The Microsoft-Yahoo Merger-Arb Plays

The New York Post says that Yahoo’s board is splitting into factions, with one group taking its fiduciary duties seriously, and the other, more emotional, group supporting CEO Jerry Yang’s attempts to rebuff the Microsoft takeover bid. It also reports that Yahoo’s share price is still trading at a premium to the bid:

Yang pleaded his case in a letter to shareholders Wednesday night, reiterating that Microsoft’s bid substantially undervalues the company.

Investors didn’t agree with Yang, as they pushed up Yahoo!’s price to $29.98. Microsoft’s offer currently stands at $29.05.

That’s a premium of more than 3%; when we last looked at the bid arithmetic, the premium was 2%.

I suspect that there are three different merger-arb plays going on here. The first is the obvious one – buying stock in the hope and expectation that Yahoo’s board (perhaps installed as a result of a Microsoft proxy fight) ends up accepting the Microsoft bid. Obviously you wouldn’t buy Yahoo stock at a premium to the bid price if that was your game.

The second merger-arb play is that Yahoo is just playing hard to get, and that Microsoft will end up buying the company after raising its bid to $36 or $40 or whatever. If that’s what you think will happen, then the shares might well be a strong buy at these levels.

And the third merger-arb play is somewhere between the two. Microsoft buys Yahoo, for $31 in cash and stock, which is what the terms of the original bid were. Since then, Microsoft stock has fallen in value, so it might have to bump up the exchange ratio between its shares and Yahoo’s shares. But the headline dollar value of the bid remains the same as it always was. If that happens, then there’s another 5% or so left in Yahoo stock – something which can be quite profitable, if you’re leveraged enough.

The one thing that you can be quite sure of, however, is that absolutely no one is taking Yang’s words at face value and buying Yahoo at these levels because that’s what they think the company is worth absent a bid from Microsoft. If the bid fails, Yahoo’s stock plunges. That’s the risk the merger arbs are taking.