All Things Digital

The stress of Microsoft’s failed bid for Yahoo has apparently been so great, the company’s been put off its food. Microsoft (MSFT) says it has no intention of seeking the search-advertising market heft it might have gained in an acquisition of Yahoo (YHOO) with a spate of other Internet purchases.

“People don’t understand what they’re talking about,” Microsoft CEO Steve Ballmer told the Financial Times, referring to speculation about a post-Yahoo buying spree. “At the end of the day, this is about the ad platform.”

And don’t forget Google (GOOG) …

Can a search-advertising alliance between Yahoo and Google possibly pass regulatory muster? We may soon find out.

Now that investor-tormentor Carl Icahn has filed a proxy slate to unseat Yahoo’s board with the intent, one way or another, to push the company back into merger negotiations with Microsoft (MSFT), an obviously panicked Yahoo (YHOO) is scrambling to pull together a search-ad deal with Google (GOOG).

The possibility of a search-ad outsourcing arrangement between the two companies was, in part, what caused Microsoft to lose its appetite for Yahoo. Could it cause Icahn to lose his as well? Seems doubtful. Even if, as sources close to the situation tell the New York Post, the deal is the sort of open-to-all-comers arrangement Yahoo and Google hope would pass regulatory scrutiny. Under its terms, a real-time auction system would be used to select the most lucrative ads for a given search query from among those sold by Yahoo, Google or anyone else that cares to participate. Structured in this way, the deal might not, as Microsoft has claimed in the past, consolidate over 90% of the search-advertising market in Google’s hands and draw the ire of antitrust regulators.

Instead it might consolidate, oh say … 89.99% in the search sovereign’s hands. Said Kevin Lee, chairman of search engine marketing firm Did-It, “Given the way the ecosystem is put together now, Google would probably be the winner in a vast majority of cases.”

Here’s the full text of Microsoft (MSFT) CEO Steve Ballmer’s letter to Yahoo (YHOO) CEO Jerry Yang.

Mr. Jerry Yang
CEO and Chief Yahoo
Yahoo! Inc.
701 First Avenue
Sunnyvale, CA 94089

Dear Jerry:

After over three months, we have reached the conclusion of the process regarding a possible combination of Microsoft and Yahoo.

I first want to convey my personal thanks to you, your management team and Yahoo’s Board of Directors for your consideration of our proposal. I appreciate the time and attention all of you have given to this matter, and I especially appreciate the time that you have invested personally. I feel that our discussions this week have been particularly useful, providing me for the first time with real clarity on what is and is not possible.

I am disappointed that Yahoo has not moved toward accepting our offer. I first called you with our offer on Jan. 31 because I believed that a combination of our two companies would have created real value for our respective shareholders and would have provided consumers, publishers and advertisers with greater innovation and choice in the marketplace. Our decision to offer a 62% premium at that time reflected the strength of these convictions.

In our conversations this week, we conveyed our willingness to raise our offer to $33 per share, reflecting again our belief in this collective opportunity. This increase would have added approximately another $5 billion of value to your shareholders, compared to the current value of our initial offer. It also would have reflected a premium of over 70% compared to the price at which your stock closed on Jan. 31. Yet it has proven insufficient, as your final position insisted on Microsoft paying yet another $5 billion or more, or at least another $4 per share above our $33.00 offer.

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Microsoft (MSFT) may launch a hostile bid for Yahoo as early as today. That’s the big news this morning from those mysterious “people familiar with the situation” who are quick to note, as they always are, that the “situation” is still fluid and Microsoft may also drop the bid entirely or sweeten it a bit.

Meanwhile, “people familiar with the matter” say that Yahoo (YHOO) may launch something in the next few days as well: a deal to carry search advertisements from Google (GOOG) alongside Yahoo search results. Such a deal would likely not be the sort of broad pact over which Microsoft has preemptively cried foul, but a non-exclusive arrangement open to the companies’ competitors as well. Under its terms, a real-time auction system would be used to select the most lucrative ads for a given search query from among those sold by Yahoo and Google. Microsoft too, if it were willing to participate.

Well this ought to cause a chair-tossing tantrum or two up at Microsoft HQ. This afternoon Yahoo (YHOO), which has been searching for alternatives to Microsoft’s (MSFT) unsolicited $44.6 billion acquisition offer, said it will explore a search-advertising partnership with its greatest rival–Google (GOOG).

The Internet portal will soon begin a “limited” two-week test of Google AdSense with an eye toward a broader search-ad outsourcing arrangement. That said, this tentative first step is by no means a harbinger of a larger deal. “… The testing does not necessarily mean that Yahoo will join the AdSense for Search program or that any further commercial relationship with Google will result,” Yahoo said in a statement.

It certainly doesn’t. Not if Microsoft has anything to say about it. In a hastily issued statement Brad Smith, Microsoft’s general counsel, cried monopoly over the exploratory alliance.”Any definitive agreement between Yahoo! and Google would consolidate over 90 percent of the search advertising market in Google’s hands,” Smith said. “This would make the market far less competitive, in sharp contrast to our own proposal to acquire Yahoo! We will assess closely all of our options. Our proposal remains the only alternative put forward that offers Yahoo! shareholders full and fair value for their shares, gives every shareholder a vote on the future of the company, and enhances choice for content creators, advertisers, and consumers.”

A popular misconception has it that Yahoo is an acronym for “You Always Have Other Options.” (According to Yahoo’s corporate history, it’s an acronym for “Yet Another Hierarchical Officious Oracle.”)

Well, not this time.

Because it appears to be the beginning of the endgame for Yahoo. Word on the street has it that the company’s board of directors will meet this afternoon to decide whether to capitulate to Microsoft. “The board, we’ve heard, is basically being told by outside advisers to take the Microsoft deal,” TechCrunch reports. “But we’ve also heard that a contingent of senior executives at Yahoo, who are willing to do literally anything to thwart a Microsoft takeover, are pushing for the Google deal and will present their case at the meeting.”

Not that it will do much good. Though a Yahoo/Google search-outsourcing deal might deliver 25%-plus accretion to Yahoo’s cash flow, spurning Microsoft’s $44.6 billion advance would almost certainly trigger a shareholder revolt. Which means it’s more than likely that Yahoo will accept the current bid or another that’s been raised a bit, as Citigroup analyst Mark Mahaney has already noted in his widely cited “Five Scenarios” analysis:

• Scenario No. 1: Yahoo hits the $31 bid. 20% probability.
• Scenario No. 2: Yahoo rejects the bid; Microsoft ups its offer; the deal happens. 40% chance.
• Scenario No. 3: Another bidder emerges and wins. 5% chance. (“We believe that the $45 billion price tag and the strategic value of Yahoo to Microsoft make the likelihood of a successful competing bidder very low,” Mahaney writes.)
• Scenario No. 4: Deal blocked by regulators. 10% chance. (Mahaney notes that the combined companies are at most 30% of total U.S. online advertising, and less than that in Europe.)
• Scenario No. 5: Yahoo/Google search-outsourcing deal. 25% chance. (“We believe the probability of this is greater than financial markets realize,” he writes. “If Yahoo’s board and management want to remain independent, shareholders will insist on a major value-creating strategy to balance the Microsoft bid. This may be the only viable strategy, as it could deliver 25%-plus accretion to Yahoo’s cash flow.”)

Looks like it’s scenario No. 2, then. Dun-dun… Dun-dun… Dun-dun Dun-dun Dun-dun DUN-DUN DUN-DUN!

Yahoo’s quite the damsel in distress these days, isn’t it? The Internet underachiever has reportedly renewed its talks with Google, as it desperately searches for alternatives to Microsoft’s $44.6 billion takeover bid. “Jerry [Yang, Yahoo CEO] is as motivated as hell to try anything he can,” a source familiar with the deal told the Los Angeles Times. “Google is hyper-competitive, and it wants to do anything it can, anytime it can, to stop Microsoft from getting one foot in the door.”

Bit of a truism, that. Still, the report–if it’s true–could mean Yahoo is considering turning over its search advertising business to Google.