Interview With Citi Analyst Mark Mahaney On Yahoo/Microsoft/Google

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mark-mahaney-small.pngCiti’s Internet Analyst Mark Mahaney has been at the center of the Microsoft/Yahoo takeover battle since the beginning. On February 2, a day after the Microsoft bid, Mahaney gave his reasons why he believed the deal had just a 60% chance of happening.

Mahaney also estimated (on February 2) that a search advertising outsourcing arrangement with Google could boost Yahoo cash flows by 25% and suggested that the financial markets were underestimating the probability of such a deal (he was right, as we learned two months later).

Later Mahaney updated his estimate based on new data and said a Google deal could increase cash flows “more than $1 billion a year,” a 50% gain in cash flow from 2007.

Last Friday, in anticipation of the expiration of the Microsoft deadline for Yahoo action on the bid, Mahaney made a new set of predictions: 45% chance of a merger at a price somewhat higher than the initial bid, a 40% chance that Microsoft will go hostile, a 10% chance that Microsoft walks away, and a 5% chance for deal at the original bid to be accepted. That means he thinks a deal in some form is 90% likely, up from his 60% chance on February 2.

Given how consistently right Mahaney has been in his analysis, Erick and I reached out to him today to pick his brain on the deal. The podcast is below, along with a transcript of the conversation.

Key takeaways:

  • Mahaney clearly thinks a Yahoo/Microsoft deal is going to happen, either through a hostile move by Microsoft (40%) or via a negotiated deal (50%).
  • He doesn’t count out the chance for a more permanent Yahoo/Google deal, though. We talk about the various ways Yahoo may be able to get a Google deal past the regulators, particularly via outsourcing only a portion of search ads on a non-exclusive basis.
  • Mahaney maintains his current estimate that Yahoo can increase cash flow in the near term by $1 billion/year by outsourcing search to Google.

The most interesting exchange came at the end, when I steered away from what Mahaney thought would happen, and asked him what he would do if he were Microsoft CEO SteveBallmer: walk from the deal, or go for it aggressively. Mahaney didn’t hesitate in his answer:

Arrington: So if you’re Steve Ballmer, do you walk from this deal or go after it aggressively?

Mahaney: You go after it aggressively. You know what it’s like to see businesses increasingly concentrate on one provider. The longer you wait to attack that provider, the worse your odds. You can’t walk away.

There are very few people who understand this situation as well as Mahaney. If he says Microsoft needs Yahoo, I’m not going to disagree.

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Transcript:

Michael Arrington (MA): Hello this is Mike Arrington with TechCrunch, and I’m here with Erick Schonfeld as well, and we’re talking with Mark Mahaney, the Internet Analyst at Citi. Hello Mark?

Mark Mahaney (MM): Hello.

MA: And Erick you’re there as well?

Erick Schonfeld (ES): Yes I am.

MA: Great. So Mark I want to chat with you about Yahoo and the Yahoo!/Microsoft deal, in particular you’ve been at the cutting edge at a lot of the research around the deal for months now. There are two data points you’ve put out, one that’s at least a couple of months old now and one more recently that I’d love to jump into a little bit. First of all you put out last week…was it on the 25th? It was a new report actually laying odds on which way the deal may go, is that right?

MM: That’s right

MA: Oh April 22nd actually. Did that report which we’ve mentioned, did you assume at that point that Yahoo! would not respond to Microsoft’s deadline of Saturday? Or did you factor in at that point that they still might respond?

MM: We were assuming that, we put this out on Friday, we were assuming that Yahoo would not respond. In a way, Yahoo! already had, they had at least twice, in public said that the current offer materially undervalued the company. They said much the same thing in maybe greater detail on their earnings call so it was kind of hard to see them agreeing to that price over the weekend.

MA: And have you heard any thing that changes your opinion on that since Friday?

MM:
Uh yes: nothing. Which means that Yahoo essentially called Microsoft’s bluff.

MA: So, I’d love to jump in to this a little bit. You say, you had put a 10% probability that Microsoft walks away from the offer; a 40% probability that Microsoft goes hostile; 5% that Microsoft/Yahoo! agree at the current price; and 45% that Microsoft/Yahoo! agree at a higher price. And that gets us obviously to 100%, and you also put it at 90% likely that the deal goes through at this point. What’s interesting, and what I wrote about this morning is that you don’t talk at all about Google in the report that I saw, and you talked a lot about Google in the early days. Is there a reason for that?

MM: No, no particular reason. I think we’re at a point now where Google…the framework here is that what was Microsoft gonna do? Were they going to walk the very narrow issue, and we’ve heard a couple of these probabilities or scenarios report and they’ve changed, this is actually the third iteration of it, we were addressing the very narrow issue which was what was Microsoft gonna do–and that Microsoft walks actually was not in any of our original scenarios–initially we had thought about Yahoo! developing a strategic alternative to the Microsoft offer, we had very low odds from the beginning, you know less than ten, call it 5% that there would be a bigger suitor to emerge, I don’t think any private equity or any strategic company wants to compete against Microsoft for Yahoo!. But we increasingly thought that there could be a forcing function to a higher bid, that’s how we phrased either the Google outsourced search option, or the potential for some sort of strategic deal with Time Warner under which Time Warner’s online assets would be merged into Yahoo!. Time Warner would take a stake in the new co, maybe there would also be wrapped in some sort of Google outsourced decision. Our view was that it will still be hard for some sort of combination like that to create more value than Microsoft could, if they wanted to raise the bid, and we also saw something like that as really the forcing function to Microsoft raising its bid.

ES: I think we haven’t heard anything from Microsoft yet, the deadline came and went.

MM: Yeah we haven’t. So it seems like Microsoft as three simple choices here. One is to walk away, we just think the odds of that are very slim and when we apply these probabilities, we always try at the end of the day to bring it down to probabilities, but it’s obviously very hard to be that precise about these scenarios. Ten percent for us means, that I think its very unlikely, and I’m in the camp probably that I think that there’s at most a 10% likelihood that Microsoft would really walk away without at least trying one of the other two steps. The other two steps are to go hostile with the current bid at 31, elect the board, go out to Yahoo! shareholders and attempt to convince 50% of them to tender at 31 bucks; or the third step, which would be either publicly or privately go to Yahoo!’s board and offer a higher bid and then wait and see how the board reacts to that and potentially if the board was to refuse just as categorically a higher bid, then take that to a shareholder vote.

MA: Has every indication you’ve seen suggest that Microsoft has made no gesture towards a dollar or two raise in the offer?

MM: I wish I knew for certain. We don’t know for certain whether Microsoft has offered a couple of bucks higher and Yahoo!’s board has just been adamantly refusing.

MA: They certainly don’t seem to have signaled that directly to any stockholders that people are talking to. If people are talking to the big stockholders and none of the stockholders have signaled publicly that I’ve heard, that Microsoft has said they’d be willing to do that. Have you heard anything differently?

MM: I have not heard anything differently.

MA: When you say that you think it’s a very small likelihood that Microsoft would walk away from the offer, do you base that on psychology, just signals that you’ve seen from the market and comparing that to your experience from the past…or do you see that as an analysis of Microsoft’s business and seeing that like, “Look, they really need this,” or is it both, or is it neither.

MM: It’s more the latter and it’s more the history of this. I think if we step back, it’s not like, uh all of a sudden Microsoft decided a couple of months ago that it was time to bid up for Yahoo, it’s something that they had seriously pursued for some time and although never publicly acknowledged it’s very hard that it’s not the case that Microsoft didn’t make offers for Yahoo! over a period of more than one year at pricepoints higher than where they went public, I mean, I want to step back… I also think, I give Microsoft from a deal perspective enormous compliment or kudos. They struck when the iron was red-hot–or perhaps in Yahoo’s world blue cold–at a 4 year trough on the stock. But they clearly have been looking at Yahoo for some time, and why? Because for four years, every July Microsoft has brought its investors its shareholders & potential investors up to its financial analyst meeting and said, “We have a new major growth area where we are pursuing in addition to PC’s,” and in addition to video games, it’s internet advertising. And they always bring out the market share or market size forecasts and have made the arguments at times that they are gaining share on Google, and they have put out the slides and they’ve had to retract them over time. And so the history here is that there’s clearly a long standing ambition at Microsoft to compete in online advertising. There’s very limited success to date and when you step back and think, “What asset could you acquire that would give you dramatic scale overnight (if the integration works well).” It’s obviously Yahoo!, that or potentially AOL, but you know Yahoo! would obviously give you greater scale…and they’ve got the search engine technology, and AOL doesn’t.

ES: If the deal goes through, what chances do you put on Microsoft messing it up? Messing up the business.

MM: Yeah, that’s a very difficult call. The integration risks have you know, have gotta be dramatic. And I’m sure Microsoft has spent a lot of time looking at how they would manage those integration risks. I’m sure that they are offering a price knowing that some of the assets including the people that they’d like to acquire they will lose. I’m sure that’s also a factor why they may want to do everything possible to avoid a hostile offer. The more friendly this deal is, the less the integration risks. The more hostile, the lesser the integration risks.

ES:
And if you look at the value of Yahoo! to Microsoft versus if they somehow got through the regulatory hurdles of doing a deal with Google…what creates more economic value? You ran the numbers, right? Of what happens if Yahoo! turns over a portion of its search advertising to Google….do the economics of a Google deal still trump Microsoft integration if you back out, you know the fact that they probably can’t do 100% because of the regulatory concerns?

MM: I think the bottom line answer is we don’t know because it would depend on just how high Microsoft would be willing to go. I think worse case scenario from Microsoft’s perspective would be a Yahoo completely outsourcing its search to Google. There are regulatory risks in there. I don’t think it’s an open and shut regulatory blocking scenario but that’s hard to know. The one area where we have a fair amount of conviction on is we believe that Yahoo has explored this opportunity in the past. We think they did that as part of their hundred day strategic review and Jerry Yang came back as CEO to the company.

MA: Mark, are you saying they explored a Google relationship in the past?

MM:
No, what I’m saying is that they explored…yes, essentially, although not necessarily with Google. They certainly ran the numbers and did their own analytics on that kind of deal.

MA: We’re talking about a year ago now?

MM: Yes and what I specifically mean is when Jerry Yang came back as CEO he set a hundred day strategic review process in motion. And we believe as part of that strategic review they seriously explored, at least examined, the possibility of outsourcing search to Google. And I think they know very well that something like that could be highly accretive near term. The question is, is there a hollowing out risk for the business in years 5 through 10.

MA: So I actually heard that as well. I heard that they commissioned an outside study sometime last year and that that study suggested that they would have 85% plus increases in cash flow from outsourcing search to Google. I don’t know if you heard the same thing or if they gave you direct…I don’t really know how that works with you. But clearly your early estimates were kind of in that range. I think you said that they would go from 4 cents to potentially up to 9 cents per search — is that right? Sort of, 40-90 dollar RPMs on searches?

MM: Hard numbers are approximately in that area. I’m sorry I don’t have them at our finger tips.

MA: You talked about a 25% boost in cash flow.

MM: Initially and then we even raised that projection. Yahoo in that public document that they disclosed about a month ago when they went around and talked with their largest shareholders made their presentation publicly available. There’s a footnote in there in which they actually said that they thought they — they didn’t name Google but it was obviously Google — that the difference in the monetization gap was 60 to 70%. That’s the first time we’d heard or seen Yahoo sign off on this specific gap.

MA:
And when did you see that?

MM: This was in Yahoo’s public presentation from a month ago.

MA:
Ok but you made your analysis before that.

MM: We’d done an analysis before that; we saw that disclosure by Yahoo and we changed our analysis, and we concluded that the deal all in could be more accretive than we had thought previously.

MA: Ok, because the numbers changed – I actually thought you were being misquoted, but originally you were being quoted as saying: increased cash flows by up to 25% and then more recently you were quoted as saying that the estimate of increased cash flows from a Yahoo-Google deal could be more than a billion a year. Is that right?

MM: That’s right.

MA: And that’s actually, I think, more than a 50% gain in cash flows from their 2007 numbers so it’s a pretty big deal.

MM: Yea, it is a very big deal. And you know, the logic here is that we’ve had people outsource search in the past. Microsoft did it, Yahoo did it (then they bought Overture). And you’ve got companies that currently outsource their search – think about the margins that Ask and AOL Time Warner get on their search rev – extremely high margins. So you’re talking about taking out all that cost, that infrastructure, outsourcing it and you can probably get a very good revenue share deal from Google because you’d have tremendous amount of negotiating leverage. Yea you’d be gaining a lot of incremental…

MA: You have negotiating leverage the first time.

MM: Correct

MA: But as soon as that deal’s up for renewal, it isn’t going to be as good.

MM: Michael, you’re right. That’s why if there were to be a deal, I doubt it would be a one year deal from Yahoo’s perspective. You’d lock in a very long…if you were going to do this step, you’d lock in a very long-term deal.

MA:
AOL lost…their search market share went from, I believe in the 30s to like 5% today — do you think that that’s partially, or entirely, because of outsourcing? Or do you think that there are other factors? Because AOL has grown while that’s happened.

MM:
Sorry Michael, I don’t have a good opinion on that.

MA: OK, let me ask a different question – do you think that Yahoo could stay competitive in search if they outsourced search marketing? And the reason I ask that is that I’ve heard experts say that they believe that being good at search requires the data that you get from the search marketing side of the business.

MM:
Well we need to separate two things. One is: would they be good as a search engine if they outsourced search? Of course not because they wouldn’t have the engine anymore.

MA: No, if they outsourced search marketing…

MM: AOL never had viable search technology. The real question was “who are they going to outsource their search engine marketing to”, “who are they going to paid search to”. They had 2 choices in the beginning, I guess they have 3 now but that deal’s been locked up. Yea, there’d be a hallowing out of the R&D infrastructure for Yahoo – look at all the effort they put into Panama – were they to outsource search to Google. The question is for them strategically – do they want to stay as a principle in search and those are the keywords that the company’s been using and they used in their last earnings call. Just a week and a half ago, they went out of their way to say that they wanted to remain a principle in search.

MA:
They’ve been signaling that all along, meanwhile they did this deal with Google to do a test, which is interesting. And do you think that means, because of their signaling to the market that they need to remain a principle in search, to sort of quote them, that they realized that a search deal with Google is not a good business decision, putting regulatory and approval issues aside.

MM: I think the answer to that is, if they had their choice, they would not outsource search to Google. If they had their choice, they also – that board management team – would not be in the situation of having to seriously consider that as an alternative to Microsoft and they may well view – I don’t want to overemphasize it – but they may well view outsourcing search to Google as the lesser of two evils.

MA:
I know you’re not a lawyer, at least I don’t think you are, and you’re certainly not wearing a lawyer’s hat right now. But is there any indication that you’ve seen that Google and Yahoo might be able to get away with a long term deal where they only give 10 or 20% of total searches to Google, possibly changing the basket of searches toward the higher revenue basket of searches but that might be a deal that could get past regulatory approval – have you seen anything like that? or thought about it at all?

MM:
We’ve thought about it. We don’t have a hard and fast legal opinion on that, but the logic setup is that you’re only outsourcing part of your search, it’s not exclusive, it’s kind of hard to see what the open and shut legal case against that is.

ES: And what about the recent justice department investigation that was opened up. Do you think that that was based on market share considerations or just based on the fact that there’s possible collusion going on?

MM:
That’s a good question, Erick. I don’t have a well-formed opinion on that.

MA:
It is interesting in that we are getting into hardcore legal issues now with the collusion issue and just how Google has been playing this deal the entire time. But to see how that plays out, Yahoo would have to do a deal with Google and see how it just sort of works out. I guess in that scenario, you put that into your bucket of Microsoft likely goes hostile. If Google and Yahoo do a deal, Microsoft either goes hostile or walks away, it doesn’t change the odds that you’ve put on last Friday?

MM: That’s right

ES: So, go to that 5% scenario that Microsoft walks away, Yahoo doesn’t do a deal with Google, and it remains an independent entity. What should it take from this whole process? What do you think should be the biggest lesson that it’s learned so that it can move forward on its own even? What does it need to do to remain competitive?

MM:
At the end of the day, Yahoo does still have two or three extremely large assets. Yahoo’s had a monetization challenge and they’ve had a lot of search queries, they didn’t monetize them well. Apparently up to 60-70% or more were less well, or worse, than Google. They’ve had a display advertising challenge in that this huge rise in this, not glut, but this huge onslaught of social networking ad impressions out there really put a lot of pressure on all of the ad impressions they had on their own site. And so in a way they’ve done the right things — they’ve clearly missed some major strategic moves, they missed the move towards social networks that you should have seen, arguably, Yahoo should have seen that. They’ve had some execution errors that Project Panama almost certainly, they missed one public deadline. Our sense is that that project missed multiple private, or internal, deadlines. That was the right project to improve monetization, you saw that in the improved search revenue results for Yahoo. Flip it over into the advertising business. What do you? You buy ad networks, which they did – Blue Lithium, Bright Media – to hedge yourself against the rise of social networking sites or really against the rise of multiple different sites for advertisers to go to, so if people were going long ad networks, well Yahoo decides to go long ad networks to and they bought two of the better ones out there. So I think they have done the right things. They’ve missed social networking, but they’ve generally done some of the right things. It’s really been more of an execution issue. To give them a little bit more credit, they have faced an extremely difficult competitor, Google. I’m not sure a different management team would have been able to fend off Google.

MA:
I have two more quick questions. 1) Do you think the current social networking strategy is the correct one? (I know this could be answered over a 3-hour call, but just your high level opinion) Is there direction a good one?

MM:
Sure, I think they realize the importance of social networking. We think they’ve attempted to acquire some of the leading social networking assets out there at reasonable prices. It seems like they haven’t necessarily gotten the ones they wanted, but they have shown some restraint to not aggressively paying for some of those social networking assets and they have attempted to build out the ones that they have. It seems to be there is no huge aggressive movement in there, but there are relatively strong moves in there.

MA: So just pulling up the last Morgan Stanley slide, it’s interesting (this is my last question) it shows that 61% of online advertising dollars go to Google and Yahoo!. Do you agree with this?

MM: That would seem relatively accurate. On a global basis, that number is probably too high.

MA: This is US.

MM: We may shade that number down 5%, but we’re in the ballpark [for the US].

MA:
So, 12 months from now, if integration between Microsoft and Yahoo! goes smoothly, do you think that Google will continue to have the market share dominance – what is it? 40 to50% of all online advertising revenue – or do you think it could dip down based on this competition?

MM: I think it would increase, and I have two reasons: Google to date as very little display advertising revenue. If they integrate DoubleClick well and effectively monetize YouTube, which we consider one of the least monetized sites on the Internet, they could start tapping into a bucket, which is display advertising – very small to date. At the end of the day, there are only three ways that Microsoft and Yahoo! can only gain share from Google and that’s search. Either convince each one of us to start doing more of our searches and MS and Yahoo. Why would we do that? If it’s because one bought the other, that’s a far from convincing offer to most people. Second, maybe have an R&D match up… you know, the Sunnyvale and Seattle engineers in a coffee room. There are a lot of bright minds working on search at both of those places, we just haven’t seen it. The open question and really the last area where they could have an impact on Google is just by creating a larger second place, or second tier, search engine. Could you have a liquidity impact on that first search engine? That would be an intriguing possibility here on how Microsoft/Yahoo! could have a negative market share impact on Google and search. We’re not going to know that for a year and a half or two years from today, assuming everything goes to plan. In the mean time, and I want to get back to that reason number 1, throughout that whole period in time there is dislocation in the market. You know, who’s your sales rep at Microsoft… who’s your sales rep at Yahoo! (in terms of their search engines)? And, guess what, throughout this whole time, Google is starting to attack more and more aggressively, maybe effectively, we’ll find out, on the display advertising market. I think it’s a reasonable bet that Google’s share of the total US advertising and the world Internet advertising is the same or maybe even a little bit greater over the next two years.

MA: So if you’re Steve Ballmer, do you walk from this deal or go after it aggressively?

MM:
You go after it aggressively. You know what it’s like to see businesses increasingly concentrate on one provider. The longer you wait to attack that provider, the worse your odds. You can’t walk away.

MA: Eric, did you have anything else, or should we let Mark guessing where the markets are going tomorrow.

ES:
I think that’s a great place to end it.

MA: Thank you Mark very much for your time.

MM: Take care.

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