Yahoo: Can it Get the Respect it Deserves?
Maxwell is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Yahoo! (NASDAQ: YHOO) seems to be stuck in a bad impression of a Rodney Dangerfield routine. No matter what it is does, it cannot seem to get any respect. Yahoo!’s lack of respect may be its own fault or simply the market’s refusal to see the value of the business. What is known is that the company has not helped its own cause. Its approach to the firing of Carol Bartz made Yahoo!!’s board of directors seem crass and even a little cruel. The ruckus that has occurred over apparent falsehoods in Scott Thompson’s resume and the failure of the selection committee to uncover it has left the board looking dangerously incompetent. The question is whether the Mother's Day resignation of Thompson and the deal with Third Point, the activist hedge fund that exposed Thompson’s resume snafu, will provide the catalyst that the long suffering shareholders need to realize value or will the melodrama that has been Yahoo! over the last three years continue.
Current Situation
Scott Thompson tendered his resignation on May 15, 2012. The new Chief Executive Officer will be Ross Levinsohn, a former internet media executive at News Corp. The deal announced on Mothers’ Day calls for three of Third Point’s four nominees to join Yahoo!’s board on May 16. Daniel Loeb, the founder of Third Point, is to be one of the three appointees. Third Point currently holds approximately a 5.8% stake in Yahoo!’s common equity. Loeb has consistently argued that Yahoo! is undervaluing its stake in Alibaba and the company should have accepted Microsoft’s (NASDAQ: MSFT) $31 dollar share offer in 2008. Jack Ma, the founder of Alibaba, announced in February 2012 that he intended to take Alibaba, whose primary share listing is in Hong Kong, private. Alibaba’s U.S. listing trades over the counter on the “pink sheets”.
In my opinion, the impact of Loeb joining Yahoo!’s board will likely be a halt or slowdown in Yahoo!’s pursued sale of its Alibaba stake to Jack Ma. As Loeb’s letter makes clear, Third Point believes that Alibaba may have significant upside potential for Yahoo! and its investors. Silver Lake and Singapore’s Temasek investments in Alibaba during the autumn of 2011 was widely reported and depending on the exchange rate used for Alibaba implied a value of between $31 and $35 billion. Assuming the $35 billion valuation, then Yahoo!’s 40% stake is worth $11.42 pre-tax per share for Yahoo! or roughly $7.50 after tax. These numbers all argue positively for Yahoo! and its shareholders, but for the Alibaba investment to be monetized requires that investor accept the fact that Yahoo! is primarily a venture capitalist with a poorly run internet business as a sideline enterprise. Determining the true value of Alibaba is extremely difficult. Yahoo!’s 40% stake is a minority interest that is likely only to be provided full or near full value by Jack Ma prior to any large scale U.S. initial public offering. Reaching an IPO is not guaranteed and is highly reliant on the buoyancy of the U.S. stock market and Western investors’ appetite for Chinese stocks.
In addition to Alibaba, Yahoo! owns a 34.75% interest in Yahoo! Japan. The largest holder of Yahoo! Japan is Softbank at 35.45%. Yahoo!’s reconfigured board is likely to pursue a sale of its Yahoo! Japan stock, which trades on the Tokyo Stock Exchange and had a recent market capitalization of 1.4 trillion Yen or approximately $17.5 billion. This equates to an after-tax value to Yahoo! of $3.3 per Yahoo!’s minority stake.
The most interesting impact of Loeb joining the board is whether Yahoo! will sell itself in its entirety or in pieces. Microsoft remains the most likely buyer for all of Yahoo! (excluding the Asian investments) and may have allies in Yahoo!’s founders, Jerry Yang and David Filo. The two hold slightly less than 10% of Yahoo!’s stock. Although Yang furiously fought Microsoft’s 2008 takeover, the risk of Yahoo! being carved up and sold may lead Yang and Filo to support a Microsoft bid. Additionally, Yahoo!’s 2009 search deal with Microsoft essentially outsourced Yahoo!’s search functions to Microsoft.
Whether Microsoft would be interested in Yahoo!’s collection of destination sites is unclear given the continued decline in display advertising prices that destination sites have been able to charge. Yahoo! was originally a pure play search service, but its approach to the internet evolved as Yahoo! elected to build media assets to drive traffic to Yahoo!’s site. These designation site assets may attract bidders like Liberty Interactive or Disney. It is unlikely the largest internet search company, Google, would have either an interest in Yahoo! or could clear anti-trust hurdles in the U.S. and potentially Europe.
Valuation
I personally feel that Yahoo! remains one of the most difficult internet stocks to value and equity investors should keep this fact in mind. The primary purpose of purchasing Yahoo! today is for the potential to reap the awards when its non-operating assets are sold. The two largest are Alibaba and Yahoo! Japan. As noted before, investing in Yahoo! to capture equity sales is essentially treating Yahoo! as a venture capital fund, with all of the corresponding risks.
Yahoo!’s March 31, 2012 10-K showed roughly $2.80 of cash, investments and accounts receivable less accounts payable per each fully diluted share. Reducing the cash balance by capital leases and deferred tax obligations left a value of nearly $2.00 per share. I believe both the Yahoo! Japan and the Alibaba investments require a minority stake discount to be applied. This discount is always difficult to determine, but I believe 20% is reasonable given the profitable nature of each asset, but the limited universe of potential buyers. At 80% of fair value, this provides approximately $8.70 per share to Yahoo! I estimate that the combined value of the cash and equity investments is $10.70, which is essentially the floor for Yahoo!’s stock price.
The remaining value in Yahoo! is in its operating businesses. Operating cash flow for the last twelve months ended March 31, 2012 was close to $1.4 billion and earnings were approximately $1.1 billion over the same period. The trailing twelve months of earnings for Yahoo! contain over $500 million of earnings from its Asian investments. This percentage coming from the Asian investments is likely to continue to grow, which will depress the price to earnings ratio of Yahoo! in 2012. Given that these earnings are non-cash, they need to be stripped out of Yahoo!’s operating performance for valuation. I estimate that Yahoo!’s operating businesses generated roughly $870 million in free cash flow available to the equity holders. For any business to operate its needs some reinvestment back into its business, which has been a problem for Yahoo! as this reinvestment has yielded declining returns.
With this mind, I believe that Yahoo! will generate roughly $918 million in free cash flow over the next 12 months and its operating assets are worth on a standalone basis $6.25 a share. Based on my estimates, I feel that a combined Yahoo! is worth slightly less than $17 a share. Yahoo! recently traded near $15.50 and given thee risk associated with the stock, I believe a 30% margin of safety is warranted. This would justify an $11.90 target entry price. Any investor looking to capitalize on Yahoo! should have a fairly long time horizon. There is little doubt that Yahoo!’s primary value lies in its Asian equity investment and that these investments hold significant upside potential, but to monetize them may require Yahoo! to take a longer term perspective than speculative investors may realize.
Overall, I like Yahoo!, and I believe the financial press is unfairly holding back on respecting Yahoo!. I do not believe that the stock currently provides enough margin of safety to warrant an investment at these levels. The departure of Scott Thompson and the Third Point board appointment will likely drive the stock price higher although the price will likely decline again after short term profit taking and the realization that the Asian assets will take more time than anticipated to be monetized. I believe there is a fairly good chance that Yahoo! will decline to levels that provide appealing risk reward characteristics and equity investors should keep the stock on their watch list.
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