Seeking Alpha
Special situations, growth at reasonable price, value, micro-cap
Profile| Send Message| ()  

Background: I became a vociferous bull on Yahoo! (YHOO) ever since Marissa Mayer returned to work about a year ago, shortly after giving birth. I began advocating for the stock on the Apple (AAPL)-oriented Braeburn Forum when the stock was at or below $16/share last fall. My first Seeking Alpha article was published on Feb. 28 of this year, titled Yahoo Stock Is Too Cheap. The stock was then $21.31 per share.

The themes then were two-fold. First, I perceived real potential that Ms. Mayer's talents could lead to a major turnaround of the company, writing:

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

I also discussed the asset value of the company's holdings in Alibaba Group ("Alibaba" herein) and Yahoo! Japan (OTC:YAHOF), its own earnings, and intangible value to a strategic acquirer. This brought me to estimate a takeover value in the low $30s.

Given the large move in YHOO shares since my last article on it on Sept. 10, I felt it was already time for a re-evaluation of the stock.

Updated discussion: Much has gone right for Yahoo (I will omit the exclamation mark in my text from now on) since I first wrote about it. It has had two upside earnings surprises. A well-defined focus on mobile apps has started paying dividends. Not counting Tumblr data, Yahoo passed Google for the top spot for online activity this summer. Not bad for a supposedly hopeless situation facing Team Mayer.

The YHOO buzz has started to turn favorable. Business Week ran an article two months ago titled Can Marissa Mayer Save Yahoo?. The article points out that morale at the company began improving promptly upon her arrival. It features comments such as this:

"Marissa has done two things at Yahoo," says Ben Ling, a partner at venture capital firm Khosla Ventures and a former Google colleague. "She has made it an attractive place for top talent to work, and she has begun to release products that engage consumers on a daily basis."

Some points in the article get to the core of how the company may succeed:

Yahoo says that after redesigns, traffic to mobile applications such as Yahoo Mail, Yahoo Weather, and the news app is up 120, 150, and 55 percent, respectively. There are clearly more apps on the way: A large chart on the office wall has a schedule crammed with product launches and suggests that apps for Yahoo Groups and Messenger are in the works. "We know there is going to be skepticism," Parry says. "The fact that we are already seeing the payoff is giving everyone faith that we're on the right path. That's what Marissa is so great at. She's shining a light and beating a path to the horizon and saying, 'This is where we are going.'"...

Mayer is relentless in her search for other believers. In addition to her mobile hiring spree, she's begun shifting funds back into Yahoo's research organization, which previous CEO Thompson gutted in a round of layoffs. She says the lab has a goal of hiring 50 Ph.D.s this year and has already signed up 30.

The article does also points out challenges that the company faces.

A recent article by a trader named Robert Weinstein argued this past week that Apple should buy Yahoo. He indirectly suggests a $40 takeover price. He alluded to the company's underlying asset value, in which its Asian corporate shareholdings play the most important value. A Japan-based investor has also just published Yahoo's Secret Weapon For Growth, which presents a number of positive points about Yahoo and may be worth reading. I do not remember seeing any positive publicity about the company or the stock a year ago. Momentum is building.

First, let's discuss the "Chinese Amazon.com (AMZN)," one of YHOO's stock price drivers:

Alibaba: When I wrote my first articles last winter and early spring on YHOO, the stock price of Yahoo Japan, a public company on the Tokyo Stock Exchange, was lower than it is now (profits were also lower). As for Alibaba, profits are revealed by Yahoo in its SEC quarterly filings with a one quarter lag. These profits have surged, though Yahoo provides no detail as to whether one-time factors have increased them. These two appreciating assets make the rise in YHOO's share price much less worrisome to new money, in my view; the rise has been largely fundamentally-based.

It appears that Alibaba is growing at extraordinary rates. From Yahoo's latest 10-Q:

Three Months Ended Six Months Ended
March 31,
2012
March 31,
2013
March 31,
2012
March 31,
2013

Operating data:

Revenue

$805,900 $1,381,644 $1,828,707 $3,222,093

Gross profit

$530,537 $1,018,056 $1,227,376 $2,365,932

Income from operations

$213,262 $708,897 $489,921 $1,461,482

Net income

$235,208 $679,537 $488,773 $1,329,514

Net income attributable to Alibaba Group

$220,483 $668,676 $457,395 $1,310,849

What might Alibaba be worth in an IPO under current market conditions? Because we are still only looking at Q1 earnings and given the many competitive uncertainties, we really are guessing on that key YHOO valuation point. With yoy earnings growth over 100%, the likely upcoming IPO could be at a $100 B or higher valuation.

Alibaba has enormous potential for growth, both vertically and horizontally. It has already begun to market not only on a business-to-business sphere but also directly to consumers. There will be competition, so success is not guaranteed, but from a stock market standpoint, we can look at a few comparables.

Comparables to Alibaba include such enterprises as AMZN, and other Internet stocks that benefit from first-mover advantage and the ability to mint money without much investment in fixed assets. In other words, their returns on invested capital are enormous if they become dominant. Other dominant, high ROIC Internet stocks include Facebook (FB) and Baidu (BIDU), as well as YHOO in days gone by. I have an out-of-consensus view that we might see $6 B in Alibaba profits meaningfully sooner than expected, and see those profits capitalized at perhaps 40X earnings. This would equate to a $240 B market cap, though with some dilution from the IPO and perhaps a secondary offering.

Yahoo must sell half (12%) of its Alibaba stake on the IPO, but I am not aware that it must sell further shares unless it so chooses. Thus the remaining 12% of Alibaba's shares (not adjusted for new shares sold in the IPO or other forms of dilution) could have an enormous value to YHOO shareholders.

To wit, a $100 B pre-money valuation on an IPO for Alibaba, which appears to be slated for next year, could produce perhaps $12 B in pre-tax income and $7-8 B in after-tax cash for Yahoo. I am hopeful for, over time, even higher Alibaba valuations to benefit YHOO shareholders.

I expect that YHOO will use the cash from Alibaba mostly for share repurchases, plus acquisitions, both of which could be nicely accretive to EPS.

The above possible Alibaba valuations may be conservative. This statement can be justified by comments out of Evercore Partners (about halfway through article) in April:

...we use this opportunity to reexamine our Alibaba valuation work in light of growing evidence that our $40bn prior estimate was insufficient. Specifically, examining Alibaba's growth, scale, and rate of monetization amongst major peers leads us to forecast a 50% higher valuation, now $60bn, or 40% of Yahoo!'s closing share price after taxes [...] In truth, our work suggests an $80bn-$100bn valuation to be more appropriate in the context of its current growth and 3P scale (each roughly 3x Amazon's).

That was well before Alibaba's blowout Q1 earnings were revealed by Yahoo this summer. It was also made when AMZN and many other Internet stocks were trading lower than they are now. If a $90 B valuation were appropriate then, over $100 B would be appropriate now.

Yahoo Japan: Depending on what tax rate one uses at the current valuation around $32 B for all of this company, of which Yahoo owns 35%, one can estimate about an $8 B after-tax cash influx to YHOO shareholders should it sell all its stake around the current price. Yahoo Japan can be studied in English. I have done so, though as an American, this was done with imperfect insight. My review leaves me ready to believe that this year's appreciation in Yahoo Japan's stock is reasonably founded, but that the stock is not now a low-risk investment.

Adding up YHOO's asset value: As of June 30, the company had about $3.3 B in current assets minus current liabilities. If we assume that other corporate long-term assets and liabilities cancel out, then adding $3.3 B to the theorized asset values of its Alibaba and Yahoo Japan investments sums to roughly $30 B. YHOO is currently valued at about $35 B (at a price over $34/share).

Thus the operating company which we think of as Yahoo is, under the above assumptions, receiving a very low valuation of only about $5 B.

This is too low. Likely this is because Street expectations for Yahoo's monetizable stake in Alibaba are lower than those used here, as well because of a discount to aggregate asset value is not unusual.

Even on other metrics, such as market share in search, where Yahoo has been a laggard, we should keep in mind that the company operates in a secular high-growth sector. Shrinking or stable market share is no disaster in a growing market.

YHOO's asset value is difficult to measure. Alibaba will - or will not- be worth a vast amount of stock market value in a certain time frame; Yahoo itself either will -or will not- be a success in varying degrees. Management's preference to engage in share buybacks with net cash further leverages the future share price (without resorting to debt).

I like what my crystal ball suggests for the future, but there are many informed sellers of YHOO stock here, so we shall simply see what unfolds.

I also like the longer-term chart:

Technical considerations: YHOO is overbought, which is often a prelude to more strength. YHOO is now in a position to challenge long term resistance at $40:

Chart forYahoo! Inc. (<a href=

In previous market cycles, a steady uptrend in YHOO that has led to a vertical move has been a prelude to much more strength in the stock. My bias is that this pattern will tend to be predictive.

Looking at charts is art (or, magic), not science. I like this chart. A high-level consolidation that occurred in the post-Lehman collapse period until last year, but at a level well above the prior consolidation during the Tech Wreck 2001-3 period. Proportionality of moves from low to high may imply an up-move of similar strength, to levels well above $40.

Operations: Yahoo's future earnings cannot easily be modeled. It is a company in transition - again. Successive CEOs have had different visions for a way for it to succeed. It is a tech company, a media company, a mobile app company, etc. Belief in its operational success going forward requires a certain leap of faith.

As we know, the Internet has joined other scalable business sectors where modest capital inputs can lead to enormous returns on the invested capital. YHOO has the possibility of rejoining the elite group on Internet winners.

I find the changes in Yahoo engaging. For example, the various maneuvers that the exclamation mark in "Yahoo!" does when one signs on to Yahoo.com are imaginative. This simple innovation is a design move that is similar to what Marissa Mayer did for Google's (GOOG) spare home page, dressing it up for holidays and other special occasions. This attention to small and large design details by a CEO also was a Steve Jobs trait. There are other similarities between these two leaders. They are (were) tech-savvy. MM is of course a software engineer. SJ was experienced both in hardware and software. MM does not suffer from this comparison, as Yahoo has no hardware focus.

Additionally, both leaders have (had) strategic visions for where they wanted their company to be in 5-10 years and pursued the goal single-mindedly. Both were devoted to their jobs and engendered loyalty from those who worked for them. Both were comfortable firing high-level subordinates.

It is of course premature to equate Marissa Mayer with Steve Jobs, but so far, I like what she's doing. Yahoo just might, by 2015, be in rapid expansion mode, just as Apple soon surged from an ignored status in 2003.

Risks: Alibaba has valuation and operational risks. Its profit margins are very high; sales growth could slow while margins compress. Yahoo Japan shares could lose value, perhaps permanently. And obviously Yahoo could begin to lose out competitively. Risks are clearly present at this stock price, over $34, that I thought were largely absent in February.

In addition, valuations throughout the stock market are argued by many observers to be above average based on historical valuations.`This consideration would likely mean that should a reversion to the mean in stock valuations occur, YHOO would be caught up in that correction or bear market.

Evaluating the risk-reward in YHOO: I will propose that reasonable downside, after-tax values to Yahoo for its stakes in Alibaba and Yahoo Japan are, together, about $10 per YHOO share. The takeover value for YHOO is unknown, but should operations turn down instead of up, it appears reasonable to me to target $10/share as a minimum takeout price ignoring the Asian shareholdings. This suggests $20/share as a minimum downside target assuming no major bear market ensues.

On the upside, I see the possibility of many things "breaking good."

If Alibaba's growth slows to 40% annually compounded for four years, earnings will quadruple. By late decade, the company may merit a 40X multiple on perhaps $8 B of earnings. YHOO could have its entire current market cap justified by its stake in Alibaba if it holds its remaining shares it will own after it sells half its stock as required on the IPO.

To the extent that YHOO monetizes Alibaba's IPO and repurchases stock, that could be a catalyst for leveraged share price appreciation. If operations do turn, then YHOO could become a high P/E stock with growing and eventually substantial earnings.

There is little practical limit to where Yahoo can go operationally. Since it markets no hardware, it is not a direct competitor of the obvious giants. It has a different business model from Facebook; they are indirect but not direct competitors. Yahoo has done little internationally, so the world could be its oyster. The key is going to be whether it can emulate Apple and come out with important great products that will drive rapid growth in operating profits.

Thus, from its current reasonable valuation on a sum of the parts analysis, YHOO shares could run uphill and keep running for years to come, with Alibaba an important part of the stock's success. Growth in Alibaba's share price, plus growth in Yahoo Japan's share price, plus a true success in Yahoo's operations, justify the title of this article in my view.

Conclusion: YHOO shareholders have several ways for the stock to continue to appreciate, with a chance to win big, whereas operational disappointment now could well lead to a sale of the company, possibly also above the current trading price in the $34-35 range. Thus this former glamour stock is an interesting, and to my mind, attractive candidate for new money, especially if it consolidates its gains here in a sloppy market as a whole.

Meanwhile, as discussed above, downside potential may be relatively limited. I therefore look at YHOO as a core holding in the growth (turnaround) and value category, noting that there is no suggestion in this article that this is an optimal short-term trading time to purchase these shares.

Source: Still Bullish On Yahoo: Why The Stock Could Challenge All-Time Highs

Additional disclosure: Not investment advice. I am not an investment adviser.