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In this article I will make a bearish case for Yahoo (YHOO). There are many similar bullish articles about this firm (a notable exception is this terrific article on Yahoo under Mayer). They usually focus on the potential of the turnaround management, but they forget to analyze the fundamentals. This article proposes a different view. It illustrates some key numbers, while keeping in mind the current transition the firm is facing. I summarize my findings in 6 points.

Before you start reading this article, please leave aside your high expectations on the new CEO and the first-quarter results. This will allow you to have a different perspective on the stock. After all, new management per se is never a panacea; and the first quarter results (where overall y/y revenue actually declined 1%) will have little impact on Yahoo's long-term growth forecasts.

1. No growth

Let me start with the most obvious fact about Yahoo: it is not growing. Yahoo hasn't experienced revenue y/y growth since 2004. This fact needs to be taken seriously because Yahoo is not a startup in its early stage.

(click to enlarge)I wish I could say that the stagnation in Yahoo's growth figures was due to the economic recession, or because of seasonality in the Internet industry. But the truth of the matter is that Yahoo didn't grow because of endogenous reasons, as the following revenue comparison (against Google) shows:

The only one who should be blamed for Yahoo's poor growth figures is Yahoo itself.

2. The search engine war is lost

This fact is particularly important if you keep in mind that more than one third of Yahoo's net revenues still come from search solutions ($425 million out of $1,140 million), a segment where they have clear disadvantages against Google, due to technological reasons, database size and traffic.

Yahoo did almost everything it could to win the search engine war, except one thing: change its design. Use a white page with a strong search box in the middle.

By the time they finally understood the advantages of having a simple design (Bing), it was too late. They kept their complicated "directory" style for way too many years. Even worse, they bought Inktomi, Overture, FAST and Alta Vista (all of them "directory" type of search engines). Now the war is over and Google is by far the indisputable king. However, as I mentioned earlier, Yahoo's EBIT is still highly dependent on this lost market.
(click to enlarge)

3. Yahoo Sites users may not be in imminent danger of extinction, but they are not growing in number and they are not engaged.

Yahoo was well-known for being excellent at building loyal audience. Not anymore. Perhaps if they had chosen not to fight the search engine war and instead focus on their core strengths, things would have turned out different.

At the moment, Yahoo still has approximately 600 million users. However, engagement metrics, specially in non-mobile users, do not look promising, as many continue migrating to other websites with more social features, gamification and a simpler design: Facebook, Twitter, Reddit, etc.

I believe that Yahoo Sites users have not increased in number for quite a long time but I have no official statistics, as Yahoo became more secretive after Mayer. Therefore, I will try to show my reasoning in an intuitive way.

First, imagine for a moment that you are the CEO of Yahoo. If your websites start gaining users after a long stagnation period, wouldn't you announce it in the quarterly results?

We can also have an idea of Yahoo Sites performance using Alexa. According to Alexa, the daily reach (estimated percentage of global internet users who visit yahoo.com sites) has decreased in the past 12 months from 26% to 19.75%:

I personally do not see any signals (innovative products) that make me think this trend will change in the near future.

That being said, I think that the recent emphasis Yahoo is putting on mobile is partially promising. What is this about?

Yahoo recently announced that they surpassed 300 million mobile active users (of course, they had no hesitations in announcing this). At first sight, this looks amazing. But was this achieved because Yahoo has an internal strong ability to plan, develop and sell mobile apps?

No. I believe that acquiring small mobile technology companies (Flickr, Stamped, Summly, amongst others) was crucial to reach this milestone. Thus, there is a risk that the mobile MAU Yahoo has obtained through these acquisitions will start decreasing, because the app market is very volatile and because Yahoo buys apps when they are at their highest popularity peaks. Even worse, Yahoo has "starved to death" some startups it acquired in the past.

4. High turnover rate

Top engineers and product managers prefer to work at Google (GOOG), Facebook (FB) or even Apple (AAPL). This is also no secret. It's hard for Yahoo to attract star engineers and this has direct consequences on the quality of software and R&D process the firm uses to keep its business innovative. The company ended the previous quarter with 11,300 employees, down 19% from the same period last year. 19% didn't leave because food in the cafeteria was horrible or because some bloggers think "your company is no longer cool." They left because they didn't see any future.

5. The only catalysts are some successful investments

When was the last time you saw a revolutionary Yahoo product? It has been awhile.

Luckily for shareholders, Yahoo has made some wise investments, like the 24% diluted stake on Alibaba Group, which owns Taobao.com. But you know there is something wrong about this firm when the only potential catalysts the stock may have for the next months are related to some external investments.

Sooner or later, Yahoo will sell its stake. If things go north, they will create massive value out of the transaction, but only once. That has nothing to do with the ability the firm has to generate its own value.

And this is not the end of the story. Not everything is going well with the investments Yahoo made. There is a lot of risk and uncertainty. Let me explain why:

Yahoo also owns 35% of Yahoo Japan, a joint venture with Japanese giant Softbank. As a result, they receive a substantial compensation in the form of a percentage of total Yahoo Japan revenues.

Since Yahoo Japan's revenue is earned in Japanese currency, yen appreciation would lead to higher reported revenues, while depreciation would translate into lower reported revenues.

Unfortunately for Yahoo, Abenomics is causing massive yen depreciation: $1/¥79 in October 2012 is equivalent to $1/¥98 now. In order to hedge the forex risk, Yahoo entered into forward contracts ($3 billion) with maturities of 9-12 months. Any potential gain or loss from these contracts will have a strong impact on the firm's cash balances. This is why there is a strong correlation between the USDJPY movements and the stock price performance.

In a nutshell, the fact that Yahoo made some sound investments in the past is not a reason for being long the stock. The final outcome of these investments is highly uncertain.

(click to enlarge)

6. Valuation

Let me finish this article with the most fundamental reason for being bearish. Yahoo can't generate the value it needs to support its current stock price. The proof is as follows:

I am going to use a discounted cash flow approach to perform a valuation on Yahoo. The template engine is from Oldschoolvalue and the financial data is from Morningstar.

Case 1) A conservative analysis

First, I am going to use the average of the 5-year and 10-year multi-year performance figures for the 10 year growth rate assumption: 16%. Now, for the terminal growth rate we are going to assume a conservative 2% and for the discount (GM:WACC) rate, at 12%. These numbers create the following cash flows:

(click to enlarge)

Under these assumptions, we can estimate that the fair value of one Yahoo share is $10.11. Therefore, under this scenario, you could say that Yahoo is extremely overvalued.

(click to enlarge)

You might be wondering how valid my assumptions are. Perhaps we were too strict with the discount rate? This is why I carried out a sensitivity analysis. Some assume a 10% WACC, after all.

Case 2) A very optimistic scenario

Let us now assume that Yahoo is in such a strong financial position that a 10% WACC is reasonable. Furthermore, let us assume that the growth rate for the next 10 years will average 20%, which is a very optimistic scenario, to say the least. Does Yahoo manage to justify its stock price now? The answer is still a no. The fair value would be approximately $15.00 per share.

Case 3) A very optimistic scenario + Alibaba effect

We could do something unorthodox to try to justify the current stock price. According to Forbes, if Alibaba waits until next year to IPO, it would be valued at $78 billion. Then, Yahoo's current stake would be worth, approximately, $11.2 billion by this time next year, or an extra $3.58/share in value. Add this to our optimistic $15/share figure and you have $19.58/share in stock value. Still overvalued!

I even assumed a 3% terminal growth rate, but I could not justify the current stock price.

The Bottom Line

Why did Yahoo fail our sensitivity checks? This is due to the fundamental law of value. No matter what management promises or how interesting some stakes in foreign companies might look like, we should never forget this fundamental rule of investing, written in the first pages of the bible "Valuation" (McKinsey): only increases in future cash flows have an impact on value.

With the current FCF decreasing trend, it is impossible to forecast consistent cash flow generation in the future.

Our conclusions could sound extreme to some. After all, expectations are very high after new management took power. But if you forget about all the media coverage on the new CEO and focus on what numbers really say about this firm, you will find a lot of evidence that support our thesis. This is why most analysts recommend a "hold" rather than a buy. Let me give you one more example: Morningstar gives Yahoo a current P/E of 7.2, whereas the Industry average is 27.0 and the S&P average is 16.6. But we don't need to make these comparisons. Yahoo's 5 years P/E average is 25.3.

Note: I have no positions. Oldschoolvalue software was used for the valuation. Spreadsheet data comes from Morningstar.

Rate: Sell
Price target: $10.11
Investment horizon: 1 year
Strategy: Value
Uncertainty: High

Source: 6 Reasons Why I'm Bearish On Yahoo