If I were a long-short, 'market neutral' hedge fund manager*, I would go long Yahoo Japan (listed on Tokyo Stock Exchange: 4689) and short Yahoo U.S. (Nasdaq: YHOO) at the market open Monday morning. Here's why this trade now looks attractive:
Yahoo Japan's Steadier Fundamentals But Sharper Share Price Decline
Over the past couple of years, Yahoo U.S. and Yahoo Japan have both been growing revenues at about 25% year-on-year. As the graph shows, Yahoo Japan's growth has been steady, while Yahoo U.S. was hurt in 2006Q3 by a slowdown in ad spending but expects to report a stronger 4th quarter. Note that the financials of both companies exhibit some seasonality, with calendar year-end Q4 stronger than other quarters.
Net income shows a similar pattern: Yahoo Japan has achieved persistent quarterly growth, while Yahoo U.S.'s earnings have been more erratic, rising rapidly in 2005 but softening this year. Consensus estimates (EPS $0.13 per share for Q4, up from $0.11 in Q3), however, suggest that some earnings "catch up" may be in the cards.
The deterioration of Yahoo U.S.'s stock price (Friday's close of $26.91 was 38% off its 52-week high of $43.66 in January) reflects challenges the company has been facing both externally (Google (NASDAQ:GOOG) continues to whittle away at Yahoo U.S.'s paid-search market share) and internally (tell-tale sign: this weekend's leak of "The Peanut Butter Manifesto" describing the company's lack of focus and coordination and ineffective top-down leadership). Interestingly, over the same time period, the fall in Yahoo Japan's stock price has been even more pronounced (Friday's close of 40,200 yen was 55% off its 52-week high of about 90,000 yen, also from back in January).
Observing the sharp decline in Yahoo Japan's share price, one might presume that its local market competitive positioning and future prospects are worse than they are for Yahoo U.S. However, such is hardly the case. Although Google has been making recent progress in Japan with the Google toolbar as a traffic driver, Yahoo Japan continues to enjoy impressive mindshare among Japanese Internet users. According to a recent NetRatings report, the ranking among Japanese Internet properties in September was:
#1: Yahoo Japan, 38.5 million
#2: Rakuten, 25.7 million
#10: Google Japan, 17.4 million
#1: Yahoo Japan, 23.6 billion
#2: Rakuten, 4.3 billion
#3: Google Japan, 2.0 billion
Observe that Google lags Yahoo in Japan by a very wide margin. Over the past year, Google has risen in the rankings but still sits clear back in the #10 spot based on unique audience, and attracts just 8% of the number of page views Yahoo receives.
Backed by Masayoshi Son's Softbank (which owns 41% of Yahoo Japan), Yahoo Japan got off to a very early start in Japan in 1996 and has maintained its dominant position as leading portal and online auction site (eBay withdrew from Japan in 2002, after failing to gain significant market share from Yahoo Japan). Yahoo Japan's broadband initiative, Yahoo BB, has become Japan's largest ADSL Internet service provider since launch in 2001, overtaking incumbent fixed-line provider NTT through price competition and innovative "triple play" (ADSL Internet access, VOIP phone, and Internet-based broadband TV) services. Furthermore, Softbank's new role as a mobile phone operator (through purchase earlier this year of Vodafone's Japan unit) should lead to new revenue opportunities for Yahoo Japan from monetization of Internet traffic coming from mobile phone users. In my opinion, Yahoo Japan stands to gain by providing integrated cross-platform (PC and mobile phone) data services that other players in the Japanese market will have a hard time matching.
Playing the Cross-Border "P/E Inversion"
Following its year-to-date price decline, just how cheap has Yahoo Japan become? A look at current P/E ratios (using annualized quarterly earnings) tells the story. During 2005, Yahoo Japan's P/E was 80 to 100, compared to Yahoo U.S.'s P/E in the lower range of 60 to 70 (adjusted to account for Yahoo U.S.'s 33.4% ownership of Yahoo Japan). This relationship--with the Japan P/E higher than the corresponding U.S. P/E--is as expected, since Japanese interest rates (the 10-year Japanese government bond yields 1.7%) are lower than U.S. interest rates (the 10-year Treasury yields 4.6%), and Japanese stocks generally trade at higher average P/E ratios than U.S. stocks. During the course of this calendar year, as a result of its rising earnings but falling stock price, Yahoo Japan's P/E has collapsed from above 100 in January, all the way down to 42 as of last Friday's close.
The bar chart below displays the recent "inversion" of the normal U.S.-Japan P/E relationship in Yahoo's shares. Expressed in P/E-equivalent terms, U.S. bonds, as expected, trade "cheaper" (1/0.046 = 22) than their Japanese counterpart (1/0.017 = 56).
Similarly, a recent comparison of global P/E ratios shows the average U.S. stock market P/E of 18 to be substantially lower than the average Japanese stock market P/E of 37--again as expected. On the other hand, the Yahoo Japan vs. Yahoo U.S. P/E relationship has become inverted: Based on Friday's close of $26.91 and the consensus EPS estimate of $0.13 for 2006Q4, Yahoo U.S. has a current P/E of 26.91/(4 x 0.13) = 52, which reduces to 43 after adjustment for Yahoo U.S.'s equity ownership in Yahoo Japan. Quite unexpectedly, then, Yahoo Japan's P/E of 42 is now anomalously lower than the P/E of Yahoo U.S.
Given the core fundamentals--with Yahoo Japan's business on a sounder footing that its parent's in the U.S.--I believe that the comparatively large "discount" the market has priced into Yahoo Japan's shares is unjustified. Part of the cheapness in Yahoo Japan's share price could be coming indirectly from the unimpressive subscriber growth numbers at Softbank Mobile during the initial few weeks of mobile phone number portability (as of October 24, Japanese users can switch mobile operators but keep the same phone number).
However, we are still in the very early days of the launch of Softbank Mobile and, if the earlier success of Yahoo BB is any indication, we should expect to see substantial growth of Softbank Mobile's subscriber numbers in the years ahead, catalyzed by new pricing plans, enhanced cell tower coverage, integrated services, and the widest selection of cell phones available in the market. I see an inherent synergistic relationship between Yahoo Japan's enormous user base and Softbank Mobile's services that should over the next few years allow 1) Softbank Mobile (currently with 16% market share) to win market share from DoCoMo (56%) and KDDI (28%), and 2) Yahoo Japan to strengthen its dominant position as Japan's top Internet content and services provider.
The current Yahoo U.S. versus Yahoo Japan "P/E inversion" is unlikely to persist for long (expect a reversion to the norm, analogous to how inverted yield curves tend to revert back to having positive slopes). In my view, given the current, peculiar, cross-border P/E inversion in Yahoo's shares, going long Yahoo Japan and short Yahoo U.S. is a timely pair trade with substantially greater upside potential than downside risk.
[Figure: The slide to the right shows integration of Yahoo content on PCs and mobile phones in Japan. Expect launch of Softbank Mobile phones with a dedicated Yahoo button to drive new traffic and revenue opportunities. Source: Softbank's (ticker: SFTBK.PK, company number: 9984 on TSE) earnings presentation for the quarter ending Sep. 30, 2006.]
* Disclosure: I do not manage a hedge fund. However, I recently sold shares of Yahoo U.S. and bought shares of Yahoo Japan, to express the same differential view by "embedding" the pair trade described in this article into my long-only portfolio.