As the Web Evolves, are Investors Less Relevant?
Maxwell is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Fool me once, shame on you. Fool me twice, shame on me. Fool me three times, and I clearly am not competent to make decisions for myself. Investors should have learned from the examples of AOL (NYSE: AOL) and Yahoo! (NASDAQ: YHOO) that the leaders of web companies can be at odds with investors. These conflicts can delay reforms within a firm and erode shareholder value. Unfortunately, Google (NASDAQ: GOOG) and Facebook (NASDAQ: FB) investors are complacent that a small number of key people in each firm have a majority of voting rights. This ignores history, and could exacerbate problems in the future.
When Times Are Tough Managers and Board Members Stay The Course
Web usage is constantly changing, and firms need to change with it to stay relevant and to generate the most value from their existing operations. Unfortunately, insiders seem committed to the status quo. Outsiders such as activist investors often have to shake things up despite the protests of hard-headed board members and executives who are enamored of prior ideas and strategies. It is hard to let go and harder to admit you were wrong.
A power struggle in AOL is currently making headlines. One of AOL’s largest investors, Starboard Value LP, wants shareholders to elect a new board. Starboard published its analysis which attributes an adjusted EBITDA loss of $398 million to AOL’s free and premium content display activities. Starboard also attributed a $147 million adjusted EBITDA loss to AOL’s patch display activities. These two segments keep AOL’s total adjusted EBITDA margin at 18% instead of a potential 57% margin which is projected without these activities.
Starboard says that these operations should be restructured, despite opposition from AOL’s board:
“Despite every effort to engage constructively with management and the board of directors (the ‘Board’), AOL remains steadfastly committed to pursuing the status quo…we believe that AOL is currently losing more than $500 million per year in its Display business alone, masking what otherwise would be a highly profitable company… Despite these significant losses, we believe that the Display business could be profitable, if operated more efficiently. Unfortunately, AOL continues to believe it is necessary to have over $1 billion in costs to operate this business.”
Starboard insists that its agitation has pressured management into starting a turnaround at AOL. It claims that the stock’s recent outperformance is a result of its influence over the company, and that company insiders are now trying to take credit for the sale of non-essential patent assets to Microsoft and the return sales proceeds to investors. Starboard insists company insiders were reluctant to do so:
“Given AOL’s past inaction with regard to monetizing the patent portfolio, as well as conversations we had with intellectual property industry experts, we question whether the Company would have executed this transaction with the same attentiveness and urgency had it not been for Starboard’s involvement.”
“Absent our involvement, do you think the Board would have committed to returning all of the proceeds of the approximately $1 billion patent transaction to shareholders? They previously told us in writing that they were not willing to make such a commitment.”
AOL’s management has stated its case for re-electing incumbent members of the board, essentially taking credit for these value-generating changes. Slides from their presentation suggest Starboard’s activism effectively delayed the sale of patent assets, and did not pressure or inspire them.
Regardless, it should not take a power-struggle for management to articulate its strategies to investors. If the firm was interested in selling non-core assets, it should have informed investors.
This Time It’s Different
Historically, Yahoo! was an upstart whose content attracted users away from AOL’s platform. Though once disruptive, today it is a collection of disjoint web properties which lack a clearly articulated synergy. As in the case of AOL, activist agitation many have helped Yahoo! management commit to selling its non-core assets, sales which will benefit shareholders. Yahoo! investors are fortunate that the stock’s largest outside owner, Third Point LLC, has openly challenged firm leadership. Third Point challenged the Yahoo! 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.
There is value to be returned to Yahoo! shareholders if only management buckles to pressure from activists and sells non-core assets. 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 market price.
Google and Facebook Insiders are Unchallengeable
In a way Google is the descendant of Yahoo!. Google’s search platform enabled web viewers to circumvent web properties like Yahoo! to find relevant content sourced across the web.
That revolution was a long time ago and Google now owns a collection of disjointed projects, the pursuit of caused R&D costs to increase dramatically 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 2010.
Google’s poor shareholder rights present a problem for thoughtful investors. Class B shares with enhanced voting rights give insiders Larry Page, Sergey Brin, and Eric Schmidt 66% of existing voting rights. Even as a block, outside investors have no means to challenge the direction of Larry, Sergey, and Eric.
There is nothing to stop endless, fruitless R&D at Google. According to Google’s latest 10-Q filing, search and advertisement revenues accounted for 96.1% of revenues. The lion’s share of revenues are from web search, while all the other projects Google dabbles in are a 3.9%-of-sales side show.
The next phase in web evolution, Facebook should also scare investors because its key person, CEO Mark Zuckerberg, has unshakable control. 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.
The relationship between Facebook management and its investors or the relationship between Google management and investors may not become strained. However, if AOL and Yahoo! are any indication, yesterday’s synergies and enterprise-wide strategies will decay and these large firms will become directionless. Their assets will eventually become more valuable than the whole of the company, and the efforts of annoying activists would sober up (or replace) management and force asset sales for the gains of investors. Unfortunately, management control of Facebook and Google remove the threat of a shareholder revolt. Investors should think twice before investing in Facebook or Google because they are invulnerable to shareholder activism.
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