Circle of Competence

I’d like to focus CoC mainly on intelligent investing topics- stock analysis, mental models, margin of safety and the like. That’s what we here at CoC love most. With that said, I can’t resist a comment on this Yahoo!-Microsoft nonsense.

My first reaction when hearing about this potential transaction was…huh? Take a terrific business, one of the best on the planet in Microsoft, and spend $40 billion on the competitively-disadvantaged Yahoo!?

Tell me this: if I’m a Microsoft shareholder, holding this absolutely wonderful business selling at a discount to its true worth (in my humble opinion), would I rather see the company take its $40 billion cash hoard and buy back a huge chunk of stock, or would I like to see them buy Yahoo!, a company that seemingly has no discernable competitive strategy or advantage? Think of it this way: you could spend $40 billion on a wonderful business selling at a good price (MSFT), or spend $40 billion on a very expensive business that is thoroughly dominated in its main market (YHOO)?

To me, this is a no-brainer: buy back stock. Count me a skeptic that a mega-merger such as this would work out. Does AOL Time Warner come to mind for anyone? Citigroup? Boston Scientific? I’m a show-me guy, and M+A success on this scale has not proven successful in the past. Show me the history of companies spending $40 billion or more to buy a business at 60-80x earnings. It’s not pretty.

Get in this house right now Steven!

Why does Steve Ballmer think this time is different? Not only that, but rumors of an advertising deal between Yahoo! and Google have been floating around for months. Would you want to buy a business that is almost about to partner with the very company you are trying to compete against?

I’m often reminded, in these situations, by Warren Buffett’s likening of major corporate purchases to fairy tales:

“In other words, investors can always buy toads at the going price for toads. If investors instead bankroll princesses who wish to pay double for the right to kiss the toad, those kisses had better pack some real dynamite. We’ve observed many kisses but very few miracles. Nevertheless, many managerial princesses remain serenely confident about the future potency of their kisses — even after their corporate backyards are knee-deep in unresponsive toads.”

From a capital allocation standpoint, I can’t see buying Yahoo! at 60x earnings being smarter than buying Microsoft at 16x earnings, regardless of how fast you think Yahoo is growing revenues. I just don’t see it. If you really are worried about Google, trying to be a hero by buying Yahoo! just won’t do it, I’m sorry. Google dominates Yahoo! in every conceivable category, and I can’t see Microsoft making any difference there.

To me, Microsoft trying to “catch up” with Google in search by buying Yahoo! is like Pepsi trying to catch up with Coke in soda by buying RC Cola. It ain’t gonna cut it.

Those Yahoos over there at Yahoo!

From Yahoo!’s side, I see some behavior that is equally asinine. The deal ultimately fell through because Yahoo! thought it was worth $40 a share. $40?? Yahoo! earned an average of less than .50/ share in the past two years, meaning they are valuing themselves at 80x earnings. Google sells for an already inflated 40x earnings, and their business dominates search.

Imagine this: Coke sells for 20x earnings, in its current business state. Now, you are Joe Private Equity looking to buy Pepsi’s cola business, leaving them with Frito-Lay. Would you pay 30-40x the cola division’s earnings for that business, which is less profitable and less dominant than Coke?

Yeah, me neither.

Which is to say, Yahoo! did a massive disservice to its shareholders by pushing for such a ridiculous price. Not only did Microsoft almost blow $40 million, but Yahoo! was dumb enough not to let them. If (YHOO) drops back down to where it was before the bid, I could see a shareholder lawsuit in the cards.

The narcissists at Yahoo! should be ashamed, and the shareholders of Microsoft should rejoice that this deal has fallen through. If you hold Yahoo! stock, I’d advise you to call up your partner Mr. Yang and read him some portions of Security Analysis; he could use a refresher on business valuation. Yahoo! is not worth $40/share Jerry.

Even so, despite Mr. Ballmer’s claims, even Microsoft’s corporate kiss wouldn’t be able to turn this toad into a prince.

Disclosure: No position in any securities mentioned.