Yahoo!: Bet on Investor Activism
Maxwell is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Though many activist investors have made substantial fortunes by unlocking the value of the firms they influence, Jim Cramer recently questioned the prospects for activist investors in Chesapeake Energy (NYSE: CHK) and Yahoo! (NASDAQ: YHOO). His skepticism is based on the past performance of each company. This crying over spilt milk is just sunk cost bias.
Simply put, when betting on a turnaround one acknowledges that the company was going in the wrong direction. Instead of longing for a strategic vision in these companies, investors should consider these investments on the basis of valuation.
Today’s Shareholder Activist Investments
Yahoo! investors are lucky to have an advocate in the stock’s largest outside owner, Third Point LLC. This activist investment firm challenged Yahoo!’s board over the resumes of CEO Scott Thompson and director Patti Hart, which resulted in the termination of Thompson. Third Point’s CEO, Daniel Loeb, was correct to confront Yahoo! leadership on this scandal based on its own merit and also as an opportunity to assert shareholder interests over Yahoo!’s future.
Yahoo!’s 1.4 price-to-book ratio, 17.6 price-to-earnings ratio, and 3.65 price-to-sales ratio do not do justice to the sum-of-parts valuation of the company. Yahoo! owns about 40% of Alibaba, which is valued at $35 billion. Yahoo! recently negotiated a sale of 20% ownership in Alibaba, which is expected to reap $6.3 billion in cash and $800 million in preferred shares. Based on projections for the current sale of 20% of Alibaba, Yahoo!’s remaining 20% stake would also be worth $7.1 billion. Yahoo!’s 35% stake in Yahoo! Japan is said to have an $8 billion market value. Yahoo!’s ownership of these two Asian web properties amount to $22.2 billion. Since Yahoo! is currently trading at a $18.9 billion market capitalization and has $2.2 billion in debt, all of Yahoo!’s other assets are basically trading for free based on Yahoo!’s $15 share price. (This analysis ignores taxes from such sales, though it also ignores tax-avoidance strategies like acquiring other firms with overseas tax-losses.)
At today’s prices, investors should consider buying shares of Yahoo!. The stock is at prices that give away its landmark web properties for free. In addition, individual investors will benefit from activist investors like Third Point who will continue to push for liquidation, management accountability, and a return of capital to investors.
Chesapeake Energy may also prove to be a good activist play. The current board is repentant for the undisclosed personal loans made to CEO Aubrey McClendon for an independent venture. The board has promised to cut McClendon’s pay, has stripped him of board chairmanship, and announced a 20% pay cut penance for independent directors. The board has also punished itself giving up the use of company aircraft. However, these concessions are insufficient for key investors who wish to see board members replaced.
Today Chesapeake shares trade near $15 per share at a 6.0 price-to-earnings ratio, a 0.74 price-to-sales ratio, and a 0.68 price-to-book ratio. It is cheap at these prices, and the rise of investor activism in this fund may force a coup in the board and a turnaround in stock price in the near future.
Tomorrow’s Principal-Agent Struggles
Make no mistake: control matters. Executive behavior changes if management is unchallengeable. Retail investors should follow pension funds and other institutional investors by questioning, discounting, or avoiding firms whose management controls a majority of shares.
Google’s (NASDAQ: GOOG) ownership presents a problem for thoughtful investors. Insiders control the company. Larry Page, Sergey Brin, and Eric Schmidt control 66% of existing voting rights based on their ownership of Class B shares with enhanced voting rights. Even as a block, outside investors have no means to challenge the direction of Larry, Sergey, and Eric.
Bear in mind that Larry, Sergey, and Eric are not likely to trash the firm for personal gain. Since Google is incorporated in Delaware, Class A shareholders would have to approve any preferential dividend to Class B shareholders. Moreover, these men are each paid $1 in salary and are compensated primarily by the appreciation of their existing stock holdings.
However, it is not just a financial conflict of interest that Google investors should fear. They should fear how Google’s key people are not fearful of scrutiny, criticism, or the possibility of termination. They may pursue projects which investors view as being wild goose chases. Certainly, R&D costs have increased year-over-year. R&D expense was 13.6% of revenues in 2011, up $1.6 billion ($1.4 billion cash and $0.2 billion stock incentives) from last year. These increases are the result of a 10% increase in R&D salaries and a 23% increase in headcount. The 10-K plainly states an expectation to continue raising R&D expenditures:
“We expect that research and development expenses will increase in dollar amount and may increase as a percentage of revenues in 2012 and future periods because we expect to continue ...”(p. 34)
Since the threat of an investor or board-led uprising does not weigh on Google’s key people, there is nothing to stop endless, fruitless R&D.
And yes, the R&D spending at Google and parade of new projects has not yet borne fruit. According to Google’s latest 10-Q filing, search and advertisement revenues accounted for $10,225 million in revenue, while everything else Google does accounts for only $420 million of firm revenues. That means that 96.1% of revenues are from web search, while all the other projects Google dabbles in are a 3.9%-of-sales side show.
Unfortunately the vanguard of web 2.0, Facebook (NASDAQ: FB) also affords unshakable control to its key person, Mark Zuckerberg. The company’s two share classes with differential voting rights give Zuckerberg 57% of voting rights over the firm though he retained a minority 28% stake of Facebook ownership. Though Zuckerberg is a brilliant young man, he is not perfect.
The relationship between Facebook management and its investors or the relationship between Google management and investors may not become strained. Of course, I wish them well. But like marriages, many management/investor relationships sour. Shareholder control is like getting a prenuptial agreement: it’s just prudent.
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