- YHOO is undervalued by 17% to 45% using a sum-of-the-parts valuation methodology.
- Yahoo!'s core operations would be worth significantly more as a standalone entity than its stub value as a conglomerate entity of Yahoo! Inc.
- A $7.5 to $10 billion USD cash infusion from the sale of 208 million Alibaba shares during the upcoming IPO should catalyze an upside correction.
- YHOO is undervalued today. Cash infusions and buybacks should unlock shareholder value. However, a meaningful turnaround of Yahoo!'s core operating businesses is necessary to create value over the long term.
- Going long YHOO is a solid trade with asymmetric return potential over the short term.
- Thesis: Yahoo's (NASDAQ:YHOO) stock is undervalued by 17% to 45% using a sum-of-the-parts valuation methodology. Yahoo's holdings of Yahoo! Japan and Alibaba suggest that Yahoo's core operating entity (core-Yahoo!) has a "stub value" of between -$10.31 to $1.32 per share. Within a portfolio of businesses, core-Yahoo! is deadweight. As a standalone entity, however, core-Yahoo! would command a significantly greater market valuation. Yahoo! will unlock shareholder value as it divests itself from its investment portfolio. The addition of cash to Yahoo!'s balance sheet resulting from the sale of Alibaba shares during the upcoming IPO should catalyze an upside correction.
- Catalysts: The catalyst that should trigger an upside correction in Yahoo!'s stock price is the addition of approximately anywhere from $7.45 billion to $10.05 billion USD ($7.22 to $9.75 per share) of after-tax cash to Yahoo!'s balance sheet resulting from the planned sale of 208 million Alibaba shares during Alibaba's hotly anticipated IPO.
- Margin of Safety: Taking Yahoo!'s two largest investments in Yahoo! Japan and Alibaba at their respective market values implies that the equity of Yahoo's core operating business may be valued from between -$10.63 to $1.37 billion USD. Yahoo's stock price reflects an extreme "conglomerate discount" in which the sum is less valued at much less than the parts. The ability of Yahoo! to divest of its investments, coupled with the fact that equity cannot be valued at less than $0, should limit downside to Yahoo!'s stock price to not much below its current market price.
- Asymmetry: Reasonable upside potential coupled with limited downside risks makes going long YHOO one of the better asymmetric trades around.
- Caveats: (1) I recommend going long YHOO as a TRADE, not a long-term investment. I abstain from weighing in on Yahoo!'s long-term prospects until management produces evidence of sustainable top and bottom line growth led by Yahoo!'s core operating businesses. (2) Estimates used in the valuation of YHOO rest squarely on the assumption that Alibaba's IPO will price at no less than $45 per share, or about $100 billion USD for the entire firm. Factors that affect Alibaba's ability to conduct an IPO in a timely fashion and within its expected price range (e.g., unnecessary delays, reporting discrepancies, or even hiccups in the broader IPO market) could materially affect my thesis and may signal potential exits from this trade.
YHOO may be undervalued by 17% to 45%, with a price target range of $39.76 to $49.32. Looming catalysts could propel share prices by that amount in the near future. While Yahoo's pending "turnaround" could send shares much higher over the long term, exploring the catalysts that could return the firm to growth is beyond the scope of this article.
I am not out to disprove the efficient market hypothesis, but when you compare Yahoo!'s balance sheet to its market capitalization, you've got to wonder. Assuming that Yahoo! Inc.'s 35% stake in Yahoo! Japan and 24% stake in Alibaba are held at their respective market capitalizations of $35.6 B USD and $100-$150 B USD implies that the market values Yahoo!'s core operating business's equity at anywhere from between -$10.63 to $1.32 billion USD, or -$10.31 to $1.32 per share. Although Yahoo! could indeed be worthless, it cannot be worth a negative amount. Therefore the situation merits further investigation. If Yahoo!'s core operating business is not worth less than $0 per share, then what is it worth?
Core-Yahoo!'s implied negative value could be indicative of a rare mis-pricing. The value a market assigns to a parent company's equity in cases of equity "spin-offs" or "carve-outs" is often referred to its "stub value." Since equity (i.e., common stock) is a call option on a firm's assets and/or future cash flows, the value of equity cannot be less than zero. Although conglomerate discounts, in which a portfolio of disparate companies is valued at a discount to the sum of the individual companies' values, are fairly common in the markets, a negative "stub value" alone represents an extreme case of a mis-pricing. The last time in recent memory when a company of such notoriety as Yahoo! commanded a negative stub was in 2000, the height of the tech bubble, when 3Com spun off Palm 1 2. Historically speaking, investors would have fared well from buying the relatively undervalued business and selling the relatively overvalued business.
The Big Picture
Before exploring the intrinsic value of YHOO shares, we owe ourselves a sobering reminder that Yahoo! has been struggling to find its niche in the internet search and advertising space ever since Google (NASDAQ:GOOG) (NASDAQ:GOOGL) took the industry by storm. Over the last several years, Yahoo! has been progressively losing global market share. From July 2007 to December 2013, Yahoo! had lost approximately 9% of the global search market's market share. (Figure 1, Table 1, Figure 2, Table 2).
Since Marissa Mayer took over as CEO of Yahoo! in 2012, Yahoo has trumpeted its "turnaround" strategy, which aims to return the firm to growth by increasing the popularity of the company's core offerings. The objectives of turnaround include "a redesign of the web portal, a renewed emphasis on mobile sites, an expansion into social media through the $1.1 billion acquisition of Tumblr, and increased investment in creating attractive content" 3. However, we have yet to see meaningful growth from Yahoo's core offerings. At best, efforts of the turn-around have only slowed the hemorrhaging of Yahoo!'s market share (Figure 3, Table 3). (click to enlarge)
Given the fierce competition from industry heavyweights like Google and late comers like Microsoft's Bing, Yahoo! faces an uphill battle to maintain its relevance in the search space. As we shall soon explore, this rather dismal outlook is already more than factored into Yahoo!'s stock price.
A Bright Spot
The gloomy picture painted by industry macro-trends is starkly offset by the performance of Yahoo's investment portfolio. Given Yahoo!'s spat of success at picking profitable investments in the search and advertising spaces, perhaps investors should begin to consider how Yahoo! has transformed itself into as much an investment entity as it is an operational entity.
Comparing the results of Yahoo!'s US operations against the relatively strong performances of its 35% stake in Yahoo! Japan and 24% in Alibaba shows that Yahoo! may have invested quite wisely. Tables 4 and 5 demonstrate how these operating entities have fared over the last three fiscal years. Most notable is Alibaba's explosive growth over the last three years, with revenues nearly tripling where the bottom line has grown by over 725%.
A comparison of Yahoo's Income from Operations versus Income from Equity Interests isolates the performance of Yahoo's core operating business from its partly owned subsidiaries. Notably, Income from Operations has been steadily shrinking in relation to Earnings in Equity Interest.
Judging from Table 6, it currently appears that as of 2013, Yahoo's core business operations account for approximately 40% of Yahoo's net income (Table 6). This will be an important assumption going forward. For better or worse, it appears as though Yahoo! Inc. is as much an investment firm as it is an operational entity. Moreover, Yahoo! appears to have been much more successful as the former rather than the latter.
An Aptly Timed IPO
Alibaba's upcoming IPO should be seen as extremely fortuitous for Yahoo! As a result of agreements between Yahoo! and Alibaba, Yahoo! has committed to sell 208 million shares of Alibaba at Alibaba's upcoming IPO. While the firm has yet to announce the final details of the IPO, some analysts believe that the firm could file SEC Form 1/A within days 4.
On October 23, 2005, Yahoo! acquired a 46% stake in Alibaba for about $1 billion USD in cash. On September 18, 2012, Yahoo! Sold 523 million shares back to Alibaba for $13.54 per share, or about $7.1 billion USD in total consideration for a pre-tax gain of approximately $4.6 billion USD. Under current terms of the buyback agreement, Yahoo! has agreed to sell an additional 208 million shares of Alibaba, which can either be sold directly back to the firm or in the IPO.
Given Alibaba's rapid growth, shares are expected to IPO at an inflated price of between $45 to $70 per share. The initial offering is expected to sell approximately $20 billion USD of stock for approximately 10% to 20% of Alibaba's outstanding shares. Not only is this within striking distance of the largest IPO ever (that title currently being held by China Agricultural Bank at $22.1 billion USD), but implies and assigns a massive valuation to Alibaba's equity of between $100 to $200 billion USD 5.
The IPO will bring in a lot of cash for Yahoo! To put the IPO in perspective, consider that if Alibaba were to IPO at a price which valued the firm at $200 billion USD, the company would be trading at 29.7x 2013′s sales and 71.2x 2013′s earnings; not quite in Amazon's or Tesla's ludicrous ballpark, but close. By comparison, if the firm were to be valued at $100 billion USD, its trailing P/E ratio of 35.6 would not be significantly higher than Google's; an apt comparison if you ask me. While estimates of the firm's market value vary widely depending on the analyst, I believe that a range of $100 to $150 billion assigns an appropriate margin of safety for the purpose of further analysis.
Given CFO Ken Goldman's statement that $3 billion of cash on the balance sheet is optimal, adding cash in excess of that mark could unlock value in a number of ways 6. Excess cash might stimulate the management to perfect its share buyback program, make long-term strategic decisions about its operating entity, engage in future acquisitions, and possibly even pay a special dividend. Hopefully, sound BoD oversight limits management's celebratory excesses.
What is Yahoo! Inc.'s Stock Worth?
Yahoo!'s market cap of $35.058 billion USD on 4/25/2013 in context with its two largest investments in Yahoo! Japan and Alibaba implies that Yahoo's core operating business (Yahoo! Inc.) may be valued from between -$10.31 to $1.32 per share. Given only that equity cannot be valued at less than $0 suggests that Yahoo may be under-valued. A conservative discounted cash flow analysis suggests that Yahoo!'s core operating business would be worth approximately $6.08 per share as a standalone entity. Building from this base, a sum-of-the-parts style analysis indicates that equity in Yahoo!'s total business portfolio is worth between $39.76 to $49.32 per share, representing a 17.0% to 45.1% premium to the $33.99 closing price as of 4/28/2014. A 17% discount requires a stretch of imagination even for the most potent conglomerate effect, especially given that Yahoo! Inc. and its subsidiaries are not a conglomerate since they operate in the same industry. Moreover, the 17% discount forms a lower boundary. Therefore, going long YHOO represents an asymmetric investment opportunity with limited downside and reasonable upside potential.
My valuation of YHOO's intrinsic value begins by investigating two scenarios. Scenario A assumes Alibaba's IPO values the firm's equity at $100 billion USD (~$45.85 per share). Scenario B assumes Alibaba's IPO values the firm's equity at $150 billion USD (~$68.78 per share). While the scenarios will be conducted in two separate columns, many of the metrics used will not vary between each scenario.
Scenario A: Alibaba's IPO values firm at $100B USD
Scenario B: Alibaba's IPO values firm at $150B USD
A snapshot of Yahoo!'s relevant accounts before the public offering captures the present value of its financial holdings (Table 7).
Table 8 summarizes the expected results of Yahoo!'s sale of 208 million Alibaba shares. I have assumed that 4% of gross proceeds would go to under-writer fees and that the gross gains would be taxed at a 25% corporate income tax. In reality, fees and taxes could vary materially. However, the 25% capital gains tax rate, which represents China's rate, is conservative given the US rate of 20%5. If capital gains were under threat from double-taxation, Yahoo! would likely lock up this cash in an offshore balance sheet account.
Table 9 is the summation of Yahoo's financial accounts before the sale (Table 7) with the effect of the sale (Table 8). The small decrease in the book value of Yahoo!'s Alibaba holdings is more than offset by the gargantuan increase in cash.
Discounted Cash Flow Analysis
A sum-of-parts analysis of Yahoo's business portfolio requires that we first determine what Yahoo!'s core business entity would be worth as a standalone entity. To estimate core-Yahoo!'s earning power, we turn to Table 6 which suggested that 40% of Yahoo's net earnings power is attributable to core-Yahoo!
In order to make forward-looking estimates, we would first like to determine how the Wall Street Consensus has fared recently. Figure 4, YHOO EPS vs. Analysts' Consensus, shows that the Street has underestimated Yahoo! recently, perhaps to Marissa Mayer's credit (Figure 4, Table 10).
Table 11 shows that analysts' estimates are broadly based in a number of opinions. Chances of outliers and outright manipulation decrease as the number of analysts increase. Although more brains are not necessarily smarter than one, I believe that consensus estimates as presented are sufficient.
Table 12 shows how I came up with a 10.1% discount rate using a modified CAPM cost of equity approach.
In order to determine the value of core-Yahoo!, I have used a ten-year discounted earnings model with no terminal value. These parameters seem roughly appropriate for an internet company with minimal hard assets, nothing to liquidate, and a limited useful-life for its technology. First, I estimate the future value 2014′s and 2015′s earnings attributable to core-Yahoo!'s as a standalone business by estimating which portion of EPS would be attributable to Yahoo!'s 35% stake in Yahoo! Japan and its remaining 14.5% stake in Alibaba (assuming the sale goes as planned). Then I apply the analysts' consensus 10.39% growth rate for the remaining eight years. The discount of 10.1% was determined in Table 12. Table 13 shows the present value of the future earnings given the aforementioned parameters.
Finally, table 14 summarizes the disparate parts of the valuation by adding the sum of future earnings attributable to core-Yahoo! to the expected after-tax net cash per share (after the sale of Alibaba shares), and the expected market values of Yahoo!'s remaining ownership in Yahoo! Japan and Alibaba. According to the pure math, Yahoo! is undervalued by between 17% and 45%, depending heavily on the price at which the firm is able to sell Alibaba shares during the IPO.
Core-Yahoo!, as a conglomerate entity of Yahoo! Inc., is undervalued compared to what it would/should be worth as a standalone business entity. Yahoo! Inc.'s unwinding of its stake in Alibaba should unlock significant shareholder value in the near future.
Gaps in the Analysis
The most obvious gap in this analysis is that I have assumed that Yahoo! Japan and Alibaba are valued at their current and/or expected market capitalizations. In this case, value does not necessarily convey worth. Although we know at which price the markets value Yahoo! Japan and Alibaba, the scope of this analysis does not explore their intrinsic values.
Yahoo! is likely to use the $7.5 to $10.0 billion USD of cash generated from the sale of Alibaba shares to continue its aggressive share repurchase programs and make strategic acquisitions. Yahoo!'s uses for the cash received in exchange for its Alibaba shares are an important consideration for the long-term investor. While the bulk of the cash could be used to perfect existing share repurchase programs, real lasting value will be created only if Yahoo! can get its house in order. Investors should also be hopeful that the congratulatory gifts, fat bonuses, and other revelry will be kept to a barely noticeable minimum.
Up to $5 billion of the excess cash is likely to be used in perfecting existing share repurchase programs. Stock repurchases have been a major theme under CFO Ken Goldman. From June 2011 to 2013, Yahoo! spent $7.13 billion on share purchases. As of Q4 2013, and under current repurchase programs, the firm is authorized to repurchase an additional $5.09 billion worth of shares 7. Assuming that Yahoo! intends to maintain a net cash balance of $3 billion, this leaves about an additional $2 to $5 billion that can be spent on putting the house in order and making acquisitions.
Although share repurchases will unlock value by boosting Yahoo!'s EPS even in the absence of organic growth, real lasting value is created, not unlocked. Yahoo! can create value either through organic growth of Yahoo!'s core search and advertising offerings, through strategic acquisitions that are synergistic to Yahoo!'s core offerings, or through well-timed acquisitions of additive businesses. However, badly thought out and/or badly timed acquisitions can just as easily destroy value.
CEO Marissa Mayer has spoken nice words about a "turnaround" that is taking place in the company to reinvigorate the company's core offerings. However, judging by Yahoo!'s ever-eroding market share in the search domain, this turnaround has yet to produce lasting fruits.
Acquisitions are another viable route to growth. Well thought out strategic acquisitions are ideal, but are extremely difficult to identify. While you almost can't pay too much for a great acquisition (i.e., one that multiplies the value of one's existing offerings), finding reasonable deals in today's bubblicious new-tech marketplace is simply unlikely. Mediocre acquisitions paid for at a premium price, like Yahoo!'s purchase of Tumblr in May 2013 for $1.1 billion, can add to online presence and drive revenue growth, but will even under auspicious circumstances take a long time to provide a reasonable ROI; i.e., they are not game changers. Finally, bad acquisitions can destroy value wholesale. Yahoo!'s management needs to practice extra diligence lest they be sucked into the whirlpool of euphoria that is today's new-tech bubble.
The Bottom Line
In conclusion, Yahoo!'s stock is undervalued today. The Alibaba IPO should help Yahoo!'s management unlock value in the near future. Lasting value, however, must be created through top and bottom line growth. Ideally, this growth will be driven by a bonafide turnaround of Yahoo!'s core businesses. Alternatively, good acquisitions could substitute for organic growth. If the current state of euphoria in the new-tech market spills over into Yahoo!'s cup, long-term value could just as easily be destroyed through bad acquisitions. Until there are definitive signs that a turnaround is happening, led by Yahoo!'s core search and advertising businesses, I am reluctant to recommend holding the stock long term.
- I am not calling this market a bubble, but certain parts of it are beginning to a look pretty bubblicious.
- Yahoo!'s 2013 10-K