Why Carl Icahn May Have His Head in the Clouds

Shares of Yahoo Inc. (YHOO) plunged over 10% Thursday as merger talks fizzled with Microsoft Corp. (MSFT). Yahoo tried to revive the last takeover offer of $33 per share or $47.5 billion, but Microsoft wasn’t willing to bid that much again, according to statements from the two companies.

Carl Icahn (my personal hero and easily the world’s coolest investor) has been very vocal about the potential merger calling it a ‘marriage made in heaven’.

Microsoft Chief Executive Steve Ballmer did say, however, that Microsoft would be interested in Yahoo’s search engine. Ballmer [basically said] he believed a deal involving Yahoo’s search engine would be more valuable than the entire company at $33 per share. (You can read the article for yourself to see if you agree with my inference).

Let’s do the math, shall we? Yahoo shares closed Thursday at $23.52. Microsoft is saying that part of Yahoo (the search engine) is worth more than $33 a share. How could Microsoft value a portion of the company for 29% more than the street values the entire thing?

And why then, wouldn’t Microsoft take the entire company for $33 a share? Shouldn’t part of a company be worth less than the entire company?

The answer to this anomaly is buried deep within the fine print of Yahoo’s bylaws. Yahoo CEO Jerry Yang reportedly installed a “poison pill” to deter any takeover offer from Microsoft. This fact was kept secret from Yahoo shareholders and employees but was brought public by Carl “the man” Icahn after he received a complaint from a fellow activist shareholder.

The Yahoo shareholder complaint states:

Yang engineered an ingenious defense creating huge incentives for a massive employee walkout in the aftermath of a change in control. The plan gives each of Yahoo’s 14,000 full-time employees the right to quit his or her job and pocket generous termination benefits at any time during the two years following a takeover.

Accourding to Icahn, this poison pill would potentially cost Microsoft or any other bidder for that matter, an estimated $2.4 billion dollars or an extra $1.70 a share. Not to mention the disruptive cost of such a mass employee exodus. Jerry Yang stated publicly that his intentions were to protect the employees of Yahoo but neglected to mention the $1.5 billion (or over $100,000 per employee) set aside by Microsoft for employee retention bonuses.

So that explains why Microsoft wouldn’t want to buy Yahoo. That would be a tough pill to swallow… ha,ha,ha. But that doesn’t explain why Yahoo’s search engine is so appealing. Yahoo averaged just over $850 million in net income over the past 5 years. Assuming Yahoo made all its money from search, which it didn’t, Microsoft would still only be getting a 1.8% return if it paid the entire $47.5 billion for the search engine. Steve Ballmer could get a better return in a savings account.

But as it turns out, without a search engine of Yahoo’s magnitude, Microsoft may not be competitive for much longer.

Last October, Google Inc. (GOOG) directly challenged Microsoft by offering a suite of word processing and spreadsheet software, FOR FREE! The technology making this possible is called Cloud Computing. This new technology was formed from a strategic alliance will allow users to access word docs, pics, and music free of charge on the google.com website. This will be huge for portable device users because they will no longer need the memory of a PC to work on, store and send documents and reports when away from a computer. Most importantly, though, customers will no longer have to pay for this software.

Microsoft, not one to sit helplessly on the sidelines, is currently planning an initiative called the Device Mesh. It will reportedly link all computer devices—desktops, labtops and handhelds over the Internet (essentially the same thing as Cloud Computing). Only there’s a catch: Microsoft currently doesn’t have the number of searches necessary to achieve critical mass and make the business model work.

But Yahoo does! Yahoo, the world’s No. 2 search engine, attracts more than twice the traffic of Microsoft’s Live Search. Back in April, Yahoo turned down Microsoft’s offer. But with my buddy Carl Icahn now on the scene, I have a feeling things will be a little different next time around.

In an article I wrote back in February, I talked a little about risk arbitrage and how an investor could potentially profit from this deal and others like it.

I think Yahoo will eventually be able to sell to Microsoft. There is a clause in the bylaws that can reverse the “poison pill” should the Microsoft deal be taken off the table, which as of Thursday, seems to be the case. It will definitely take some time to get rid of Jerry Yang and patch up all the hard feelings. But it is my opinion, with the leadership of Carl Icahn, Yahoo will eventually be in the hands of Microsoft and hopefully for the $33 deal price.

Disclaimer: Risk arbitrage is an extremely risky form of investment. The statements above do not represent the opinions of YBPGuide. Greg does not own shares in Yahoo or Microsoft but does own Google Inc. in his personal portfolio. Investors should be cautious about any and all investment related recommendations and should consider the source and objective before investing. Various factors, including personal or corporate ownership may influence opinion.

All investors are advised to conduct their own independent research before making a purchase decision. Past performance is never a guarantee of the future.