Evidence Now Suggests Yahoo's Q1 Will Be Strong, So What Next?

All eyes are on Yahoo's Q1 (YHOO).

If Yahoo blows the quarter--by delivering revenue growth below the high-end of the guidance range--management will look like (and be) idiots for not having negotiated with Microsoft before their business deteriorated. If Yahoo blows out the quarter, meanwhile, management will look like heroes for insisting on a higher valuation, and Microsoft will likely end up paying one.

So what do we know about Yahoo's quarter?

For the past couple of weeks, we've known it was "consistent with previous guidance"--i.e., revenue up 8%-17%. By now, however, we also know something else: Revenue growth was almost certainly in the high end of that range.

How do we know that? Because Yahoo's board may be indecisive and feckless, but they aren't stupid.

Yahoo's board knows what the Q1 numbers were, and it doesn't need $300 million in M&A advice to also know that, if Q1 is disappointing, the company's negotiating leverage will decrease. And yet, despite Microsoft's threat to cut the offer in two weeks, as of this morning, Yahoo is still refusing to negotiate (at least according to a Microsoft source we talked to).

So, at this point, we think it's safe to assume that Yahoo's revenue growth will be in the high end of the range--say 14%-17% growth.

WHAT HAPPENS IF YAHOO HAS A STRONG Q1?

Well, first, before the quarter, Microsoft will likely get its PR engine in gear to condition the market to expect a high-end quarter. Right now, thanks to a couple of reports in the New York Post, the market expects a weak quarter, so even a marginal above-consensus number would be greeted with shock and cheers. Unless Microsoft wants to react to this by parroting the lame theme that its "valuation is not based on a single quarter," it needs to get out there and move the consensus up. That way, a strong quarter won't be a surprise. So, in the next week, expect to see a bunch of stories suggesting that Yahoo's Q1 will be strong.

Second, Microsoft may be able to use a strong quarter as an excuse to avoid cutting its bid when it launches an exchange offer. Cutting the bid will piss off the very shareholders Microsoft is trying to suck up to, so a strong quarter might give Microsoft an excuse to say, "good, business is still strong, so we don't need to cut bid," and shareholders would probably react favorably to that.

Third, on deep background, Microsoft will try to plant the idea that the quarter was only strong because Yahoo's management stuffed every dollar of revenue they could into the quarter, raiding the future as they did. "Sure Q1 was strong," Microsoft will try to get people to say, "but how do you know they didn't just steal revenue from Q2?" Etc.

Fourth--and here's the good part--Microsoft might use the quarter to send a backchannel message to Yahoo that it is impressed with the company's performance and is now ready to pay $35, if only Yahoo comes to the table. And, having saved face, and wishing to avoid an unpleasant fight, Yahoo might just do that (after leaking that it is only launching talks because Microsoft has effectively agreed to raise its price).

Lastly, if Yahoo posts a good quarter and still refuses to engage, we think Microsoft will either post its slate of directors or, less likely, walk away. Even with a strong quarter, it's not impossible that Yahoo's stock will soon be back at $20 again.