Yahoo Is Making The Big Moves Necessary For Its Turnaround

May.30.13 | About: Yahoo! Inc. (YHOO)

Mayer's Yahoo: Outcome of acquisitions will be the key

Yahoo! Inc. (NASDAQ:YHOO) has been using the Google playbook; free meals and iPhones for employees. The Sunnyvale, CA based search giant has also started buying small tech start-ups to gain a wider audience. It all started with the purchase of the social media site Snip.It and now it is the headline-grabbing acquisition of blogging site Tumblr for $1.1B. This is a big step in boosting Yahoo's mobile ad business as a lot of Tumblr users are teens and young adults that log into the site via its well-liked mobile app.

Yahoo has also been in talks to buy Hulu. This would be a good purchase as it is a popular video-streaming service that would give Yahoo additional advertising revenue. Hulu has a strong user base and the subscription revenue will also factor into any potential offer.

It is true that Yahoo has a bad record with its past acquisitions with GeoCities being a famous example. But that is going to change under Mayer who has been instrumental in leaving the underlying structure of a purchased company mostly unaltered. At the end of the day, Yahoo will be judged on the success of Tumblr over the next couple of years and this is justifiable given the $1.1B price tag.

With all that Yahoo has got going on, the stock makes sense for a value play. I want to see how much I should pay for Yahoo shares and I will use the present value of free cash flows (FCFF) to find out.

Present Value of FCFF

Valuing Yahoo using the present value of FCFF makes a good case to buy the stock right now. The Present value of FCFF is an easy to use tool for investors to quickly assess a stock as it is great at finding intrinsic stock value estimates.

The Present Value of FCFF is based on a discounted cash flow (DCF) valuation technique. The idea is that if the value obtained from this method is higher than what the shares are currently trading at, then the stock is undervalued.

Free cash flows are basically cash flows minus direct costs and payments made to capital suppliers.

Intrinsic Stock Value

This is using the free cash flows.

Year

Value

FCFFt or Future Value [FVt]

The Math

Present Value at 6.64%

0

FCFF01

921

1

FCFF1

893

=921*(1+ -2.98%)

837

2

FCFF2

878

=891*(1+ -1.50%)

823

3

FCFF3

876

=876*(1+ -0.025%)

822

4

FCFF4

888

=875*(1+ 1.45%)

833

5

FCFF5

913

=887*(1+2.93%)

856

5

FutureValue (FV5)

25,330

=913*(1+2.93%)/(6.64%- 2.93%)

23,753

Intrinsic Value of capital

27,924

Less: Debt (Fair Value)

-

Intrinsic Value of common stock

27,924

Intrinsic Value of common stock (per share)

$25.02

Current share price

$25.81

Click to enlarge

1 FCFF0 = 2012 Values

It is easy to see that Yahoo is trading close to its intrinsic value (a little overvalued) from the table above and so it makes for a fairly good investment idea. But there must be a number of questions on your mind. Specifically, what is the "calculation" column and how are the growth rates obtained. The good thing is that I am going to show you everything so that you will be able to do a Present Value of FCFF valuation on any stock you wish to analyze.

First, here is how the FCFF for 2012 is arrived at.

12 months ended

Dec 31, 2012

EBIT* ( 1 - T )

2,655

Add: Depreciation & Amortization

655

Investment in Long Term Assets

(272)

Investment in Working Capital

(2117)

Free Cash Flow to the Firm [FCFF]

921

Click to enlarge

USD $ in millions

Weighted Average Cost of Capital - WACC

To calculate the WACC simply take the weight of the source of financing and multiply it by the corresponding cost. There is one exception: you should multiply the debt portion by one minus the tax rate. Then sum the totals. The equation looks something like this:

WACC = Wd [kd(1-t)] + Wce(kce)

Click to enlarge

Where:

  • WACC = weighted average cost of capital (firm wide required rate of return)
  • Wd = weight of debt
  • kd = cost of debt financing
  • t = tax rate
  • Wce = weight of common equity
  • kce = cost of common equity

Yahoo has no debt and so we can forget about the debt part of the equation and focus only on the common equity component.

Then for kce, we look up Yahoo's beta value which is 0.91. We then subtract the risk-free alternative rate which is the current yield to maturity of a 10-year T-bill which is about 2% from the overall market return which is taken here as the return of the S&P 500 over the last 10 years. So we subtract 2% from 7.1% to get 5.1%.

We then multiply this figure by the stock's beta value and we end up with 4.64%. The risk-free rate is added to this to calculate the required rate of return on equity. In this case, it is 6.64 percent.

Then WCE will be 1 because Yahoo has no debt. We proceed to put these values in the WACC equation above:

WACC = 0 +1(6.64%)

WACC = 6.64%

FCFF growth rate [g] implied by DuPont Analysis

Dec 31, 2012

Dec 31, 2011

Dec 31, 2010

Dec 31, 2009

Dec 31, 2008

Selected Financial Data

(USD $ in millions)

Provision for Income tax

1,940

242

222

219

263

Net income

3,945

1,049

1,232

598

424

Tax rate1

32.97%

18.75%

15.27%

26.81%

38.28%

Interest expense after tax and dividends2

3,945

1,049

1,232

598

424

EBIT(1 - Tax Rate)3

2,655

852

1,044

438

262

Total stockholders' equity

14,560

12,541

12,558

12,493

11,251

Total capital4

14,560

12,541

12,558

12,493

11,251

Click to enlarge

1 2012 Tax Rate = [Provision for Income Tax/(Net Income + Provision for Income Tax)] * 100

=[ 1,940/(3,945 + 1,940)] * 100 = 32.97%

2 2012 Yahoo has no interest Expense and dividends paid over the last five years

3 EBIT*(1-tax rate) is the cash flow from the firm's operations assuming no debt financing. This is the net income added to the interest expense after tax. For 2012, EBIT*(1-tax rate) = 3,945*(1-32.7%) = 2,655

4 Total Capital = Short-term debt + Long-term debt + Total Stockholders' equity (Yahoo has no debt)

From the values in the table above where we derived the "Total Capital" figure we need in this analysis, we compute the Retention Ratio (RR) and the Return on Invested Capital [ROIC] for the last 5 years. The calculations for 2012 are shown here.

RR = [EBIT(1 - Tax Rate) - Interest expense after tax and dividends]/ EBIT(1 - Tax Rate)

= [2,655 - 3,945] ÷ 2,655 = -0.49

ROIC = [EBIT(1-Tax Rate)/total capital] * 100

= [2,655/14,560] * 100 = 18.23%

The values for the last 5 years are listed below.

RR

-0.49

-0.23

-0.18

-0.37

-0.62

ROIC

18.23%

6.79%

8.31%

3.51%

2.33%

Click to enlarge

We will then find the averages of these RR and ROIC values and their product gives us the growth rate of FCFF or g. The averages are -0.38 and 7.83% respectively.

g = RR * ROIC = -.41 * 7.93% = -2.98%

The growth rate can be difficult to predict and can have a drastic impact on the resulting value of the firm. This is why we use two growth rates and then use linear interpolation for the rest of the growth rates.

Single-stage model FCFF growth rate [g]

g = {Enterprise Value * WACC - FCFF0/(Firm Value + FCFF0)} * 100

= {25,540 × 6.64% - 921)/(25540 + 921)} = 2.93%

Year

Value

gt

1

g1

-2.98%

2

g2

-1.50%

3

g3

-0.025%

4

g4

1.45%

5 and thereafter

g5

2.93%

Click to enlarge

where:

g1 is implied by the DuPont formula

g5 is implied by single-stage model

g2, g3 and g4 are calculated using linear interpolation between g1 and g5

Calculations

g2 = g1 + (g5 - g1) × (2 - 1) ÷ (5 - 1)

= -2.98% + (2.93% - -2.98%) × (2 - 1) ÷ (5 - 1) = -1.50%

g3 = g1 + (g5 - g1) × (3 - 1) ÷ (5 - 1)

= -2.98% + (2.93% - -2.98%) × (3 - 1) ÷ (5 - 1) = -0.025%

g4 = g1 + (g5 - g1) × (4 - 1) ÷ (5 - 1)

= -2.98% + (2.93% - -2.98%) × (4 - 1) ÷ (5 - 1) = 1.45%

Conclusion: Is Google's dominance unsurpassable?

Yahoo knows that it will have to step up its game to compete with Google Inc. (NASDAQ:GOOG). GOOG has made some great acquisitions in the past, most notably the YouTube video streaming service. Yahoo is trying to narrow the gap by spending a lot of its cash. The Tumblr and PlayerScale acquisitions is a move away from its traditional business. Yahoo's shareholders must be hoping that the internet giant can buy Hulu as well as it looks like the most promising of the three. But a deal might be hard to get as the price target could be too high for Yahoo and then there is the competition that will come from Netflix, Inc. (NASDAQ:NFLX) if Yahoo snaps up Hulu.

I have no qualms with what Yahoo is doing at the moment as the Ali Baba sale late last year netted the company $2.8B. So Yahoo has a lot of cash and it can either sit on it or use it to fund purchases that can bring in additional revenue and content. Yahoo needs to outpace its Silicon Valley rivals and these large cap tech companies have been quite active. Facebook (NASDAQ:FB) recently bought Instagram for close to $1B. The recent acquisitions by Yahoo are a gamble and they had to be taken.

Still, there are a lot of reasons for investors to be bullish about Yahoo. Mayer's Yahoo has a highly competent management team and now there is Tumblr's David Karp that joins the ranks. The 26-year old self-taught Karp has a very unique story and he actually makes me believe in Tumblr and that the match with Yahoo is a good one.

Moreover, the Present Value of Free Cash Flows reveals an intrinsic value of $25.02 a share and Yahoo shares are currently hovering slightly above this value. This is a good time to buy Yahoo stock and it could continue to dive slightly post-acquisition in the coming weeks enabling investors to dollar cost average.

All material sourced from Morningstar and MSN Money.

Disclosure: I am long YHOO. 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.