While it is arguably beyond sensible argument that Yahoo! has lost-out significantly to Google in the battle of the search engines, a completely separate question is whether or not Yahoo! Inc shares represent an attractive investment. On the face of it, at a price/earnings ratio of 20.5x for a company which is showing relatively modest earnings growth (5.7% forecast for FY11) this looks an expensive investment, particularly as many would argue that they expect Yahoo! Inc earnings to decline further over time as the business continues to get squeezed by Google, as well as social networking sites such as Facebook and Twitter. However, I would argue that there is significant “hidden” value at Yahoo! which could be unlocked via a change in strategy and/or management.
Yahoo! is best known for its portal, along with a webmail service, instant messenger and websites search as Yahoo! Groups, Yahoo! Answers and Flickr and despite losing-out to Google in search, the site remains the fourth most-visited on the web (behind Google, Facebook and YouTube), with 26% a internet users visiting the site on a daily basis (a statistic that has remained stable since at least late 2008). Revenues are predominantly (87%) generated by advertising, which is split between display format and search results-linked. Of this, roughly 60% of advertising revenue is from Yahoo’s! own sites, with the remaining 40% of revenue from advertisement placed on third-party websites. The 13% of non-advertising revenues is mainly generated by user-fees for premium services. However, in addition to these well-known English language websites, Yahoo! also owns minority shareholdings in the publicly-listed Yahoo! Japan (35%) and the closely held Alibaba Group Holding Limited (43%). Finally, Yahoo! Inc has no long-term debt, $2.8bn of cash, and $1bn of tradable fixed income securities.
We can see from the table below that Yahoo! Inc currently has an enterprise value (equal to market capitalisation plus net debt) of $17bn. On the other side of the balance sheet I have attributed this valuation between the various assets owned by Yahoo! Inc. The value of debt securities held comes directly from the most recent Yahoo! Inc 10Q filing. As Yahoo! Japan is publicly-listed, this valuation of the the stake held by Yahoo! Inc is directly observable from its latest share price on the Tokyo Stock Exchange ($6.9bn at present). Alibaba Group Holding Limited is privately held, though its biggest asset, alibaba.com, is publicly-listed on the Hong Kong Stock Exchange. We can see from the latest share price of alibaba.com that the value of Alibaba Group Holding Limited attributable to Yahoo! Inc is at least $3.2bn. Note that this ascribes zero value to all the other companies owned by Alibaba Group Holding Limited, which includes taobao.com, alipay.com, Alibaba Cloud Computing and China Yahoo! Consequently, $3.2bn should be seen as a floor valuation, and therefore that the residual (ie. the value of the core Yahoo! portals and web services business) has an implied ceiling valuation of only $5.8bn. Therefore, I would argue that Yahoo! Inc is currently trading at a significant discount to the sum of its parts and should therefore be broken-up.
|Yahoo! Inc Enterprise Value Decomposition|
|Equity & Liabilities ($m)||Assets ($m)|
|Long-term Debt||0||Yahoo! Japan||6948|
|Other LT Liabilities||665||Alibaba Group||3211|
What I would do as Chairman of Yahoo! Inc:
- Put in place a $750m undrawn acquisition facility.
- Borrow $1.8bn via a term loan or investment grade bond issue. With $500m for working capital purposes and $1.3bn to return to shareholders as a special dividend, this will take Yahoo! Inc’s net debt to EBITDA ratio to ~1x. This is still a comfortable ratio for a such a cash generative company.
- Sell the $1bn of tradable debt securities.
- Distribute the $2.8bn of cash on balance sheet, $1bn debt securities proceeds and $1.3bn of term loan proceeds to shareholders as a special dividend (or as a capital reduction if this is more tax efficient). This would represent a return of 26.7% of the company’s current market capitalisation.
- Spin-off the holding in Yahoo! Japan to shareholders. Shareholders can then decide themselves whether to hold or dispose of this asset.
- Seek to re-open negotiations with Alibaba Group Holding Limited to sell dispose of the 43% stake currently held by Yahoo! Inc. This should raise a minimum of $3.2bn (though some analysts believe it could be worth closer to $10bn), taking the total cash distribution to shareholders to $8.3bn, or 43% of the current market capitalisation. However, the strained relationship between Yahoo! and Alibaba could prevent a deal in the near-term.
(Note: Please let me know if you’re a shareholder and would like me to represent you on the board of directors.)
This would then leave Yahoo! Inc shareholders with $8.3bn of cash, a directly-held stake in Yahoo! Japan (currently worth $6.9bn) and shares in the core portals and web services business. This raises the question of what the business might be worth on a standalone business. We can see from the table below that Yahoo! Inc has generated cash flow to equity at an average of $775m per annum over the last four years. Assuming that cash generation grows at 2% per annum (admittedly a significant assumption which is open to challenge), annual interest costs on the new debt are $90m per annum (interest rate of 5%) and that the cost of equity is 10%, this gives an estimated market capitalisation of $9.6bn. This compares to the residual value ascribed to the core business by the market at present of $5.8bn (equivalent to 4.5x EBITDA). In summary, this break-up proposal could leave shareholders with $24.8bn of value, compared to the current market capitalisation of $19.1bn, a return on investment of 29.8%.
|Income from operations ($m)||695||13||387|
|Restructuring charges, net||0||107||127|
|Goodwill impairment charge||0||488||0|
|Amortization of intangible assets||250||281||184|
|Estimated Cash Tax (adj for new interest charge)||-212||-181||-148|
|Assumed Interest Costs||-90||-90||-90|
|Change in Working Capital||359||397||85|
|Free Cash Flow to Equity ($m)||810||849||666|
But what are the risks of making such a investment? The first and most obvious risk is that the directors of Yahoo! continue plodding onwards with the current strategy and make no moves to dispose of their cash, debt securities or minority holdings, leaving shareholders stuck in a value-trap and receiving no dividends in the meantime. This risk is heightened by the current uncertainty surrounding the future of the management team. On 1st October it was announced that Hilary Schneider, Executive Vice President of the Americas, will leave the business on 31st December. There is significant media speculation at present surrounding the future of other directors and of the direction of the company.
The second problem with Yahoo! Inc as a potential investment is that the company has a “Shareholder Rights Plans” in place. This is something of a misnomer, as it acts as a poison pill to prevent any third party building a stake in the company (without the prior agreement of directors). The potential for takeovers (and therefore the potential for directors to become unemployed) has been shown to act as a motivating factor upon management, making them more responsive to the demands of shareholders. The poison pill shareholder rights plan expires in March 2011, though can be extended at the discretion of the board.
The third key risk with Yahoo! Inc as an investment is simply that the core portals and web services business loses further ground on Google (and the social networking sites), consequently impacting revenues and damaging the value of the business. Clearly, this is a significant risk given the lack of innovation and growth from Yahoo! in recent years, though in this case I believe sufficient compensation is provided by the low valuation at which the business can currently be purchased. Secondly, it is not necessarily technological innovation that is required to turn the business around, but instead a much better strategy, along the lines of the one advocated by Henry Blodget writing recently in the San Francisco Chronicle.
In summary, I think Yahoo! is clearly undervalued, based on its assets and cash flow generation, however, I do see a number of hurdles that need to be cleared before that value can be unlocked and the risk remains that none of these steps are taken and the core business deteriorates, leaving investors short-changed.
Finally, I want to thank @TMTanalyst for suggesting Yahoo! as an investment idea.
Comments are much appreciated.
Disclosure: upon publication CautiousBull owns no beneficial interest in Yahoo! Inc, though this may change at a later date.
- After Yahoo Talks, Alibaba Says Its Buyback Bid Is Over (nytimes.com)
- Yahoo Shows No Interest In Selling Alibaba Stake (dealbook.blogs.nytimes.com)
- Yahoo’s Relationship with Alibaba Goes From Bad to Worse (dailyfinance.com)
- Alibaba Still Wants Yahoo to Sell Back Stake (pcworld.com)