Yahoo Deal (Bargain)?

Yahoo just dropped over 10% today after it announced a stop to talks with Microsoft. This drop might be exaggerated, ignoring much of Yahoo!'s stand alone value and ability to broker other favorable deals that can add both short- and long-term value for shareholders. Please keep in mind the following:

• After today's drop, Yahoo!'s trailing P/E is close to 30, which is much lower than it's been in quite some time.
• Yahoo! quickly announced a flexible, non-exclusive search deal with Google that could add $250-$450 million in free cash flow within the first year.
• Microsoft is still open to a deal with Yahoo!, just not an all-out acquisition. The Google-Yahoo! deal is the last thing that Microsoft wanted to come out of the whole Yacrosoft hoopla. Don't expect Microsoft to just sit back idly.
  

To this last point, Microsoft may have had no intention to buy Yahoo! (as Gates and Ballmer have both alluded to), but to rather ruin Yahoo! and fight aggressively for its current market position. Yahoo!'s search outsourcing deal with Google would certainly ruin Yahoo!'s long-term legitimacy in search, but as a clear windfall for Google and not Microsoft. Regardless of what Microsoft's Yacrosoft intentions were, they can not stand by and let Yahoo! shop its search out to Google.

So, Yahoo!'s position as the #2 in search should not be undervalued. They're stuck between two battling titans who are more than happy to give the company a favorable deal. If Microsoft is ready to recognize $33 in value for each Yahoo! share, $23 should be seen as a fleeting discount. Any deal that Microsoft and Yahoo! might do will likely reflect this value, even if the deal isn't a full acquisition. Similarly, if Google does go ahead with the Yahoo! deal, the bottom-line gains will add instantaneous value to the company and let it pursue the defense of its own bread and butter, display advertising.

For an example of the value that bottom-line gains might add to Yahoo!, if you add $250 million to Yahoo!'s 12-month trailing earnings, Yahoo!'s current P/E ratio would be 25.5. If you add $450 million, which is the high-end of the deal estimates, you'd get a P/E of about 22. If you expect Yahoo!'s earnings from other sources to simply remain stagnant, you still have a Yahoo! stock that's pretty cheap on valuation, something we haven't been able to say for years!

So, the main takeaways here are the following:

• The deal with Yahoo! signals Google's strength. Buy on this strength.
  
• The end of dialog between Yahoo! and Microsoft has unduly suppressed Yahoo! shares. Buy on a possible short-term correction

However, please mind the following caveat: If a Google-Yahoo! deal doesn't hold up to regulator scrutiny, expect Yahoo! to go sideways or continue its downward trend.