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posted on 06 October 2016

The Romance Is Over

by Ari Charney, Investing Daily

Investing Daily Article of the Week

You never know what someone is really like until you have to live with them. That can also be the case with mergers and acquisitions, even with all the due diligence that companies perform prior to closing big deals.

This time around, however, circumstances forced Yahoo Inc. (NSDQ: YHOO) to reveal to its prospective suitor, Verizon Communications Inc. (NYSE: VZ), that the troubled Internet pioneer comes with significant baggage, even before the two got to the altar: one of the biggest data breaches in history.

The former search giant recently learned that it was the victim of a massive state-sponsored hack in late 2014, one that compromised 500 million accounts. Conveniently, Yahoo claims to have only discovered the mega-breach after the deal was signed.

Verizon has been hoping to make hay from companies perceived by most consumers as Internet also-rans.

Last year, the telecom giant acquired AOL, a company that had been a punchline for more than a decade, for $4.5 billion. During that time, however, AOL developed two assets that Verizon coveted: exclusive short-form video content that’s perfect for smartphone users and a program that automatically targets ads to those watching mobile video.

In a complementary move, Verizon agreed to purchase Yahoo’s core operations and land holdings in a $4.8 billion deal that was announced in late July. Like AOL, Yahoo was, for a time, one of the dominant Internet portals of the 1990s, but lost the crown to Google and has long since been a punchline too.

But also like AOL, Yahoo has developed original content and ad technology that Verizon covets and intends to combine with similar assets it acquired from AOL.

Although this latest deal could double Verizon’s digital ad sales, the telecom would still have just a 4.4% share of the $187 billion market, ranking it a distant third behind Facebook, which has a 17.2% market share, and Google, which boasts a 35.7% market share.

As the No. 1 wireless company in the U.S., Verizon has nearly 113 million customers. And management believes that the insights the company has into these customers’ habits and locations at any given moment can help deliver the sort of closely targeted advertising that will help it win a greater share of the mobile ad space.

The question now is whether the Yahoo hack changes the firm’s value proposition and, if so, whether Verizon will be able to back out of the deal.

The data breach certainly entails considerable drama, including investigations, regulatory scrutiny, and presumably eventual litigation.

Perhaps more important, the hack could persuade users to abandon Yahoo in droves, even though it occurred nearly two years ago and the company has found no evidence that the state-sponsored actor is still lurking in its network.

For now, most analysts believe the breach will have a limited impact on Yahoo’s valuation and the habits of its more than 1 billion active monthly visitors. The breach mostly targeted email accounts, whose users may not have significant overlap with the audience for Yahoo’s websites that Verizon wants.

For its part, Verizon has understandably remained mostly mum, though clearly it’s working to assess the deal’s viability in light of this news.

A company spokesman told the media,

“We will evaluate as the investigation continues through the lens of overall Verizon interests, including consumers, customers, shareholders and related communities. Until then, we are not in position to further comment."

In order for Verizon to abandon the deal, the “material adverse change" (MAC) clause would have to be triggered. In the merger agreement, a material adverse effect is defined as one that would

“reasonably be expected to have a material adverse effect on the business, assets, properties, results of operation or financial condition of the business, taken as a whole."

Although most analysts believe the hack does not constitute a MAC, one attorney who reviewed the merger agreement told The Wall Street Journal that because Yahoo promised Verizon that no significant breaches had taken place or would take place prior to closing that this could give the telecom leverage to renegotiate or even walk away.

However, other legal analysts noted that it’s rare for MACs to get triggered, and that courts have a very high standard for whether its conditions have been met.

But it’s also exceedingly rare for such breaches to go undetected for so long - the average period from hack to detection is around 150 to 200 days, not nearly two years - and if it’s revealed that Yahoo knew about the breach prior to the agreement, then that would give Verizon another legal escape hatch.

Perhaps we lack the strategic vision that Verizon has of how to put these Internet has-beens to good use, but given the latest news, we’d prefer the telecom to scotch the deal. Unfortunately, it sounds like that would entail a costly legal battle that wouldn’t necessarily achieve its aim.

At the very least, we would like to see Verizon renegotiate the deal. The telecom’s execs are reportedly “livid" about the hack, and one insider says they’ll seek to revise the deal price “at a minimum."

Hopefully, that conversation is already taking place.

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