Yahoo's Investment Considerations
• Yahoo (NASDAQ:YHOO) is a digital media company. The firm generates revenue from display advertisements, the display of text-based links to advertisers' websites, and other sources. Its ownership stakes in Alibaba (NYSE:BABA) and Yahoo Japan are quite valuable and potentially double the $30+ per Yahoo share we attribute to them in our valuation. A large portion of the firm's value sits in net cash as well.
• Yahoo's core business is stumbling. CEO Marissa Mayer is working to turn things around, but it's possible that Yahoo becomes the 'new AOL' in that teaming up with a larger player may be the only option. Verizon (NYSE:VZ) and private equity have expressed interest in acquiring the company.
• Yahoo is in the process of re-imagining every one of its products from search, communications, digital magazines and video to Flickr and Tumblr. The company is investing in Mail as well. The transition to reinvention may have alienated customers, but that doesn't mean Yahoo's assets aren't extremely valuable, especially if used by an e-commerce giant such as eBay (NASDAQ:EBAY).
• We're growing more skeptical of the turnaround in Yahoo's core business, especially with the likes of Facebook's (NASDAQ:FB) and Twitter's (NYSE:TWTR) growing share of the ad pie. Yahoo's core is at risk of dwindling away in the next decade or so, if it is not implemented in a fashion to drive free cash flow. We think a combination with eBay makes the most sense.
• The IRS could create a big headache for Yahoo if it does not step lightly. The board continues to evaluate strategic options, including a reverse spin-off of its non-Alibaba holdings and a sale of its core. Our open letter speaks of another option, however.
• Interest in Yahoo's core assets has risen as of late. Verizon (NYSE:VZ) is said to be proceeding with a bid, and Alphabet (NASDAQ:GOOG,GOOGL) is also considering making a bid. Yahoo recently pushed its deadline for bids back a week in an attempt to stir up additional interest in its assets.
Economic Profit Analysis
In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.
The gap or difference between ROIC and WACC is called the firm's economic profit spread. Yahoo's 3-year historical return on invested capital (without goodwill) is -7.1%, which is below the estimate of its cost of capital of 11.5%. As such, we assign the firm a ValueCreation™ rating of VERY POOR.
The concept of an economic moat - or sustainable competitive advantages - focuses purely on the sustainability and the duration ofthe competitive advantages that a firm possesses. The concept of an economic moat does not consider the cumulative sum of a firm's potential future economic profit creation, but only that at some pointin time in the future, a moaty company will continue to have an economic profit spread and a no-moat firm will not.
Let's examine the problem that arises by focusing exclusively on companies that have economic moats, or sustainable and durable competitive advantages.
Image Source: Valuentum; EVA is trademarked by Stern Stewart & Co
In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate. We assign Yahoo a neutral Economic Castle rating.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Yahoo's free cash flow margin has averaged about 4.6% during the past 3 years. As such, we think the firm's cash flow generation is relatively MEDIUM.
The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Yahoo, cash flow from operations moved into positive territory from levels two years ago, as capital expenditures fell about 26% during this time period.
In fiscal 2015, Yahoo reported cash used in operations of ~$2.36 billion and capital expenditures of ~$578 million, resulting in negative free cash flow generation of ~$2.9 billion.
This is the most important portion of our analysis. Below we outline our valuation assumptions and derive a fair value estimate for shares.
Our discounted cash flow model indicates that Yahoo's shares are worth between $33-$49 each. Shares are currently trading at ~$36, in the lower half of our fair value range. This indicates that we feel there is more upside potential than downside risk associated with shares at this time.
The margin of safety around our fair value estimate is derived from the historical volatility of key valuation drivers. The estimated fair value of $41 per share represents a price-to-earnings (P/E) ratio of about 5.5 times last year's earnings and an implied EV/EBITDA multiple of about 4.6 times last year's EBITDA.
Our model reflects a compound annual revenue growth rate of -0.4% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of -2.5%. Our model reflects a 5-year projected average operating margin of 5.1%, which is below Yahoo's trailing 3-year average.
Beyond year 5, we assume free cash flow will grow at an annual rate of 1.4% for the next 15 years and 3% in perpetuity. For Yahoo, we use a 11.5% weighted average cost of capital to discount future free cash flows.
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $41 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.
In the graph above, we show this probable range of fair values for Yahoo. We think the firm is attractive below $33 per share (the green line), but quite expensive above $49 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Yahoo's fair value at this point in time to be about $41 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Yahoo's expected equity value per share over the next three years, assuming our long-term projections prove accurate.
The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.
The expected fair value of $57 per share in Year 3 represents our existing fair value per share of $41 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Wrapping Things Up
Yahoo came under pressure recently as investor concerns over whether the planned spinoff of its Alibaba shares would be tax free arose after the IRS did not grant a private letter ruling on whether a potential transaction could result in a tax violation. Now the company plans to package all of its assets, except for its stake in Alibaba, in a separate, publicly traded company that may very well go up for sale. It appears that Verizon is proceeding with a bid for Yahoo's core assets and Alphabet is weighing its own bid, but we would like to reiterate our opinion that shares of now-standalone eBay would fit extremely well with Yahoo's core assets, and the long-term value generating proposition from a combination is quite compelling. However, we're comfortable watching the situation unfold from the sidelines, as there is simply too much uncertainty surrounding shares at the moment. Yahoo currently registers a 6 on the Valuentum Buying Index.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.
Additional disclosure: Some of the firms mentioned in this article are included in the newsletter portfolios.