Yahoo!'s Earnings Are Pivotal in Merger

SAN FRANCISCO - Yahoo!'s(YHOO) first-quarter results could be a valuable bargaining chip in its merger talks with Microsoft(MSFT).

In making a swift response to the threat of a proxy fight, the Internet giant may be signaling it expects to report a decent quarter, or at least one that will help it to wrangle more money out of a potential merger between the two companies.

Yahoo! on Monday stood firm in its belief that Microsoft is substantially undervaluing its worth. This comes just a little over two weeks before Yahoo! plans to report first quarter earnings.

Microsoft, on the other hand, may be banking on weak results from the Sunnyvale-Calif.-based company. Chief Executive Steve Ballmer turned up the heat on Yahoo! over the weekend, giving it three weeks to come to the table and work out a deal or face a proxy battle with Microsoft to elect alternative directors to Yahoo!'s board.

"I think what prompted Microsoft's motion to Yahoo! is that they think they'll do badly but Yahoo! responded quickly and confidently," says analyst Jeffrey Lindsay, an analyst with Sanford Bernstein, which does make a market in Yahoo! and Microsoft.

Lindsay adds that Yahoo! likely wouldn't have been quite so vocal in its opposition to Microsoft on Monday if it didn't have some idea of how it would do this quarter.

"They're either really good at bluffing or they don't think they'll come in with a bad quarter," Lindsay says.

Last month, Yahoo! reiterated its revenue guidance of between $1.28 billion and $1.38 billion for the first quarter. It expects a top line of $5.35 billion to $5.95 billion for the year. Analysts are predicting first-quarter revenue of $1.33 billion and full-year revenue of $5.64 billion.

If Yahoo! does meet or beat estimates, it could allow the company to finagle a higher bid out of Microsoft. Chief Executive Jerry Yang and Chairman Roy Bostock have already stated in their letter to Ballmer that the current offer price of $31 a share is unacceptable.

Microsoft, for its part, has implied that it might even lower its bid if it is forced to take its offer directly to Yahoo! shareholders, an action that "will have an undesirable impact on the value of your company from our perspective which will be reflected in the terms of our proposal," Ballmer wrote in his letter over the weekend.

The company has also pointed out that the macro-economy has only deteriorated in the time that Yahoo! has failed to reach an agreement with Microsoft.

"During these two months of inactivity, the Internet has continued to march on, while the public equity markets and overall economic conditions have weakened considerably, both in general and for other Internet-focused companies in particular," Ballmer wrote. "At the same time, public indicators suggest that Yahoo!'s search and page view shares have declined."

Marianne Wolk, an analyst for Susquehanna Financial Group, says she doesn't think Yahoo! will be able to extract more money from Microsoft's pockets. For one, Yahoo! has not been able to find another suitor who could offer a better deal.

Wolk also points out that Yahoo! faces even greater challenges in the future, especially with rival Google(GOOG) recently acquiring Double-Click, giving it a foothold in the lucrative display advertising arena, where Yahoo! is now dominant.

"The more likely scenario is that Microsoft pursues the proxy fight," says Wolk, whose firm makes a market in Yahoo!, Microsoft and Google.

Analyst Martin Pyykkonen of Global Crown Capital, says a proxy fight would be the worst outcome for both companies because it would tie up any potential deal well through the summer, followed by an exhaustive regulatory proceeding