The Value Line Daily Options Survey

Investment Opportunities in the Proposed Microsoft/Yahoo! Combination

In this week’s report, we assess Microsoft’s high-profile pursuit of Yahoo! and discuss the various ways that investors can participate in the proposed transaction. As well, we mark the one-year anniversary of our Model Covered Call Portfolio with a brief review of its performance.

Terms of the Proposal

On February 1st, Microsoft Corporation announced that it had made an unsolicited offer to buy Yahoo! Inc. for $31 per share, or $44.6 billion, for the entire company. The proposed consideration is $31 a share in cash or 0.9509 of a share of Microsoft, based on the January 31, 2008 closing price of $32.60, prorated so that it would be a 50% cash and 50% stock transaction. At the time of the announcement, the offer represented a 62% premium to Yahoo! stock’s closing price on the day prior to the bid. The premium has since narrowed, reflecting the fall in the price of Microsoft stock. On February 11th, Yahoo!’s board rejected the offer, saying that it “substantially” undervalues the company. On a blended basis, the offer of $15.50 a share in cash and 0.47545 of a share of Microsoft was worth $28.993 for Yahoo! stockholders at the close of trading on February 26th.

The Redmond, Washington-based Suitor Microsoft is the largest independent purveyor of software products for a wide range of computing devices. Demand for the company’s Vista operating system is growing, and it’s in the midst of an exciting product/services rollout cycle. Significantly, too, a large, and expanding, presence overseas, particularly in fast-growing emerging markets, will likely minimize the impact of any sluggishness in the domestic economy. Value Line expects the software giant’s per-share earnings to compound at a mid-double-digit annual percentage rate over the next three to five years, supported, in part, by aggressive stock repurchases.

MSFT shares carry our top rank (1) for Timeliness. We also expect them to generate superior capital appreciation over the long haul. The dividend yield is somewhat meager, but cash flow that’s likely to exceed $20 billion per year affords directors substantial flexibility, with respect to raising the regular dividend and/or paying a special dividend, like the $3.00 a share paid out in late 2004. The company also had $21 billion in cash at the end of 2007.

The Sunnyvale, California-based Target

Yahoo! is a leading online supplier of aggregated proprietary and third-party content, search, and navigation services. Competitive pressures from the likes of Internet search giant Google are taking a toll, though, and earnings have fallen for two straight years. Profit margins have contracted dramatically, and our projection that share net will about double to $1.05 by 2010-2012 is highly tentative and assumes drastic cuts in expenses.

YHOO shares have been trending downward for several years, and had fallen to levels not seen since 2003 when Microsoft made its offer. Their Timeliness rank has been suspended, due to the possibility of an extraordinary transaction. It would otherwise be 3 (Average). At the current price ($28.22; all prices cited in this report are as of the market’s close on February 26th), they are trading at 51.3 times our earnings estimate for 2008, and close to our three- to five-year price target.

Yahoo!’s Days as an Independent Concern Are Probably Numbered

In addition to rejecting the $31 offer as insufficient, the California company is apparently exploring strategic alternatives. The speculation in the media is that Yahoo! is talking with Time Warner/AOL, NewsCorp., and Google about potential mergers or partnerships. A deal with Google is unlikely, not least of all due to antitrust concerns. An agreement with either of the other two potential suitors would probably be too complicated for most Yahoo! stockholders. All in all, we’re skeptical that a White Knight, particularly one with a meaningfully superior bid, will materialize. Indeed, our view is that Microsoft will ultimately succeed in its pursuit, the only question in our mind being the eventual takeover price.

According to Microsoft, the two companies have had discussions dating back to late 2006 about potential commercial partnerships and mergers. Microsoft further notes that Yahoo! rebuffed takeover overtures last February, wanting time for a “reformulated strategy based on certain operational initiatives” to take hold. It also said that the target’s “competitive situation has not improved”.

The software giant’s long courtship and aggressive offer (62% premium) certainly underscores its determination to effect a combination. The company responded to the latest rejection by hinting at the possibility of a hostile takeover, which could take the form of a proxy battle to replace Yahoo!’s entire board of directors at the annual stockholder’s meeting in June.

We don’t think it’s in either of the two companies’ best interests to let this mating dance drag out for too long or for it to become too contentious. For Microsoft, a protracted battle that would undoubtedly further weaken Yahoo!, by distracting management, hurting morale, and costing top talent, would mean a less attractive acquisition. For Yahoo!, if Microsoft were to walk away and no other suitor emerged, its stock then would most likely quickly drop back to pre-announcement levels, south of $20.

Yahoo! is apparently unwilling to consider bids below $40 a share, which is considerably above the only offer that’s on the table. Absent another offer, though, the company has little bargaining leverage, especially if Microsoft is willing to fight a proxy battle. Our best guess is that a deal will get done at about $34 or $35, which wouldn’t be prohibitively dilutive to the acquirer. We also think that a merger agreement will be reached before the date of the target’s shareholder meeting. Such a scenario would probably trigger a modest rebound in the price of Microsoft stock, since fears that it would overpay likely account for some its recent weakness. Assuming that this is how the takeover battle plays out, investors have the following ways to participate.

Ways to Participate

1. The simplest investment would be an outright purchase of Yahoo! stock, with 100 shares costing $2,822 (100 x $28.22). This would be tantamount to buying Microsoft stock at a 2.7% discount if the deal goes through at the current terms, since they would be exchangeable for 47.545 MSFT shares plus $1,550, worth a total of $2,899 (price of MSFT: $28.38). The investment becomes more attractive if the price of MSFT rises, the offer is increased, and/or another suitor enters the fray.

2. An alternative to this would be the purchase of a deep-in-the-money call option on Yahoo! The asking price on a July $20 call is $9.00, so a contract would cost $900 (100 x $9.00). The $0.62 time premium reduces the profit potential, but the smaller outlay reduces both the downside risk and carrying cost, while offering superior percentage return potential. If a deal were to close at $35, 100 shares would yield a 24% capital gain, whereas the call would generate 67%.

3. A more conservative approach would be a covered call, whereby the investor would purchase 100 shares of Yahoo! for $2,822 and sell a July $30 call option for $184 (with a bid price of $1.84). The net cost would be $2,638. This position would prove profitable as long as Yahoo! shares are trading above $26.38 at the option’s expiration, and would generate 13.7% if they reach at least $30. The $1.84 in premium received from the option sale also provides a cushion in the event that no deal is consummated. The downside to this strategy is that the investor wouldn’t participate in any upside beyond $30.

4. A fourth approach is called a vertical spread, whereby the investor buys a July $20 call option on Yahoo!, as a proxy for the stock, and sells a July $30 call. The long position would cost $900 and the short position $184. The net outlay for this spread would be $716 ($900 - $184). At expiration, this strategy would yield 40% if Yahoo! stock trades at $30 or more, since the two positions would net $1,000. It would be profitable at a price above $27.16, and the maximum capital at risk is $716, the initial outlay to create the spread.

5. The final alternative is the selling of naked puts. Based on the expectation that the two companies will come to terms by midyear, an investor could sell July puts on Yahoo!, at strikes of $27.50, $30.00, $32.50, or $35.00. Alternatively, the investor could generate premium income by regularly selling shorter-term options at the $27.50 strike, assuming that the possibility of a deal will keep the price of Yahoo! stock above that price. The writing of higher strike puts offers greater profit potential, but increases the risk that the stock could be put to the writer. That said, as long as talks don’t collapse, even this probably wouldn’t be a bad outcome since the writer would eventually end up with Microsoft stock, hardly a bad proposition.

The best strategy depends on each investor’s propensity for risk, amount of capital on hand, and level of confidence in how the situation is going to play out. The second alternative offers the greatest leverage, and is probably best-suited for aggressive investors who share our assessment that Yahoo! will ultimately be acquired at a price north of $31. The third and fourth alternatives are fairly similar, and either may be appropriate for investors who think a deal will get done on terms that are not that different from those currently on the table. The former offers greater profit potential, but also has greater downside risk, since the initial outlay is larger ($2,638, versus $716). Note, too, that all of these strategies would probably prove profitable even if our expectation that Microsoft will prevail proved wrong and a White Knight emerged.

Update on Our Model Covered Call Portfolio

This portfolio was established on February 27, 2007, in the aftermath of the market turmoil that was triggered by a sharp selloff in Chinese stocks. We noted then that the ideal environment for a covered call portfolio would be a steadily rising market. The past 12 months have been far from ideal, with stocks gyrating wildly both from trading session to trading session and intraday. This volatility caused us to significantly lag our expectations. That said, the portfolio outperformed the Standard & Poor’s 500 Index by 5.0 percentage points, rising 3.7%, while that key benchmark lost 1.3%

Prepared by George Rho
Senior Options Strategist vloptions@valueline.com