Yahoo Stock Is Too Cheap

| About: Yahoo! Inc. (YHOO)

Could Marissa Mayer be to Yahoo! (NASDAQ:YHOO) what the second coming of Steve Jobs was to Apple (NASDAQ:AAPL)? Or what Michael Eisner was to Disney (NYSE:DIS)? Or Lou Gerstner to IBM (NYSE:IBM)?

This article is going to make the bull case for YHOO, while discussing risks later in abbreviated form.

The short-form bull case: A lot of upside, probably limited downside.

Let's examine why the argument for limited downside in the stock makes sense.

Valuation: Takeover price: With Ms. Mayer representing something like Yahoo's sixth CEO in five years when hired last year, if she can't lead a major turnaround, then this company is likely to be sold to the highest bidder, according to the bullish case I am laying out here (no guarantees!). Currently YHOO trades near $21.

A sum-of-the-parts analysis of YHOO can be performed, with data per share unless indicated otherwise:

1. Cash and marketable securities net of debt: $5.

2. Ownership interest in (privately-held Asian Internet conglomerate) plus Yahoo! Japan: $6. Note this accepts current market valuation, so it is uncertain. But it is also conservative, because the actual estimate is $10, and then a 40% tax rate is subtracted. Whether an Asian acquirer of Yahoo! would have to pay that high a tax rate is unknown to me. (Per S&P, I am using a 24% ownership interest in Alibaba and 35% interest in Yahoo! Japan.)

3. Projected operating earnings for 2013 of $1.10 with cash flow of $1.80. Capital spending of $0.55 and negligible debt repayment. Thus, free cash flow (FCF) of $1.25.

4. Intangible values: famous, well-liked brand name; 700 million visitors to per month; one of the leading sites for searches and as an email platform.

Summing No.1 and No.2 gives $11. That leaves $10 to get to the current trading price. I proffer 10X earnings or 8X projected FCF as reasonable, given the company's issues in generating growth. That gets us to or slightly above the current price.

So it comes down to the value of intangibles. YHOO's current market cap net of No.1 and No.2 above is about $12 billion. Not a lot for Viacom, Disney and many others. The acquirer gets a better operating company than many think. Here's why:

Quietly, Mayer's predecessors may have had a positive effect. The following data are from Value Line. In 2007, operating margin was down to 19% from about 28% in 2004-5. For 2012, pending final quarter numbers, Value Line estimates operating margin of 32%. It projects net profit margin for 2013 of 24%, up sharply from 9.5% in 2007. Share count was 1.43 B in 2006 and was down to about 1.1 B at year-end 2012. This was done while reducing long-term debt from $750 M in 2006 to $125 M in 2012. When a company buys in stock above book value, it incurs a charge to book value (this explains a lot about IBM's minimal book value). Despite retiring such a large part of its shares outstanding, YHOO's book value has risen from $6.40 in 2006 to a projected $13.20 at year-end 2012 and a projected $14.70 at year-end 2013.

Given the above positive operating and standard valuation metrics, I would guess that an acquirer would readily pay 20X earnings or 16X FCF to gain control of Yahoo! The ability to drive business to the acquirer would be a major additional benefit. Then there would the access to Yahoo's patents and know-how, which could assist the acquirer in its own businesses. Of course, there would be the ability for most acquirers to fire personnel to increase margins.

The above valuation exercise suggests that YHOO's takeover value to the low $30s. Perhaps not coincidentally, that is exactly what Microsoft wanted to pay to buy Yahoo! before the Great Recession.

Now let's move on to the other reason to want to be a YHOO shareholder.

Growth potential: In the big picture, Yahoo! competes in very large and expanding markets. Just as Messrs. Jobs, Eisner and Gerstner took Apple, Disney and IBM from has-beens to leadership again in their fields, the latest CEO, Marissa Mayer, likely has carte blanche to direct, redirect and prune Yahoo's operations. Today's main revenue sources, display ads and search, are likely to generate secular revenue growth for some companies. Why not YHOO? Other sources of revenue, including user fees for such popular sites as Yahoo! Finance as well as fees to deliver media to users, may exist. As a key early employee at Google (NASDAQ:GOOG), expert at so many aspects of Google's core business, and as a star software engineer before moving up the ladder, she may have what it takes to truly turn this company around.

It is important not to over think how Yahoo! is going to attempt to grow. When Steve Jobs regained the CEO position at Apple, what the world saw at first was a "shrink to survive" strategy, as well as an outsourcing to Asia manufacturing strategy. The iPod and retail store innovations could not be imagined. Similarly, who could have known that Lou Gerstner, who was not even from a high-tech background, would prove the bears who were arguing for a breakup of IBM so wrong by focusing

If you want to own YHOO for growth potential, I think that you have to think that Ms. Mayer has what it takes to be a great CEO. Certainly, the latest policy about forcing employees to work in a Yahoo! office has generated publicity, both good and bad, but even controversial action that keeps the company in the public eye is OK. I am inclined to favor this view of her action:

Marissa Mayer Is Right: Working From Home Kills Innovation

Now, I am the CEO of a webcasting company, and we make our living selling technology for Internet-based meetings and broadcasts. And guess what? I agree with her strategy! Online technology absolutely has its place in corporate America and should be leveraged to its fullest. However, it can never replace the benefits of face-to-face collaboration and team building.

Telecommuting, once a novelty and a very practical solution in some situations, has now become an entitlement. An entitlement that in many cases has been misused, or dare I say, abused...

And I'm credulous regarding this snippet from a HuffPost report:

Now, several former Yahoo employees are coming forward in support of Mayer, saying that some of the company's employees took the leniency around telecommuting too far. "Mayer has found out just how dysfunctional the company can be," said one former online editor at Yahoo, who recently left the company and agreed to speak to The Huffington Post on the condition of anonymity.

"I agree with what she did. Many workers were milking the company," the former employee told HuffPost. Workers were abusing the policy on working from home, the former employee said. "There was a ton of flexibility, and I remember several times going to ask my manager a question -- and he was nowhere to be found."

In an interview with Business Insider, a former Yahoo engineer recalled a similar situation at the Internet company.

"For what it's worth, I support the 'no working from home' rule," the engineer told the news site. "There's a ton of abuse of that at Yahoo," the former employee reportedly said, leading to "people slacking off like crazy, not being available, spending a lot of time on non-Yahoo projects."

In other words, my base case is that Yahoo! is poised to again grow with the growth of the Internet, including the mobility revolution, and continue the progress prior management has made in increasing profit margins. Success with these dual goals would lead to accelerating earnings and, sooner rather than later, take YHOO out of the value price range and into a more rarefied range where it could use its stock as currency for acquisitions. The five-year chart is horrible, which given the underlying values to an acquirer and the reasonable success I see in accelerating earnings, strikes me as attractive:

Chart forYahoo! Inc. Splits: Sep 2, 1997 [3:2], Aug 3, 1998 [2:1], Feb 8, 1999 [2:1], Feb 14, 2000 [2:1], May 12, 2004 [2:1]

While few stocks go straight up, I believe that YHOO has made a durable base and "wants" to return to the $30s - perhaps through a buyout and perhaps through improving operations.

The new Yahoo!: focus on the board of directors: Many of us remember with dismay the arrogance and poor judgment that Yahoo's board showed when it cold-shouldered Microsoft's reasonable bid for the company. That has left a bad taste in the mouths of many institutional and individual investors. Well, I like the look of this board. The chairman, Alfred Amoroso, only became a Yahoo! director last year. From his bio:

From November 1993 to October 1999, Mr. Amoroso held various positions at IBM, a global technology company, including as a member of the worldwide management committee. Prior to working at IBM, Mr. Amoroso was the lead technology partner and partner-in-charge of the Worldwide Insurance Consulting Practice at Price Waterhouse LLP.

Great! He's mainstream, he's not a "yahoo" at all. Then there's Sue James, a retired partner at the Big 4 accounting firm Ernst & Young. And another suit, John Hayes, EVP and Chief Marketing Partner at AmEx.

The above directors and chairman look good to me. There are a lot of directors, including the chairman, who are focused on the bottom line.

What I think is great is the newest addition to the board:

Max Levchin joined only two months ago. He probably has a superior IQ even for Google (over 250?). He was a key executive at PayPal until it was acquired by eBay (NASDAQ:EBAY), then founded and led Slide, which was acquired by Google in 2010. He didn't last long with Google and founded HVF, "a start-up lab focused on solving big problems and improving lives by extracting insights from the vast quantities of recordable information." Yikes! Do you think this is right up Yahoo's alley? I sure do. Did he need to join Yahoo's board to become successful? No. Max Levchin is 38-years old. He is also chairman of Yelp! (NYSE:YELP) I can only think of one reason he joined Yahoo's board. It is not to hang out with accountants. I think that he thinks that Yahoo! is going places. (Does Yahoo! acquire or partner with HVF?)

Another thing I like about this board: scrolling down the list of directors, one stops at "W." There is no "Yang" anymore.

Finally, as is well-known, Dan Loeb, a hedgie, controls three board seats: his own, and his allies Messrs. Wilson and Wolf. His goal: get the stock price up.

I thus think this is a new YHOO, but that the past problems have led it to trade too cheaply. I also think the surging stock price reflects good vibes from insiders and the Silicon Valley community. YHOO hit a new recovery high today on a strong tape, up almost 2% on a day the Nasdaq was up 1%.

Negatives: Everyone knows that this company has really tough competition. Growth is not assured, and neither are profitable operations. Also, the future takeout values of and Yahoo! Japan are unknown. There are company-specific risks and market risks. But this paragraph tells you what you already know, so let's wrap up.

Summary: YHOO is a stock that I would argue is significantly undervalued if it comes in play as a takeover target. Operations have quietly been improved over the past few years, but this has been overlooked between the soap opera involving multiple CEOs and difficulty in getting revenue growth going. But the company operates in a secular growth area, so there is no reason that inspired leadership cannot get it to join in that growth.

YHOO is thus a twofer: it could regain growth stock status again, or I expect the board will do the right thing for shareholders and get them the most they can for the stock. Thus I own YHOO with a multi-year perspective.

Disclosure: I am long YHOO, AAPL, IBM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Long AAPL, long IBM

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