO was actually worth. I guesstimate that that charge will be at least $1/share, and it could easily be $2 or more depending on what the final price is, how the integration goes, etc.. Needless to say, a $1-2 charge in some future fiscal will have the effect of wiping out a large part of MSFT's overall earnings for that entire year.

As I said in the last post, if you're a MSFT shareholder you should be hoping this deal gets kiboshed by either YHOO or regulators (however unlikely). Alternatively, you should hope that MSFT and YHOO come to some other accommodation. The best option there would be a standalone entity (either under the YHOO listing or a new one), into which both YHOO and MSFT contribute and MSFT shareholders get stock.

 

Update:

• Is Microsoft Desperately Seeking Yahoo?

Our case-in-point arrived today when Canaccord Adams cut Microsoft from "buy" to "hold." Prior to today's activity, MSFT sported 14 "buy" or better ratings, compared to just 4 "holds." If this line of thinking begins to take hold on Wall Street, the shares could be looking at additional declines over the next few months. Additional fuel for the fire could come from the options pits, as the stock's Schaeffer's put/call open interest ratio (SOIR) of 0.44 ranks below 72% of all those taken during the past year. While we can sit and debate the desperation and necessity of Microsoft's bid for weeks, it is investor sentiment that will ultimately vindicate or scuttle the company's shares. And right now, investors appear to be leaning heavily toward the "scuttle" end of the spectrum.