A lot has happened to Yahoo (YHOO) in the last few weeks and while many uncertainties remain, the risk/reward dynamics of an investment at the current stock price of $15.73 is compelling.
In early January Yahoo announced Scott Thompson as the new CEO of Yahoo. Prior to the appointment Mr. Thompson was President of the Paypal division of eBay (EBAY). Then, after the market closed on Tuesday January 17, Yahoo co-founder, board member, and former CEO Jerry Yang resigned from the company. This was seen as a positive for the company and the stock traded up. Jerry Yang was seen as resisting change. This past September he was called out by the activist hedge fund Third Point both for rejecting Microsoft's (MSFT) buyout offer in 2008 and for attempting to play both sides of the table in the current strategic discussions between Yahoo and various private equity firms. It was rumored that Jerry Yang was trying to team up with private equity to take a significant stake in Yahoo while also a board member who had influence over the future direction of the company.
Then on January 24th Yahoo announced Q4 2011 earnings of $0.25 per share, slightly above Wall Street consensus estimates although revenue was slightly below expectations. Both revenue and earnings were down versus the year ago period, which was expected. The timing of earnings, only a few weeks after Scott Thompson took the CEO job, did not provide him enough time to be in a position to offer concrete strategic thoughts. His commentary on the Asian assets was limited to the following:
"We have engaged in a variety of discussions with potential partners to enhance shareholder value. We're in active discussions with our Asian partners to significantly restructure our holdings in Alibaba Group and Yahoo! Japan in order to unlock value for our shareholders. While we're pursuing these discussions with enthusiasm, given the complex, unproven, and multi-faceted nature of the restructuring, we're not in a position to provide further detail or certainty on today's call."
Where does this leave Yahoo from an investment perspective?
At $15.73 per share Yahoo has a market capitalization of $20.0 billion, net cash of $2.3 billion, and an enterprise value of $17.7 billion.
Third Point's Valuation
In Third Point's letter from September 8, 2011 they discussed their view of valuation. At the time of the letter Yahoo was trading $13.61 per share, 13% less than the current price. The key components of Third Point's base valuation are as follows:
- Tax adjusted net cash of $2.49 per share
- $3.10 per share of after-tax values for the Yahoo! Japan stake
- $5.24 per share of after-tax values for the Alibaba Group stake
At the then price of $13.61, Third Point pointed out that this implied a value for the remaining business of only $2.78 per share or 2.2x 2012 EBITDA (this suggests a 2012 EBITDA of approximately $1.6 billion).
Third Point suggested that "with more effective and focused management, one could realistically envision a re-rating to at least 7.0x 2012 EBITDA, driving a target of over $19.00 per share." They also saw upside to this outcome if Yahoo could execute a tax efficient divestiture of the Asian assets (another $3-4 per share according to Third Point). Further, Third Point also saw potential value creation by optimizing the capital structure (i.e. share buybacks).
Third Point also addressed the potential for Yahoo under new management: "In addition, based on our discussions with industry experts and entrepreneurs, we believe that with new management, there is significant further value in leveraging Yahoo's globally trusted franchise and platform for a range of new products and innovations." Whether or not Scott Thompson would have made Third Point's short list is unclear.
With respect to Alibaba Group Third Point suggested that Alibaba Group's value could double over time suggesting that "the mid-term value potential for this stake alone could represent another $5.00 per share of upside."
In summary, Third Point presented several valuation constructs for Yahoo.
Value per Yahoo Share
Illustrative Base Valuation
$19 per share
· Assumes re-rating of Yahoo core business to 7x EBTIDA
Tax Efficient Divestiture of Asian Assets
$22 to $23 per share
· Tax efficient outcome for Asian assets
Alibaba Group Upside
$27 to $28
· Full value for Alibaba Group potential
· Capital structure optimization
Value Creation Catalysts
The next logical steps for Yahoo make the current stock price a good entry point. There are multiple potential catalysts for the stock. At some point, hopefully soon, Scott Thompson will articulate his turnaround strategy. With Jerry Yang out and a February deadline for an activist like Third Point to launch a proxy contest, it is reasonable to expect additional news out of the company as they proactively try to avoid a proxy fight. This could take several forms. Here are a few idea of what we could see:
- More board members leave - Jerry Yang is not the only one responsible for turning down Microsoft and this is the board that hired (and fired) Carol Bartz. New CEO Scott Thompson should get a clean slate and fresh ideas and energy are needed at the board level.
- An announcement regarding the monetization of the Asian assets. While a tax efficient deal in the form of a cash-rich split could take time to execute given its complexity, it could still be announced to let shareholders know that the company is moving forward. When the company announced Scott Thompson's hiring they made several references to the hiring not slowing down the discussions around the Asian assets and made it clear that Scott Thompson is being hired to focus on the core business.
- A levered recap in which Yahoo issues several billion dollars of debt and executes a large share repurchase (private equity need not be involved). With over $1.5 billion of annual EBITDA Yahoo could raise $3 billion and still only be 2 times levered. When combined with their $2.5 billion of net cash on their balance sheet they could buy back $5 billion of stock representing 25% of the current market capitalization.
Whether or not Scott Thompson can turn around the core business remains to be seen and it will certainly be no easy task, but the first step is articulating a plan that investors can buy into. Providing clarity around the monetization of the Asian assets would be a significant positive step for the company and the stock. Further, board level changes that support the turnaround efforts and add fresh blood to a stagnant board would also be viewed as positive news.
In the near-term there is likely to be more positive news than negative. With earnings in the rear-view mirror the company has some time to get its act in order and I would expect to see some interesting and positive news in the next 4-6 weeks.
Disclosure: I am long YHOO.