No company has more drama surrounding it than Yahoo (NASDAQ:YHOO). The one-time leader in search has been reduced, at least from a perception standpoint, to a shell of its former self. Recent events and the actions of Yahoo's management have proven that in order for there to be true change in the company's direction and share price, Dan Loeb and his candidates for the company's board of directors must be elected. From this point forward, we believe that investors should trade Yahoo based on their opinions of Loeb's chances of successfully electing his board candidates. We delve into recent events and the proxy battle below. But first, an overview.
Since Carol Bartz was fired as CEO on September 6, 2011, Yahoo's stock price has become unhinged form fundamentals, and has traded largely on developments regarding Yahoo's stakes in Alibaba and Yahoo Japan. Given that these stakes, combined with Yahoo's cash and investments, are worth more than the company as a whole, it is understandable why the market so keenly follows these developments. Our own analysis of Yahoo shows that it is worth $18.41 a share (pre-tax). That represents upside of 23.72% from current levels. And that valuation assigns no value to the core search business.
Despite a rise of more than 15% since September 6, Yahoo shares have underperformed the S&P 500, due to worries over what will transpire with regards to Alibaba and Yahoo Japan. Whenever negative news over these stakes breaks, shares sell of, because investors worry that without a sale of these stakes, there is little else to drive Yahoo forward. We dive into these concerns below.
One of the core problems facing Yahoo is a matter of perception. For all the troubles Yahoo is set to be facing, the company is, for the moment, doing just fine financially. Though earnings per share fell to 82 cents in 2011 from 90 cents in 2010, 2010 earnings were inflated by asset sales, such as that of HotJobs. Income from operations (Yahoo's core search business) rose 3.6% to $800.341 million. And perhaps even more importantly, earnings from its stakes in Alibaba and Yahoo Japan rose 20.51% to $476.92 million. Though revenue did fall 21.19% to $4.98 billion, Yahoo's costs plunged right alongside it, thanks to the search deal with Microsoft (NASDAQ:MSFT) and cost cuts at the company. Yahoo's operating cash flow rose to $1.3 billion in 2011, and the company has over $2.5 billion in cash and investments on the balance sheet, and no debt. That equates to $1.97 in cash and investments per share. Make no mistake, Yahoo's core search business is in need of a major turnaround, but the market has already marked the value of that business to nothing, even if it is still solidly profitable and generates healthy cash flows.
Yahoo's REAL issue is not one of fundamentals (though they are in need of long-term fixes), but of perception and leadership. The management and board of directors of Yahoo could give HP (NYSE:HPQ) a run for their money in terms of corporate incompetence and mismanagement. After turning down Microsoft's once-in-a-lifetime offer in 2008, Yahoo spent the next several years flailing around, first hiring Carol Bartz, then firing her. Since then, the board has announced nothing of substance, other than generic statements about its strategic review process.
But this is Yahoo, after all, so it is inevitable that leaks occur. We have not seen any major company with as many leaks as Yahoo. That, along with virtual silence from management and the board, leaves the market guessing, and has turned Yahoo stock into little more than a measure of sentiment on a deal with Alibaba and Softbank over Yahoo's Asian stakes. And recent developments have done little to inspire confidence in Yahoo's leaders, and show why Dan Loeb must succeed in his proxy battle.
When the world first learned that Scott Thompson, formerly the head of PayPal (NASDAQ:EBAY), would become Yahoo's new CEO, many were perplexed. While Thompson was certainly successful at PayPal, this was a media company, and commentators openly wondered if he was up to the job. His lack of media experience, combined with what is perhaps the most inept board in corporate America, left many to ask how Yahoo would turn itself around. And so far, the skeptics have been proven correct.
The resignations of Chairman Roy Bostock and Jerry Yang, along with other board members, was framed as a positive thing for investors. The press release announcing the resignations of Roy Bostock and others framed it as a result of an assessment of "the composition of the Company's board of directors relative to its ability to enhance the prospects for Yahoo's future success." In reality, however, this action was taken as a way to sooth angry shareholders. The resignation of Jerry Yang was no different. Shares rallied 5% when news broke that Yahoo's co-founder was resigning.
Shares rallied on word of Yang's resignation because investors took it as a sign that talks with Alibaba and Softbank were progressing. But on February 14, 2012, news broke that those talks had collapsed. Shares immediately plunged. We discussed this deal in a previous article, arguing that investors should not worry about whether or not a deal occurs, especially when Yahoo's fastest growing source of earnings are its Asian assets. What worries us is not the potential collapse of a deal. Rather, what worries us is what this says about Yahoo's management. Yahoo's management cannot seem to agree on anything, and although we do think it is wise for Scott Thompson to break off deal talks if they were leading to a poor outcome for Yahoo, the complete lack of communication with investors is unnerving. To us, the issue is not whether or not the stakes will be sold. It is how Yahoo management is approaching the process. Furthermore, Thompson and the rest of his management team have yet to address Yahoo's glaring identity crisis, something that Carol Bartz did not address either. Is it a media company? Is it an advertising company? Is it a technology company? No one seems to be able to give a clear answer, least of all Yahoo's executives.
An internal memo leaked to AllThingsDigital (yet another leak from Silicon Valley's most porous company), sent from Scott Thompson to employees, suggests that "change is coming." But, other than generic statements such as "liberating all of us to work faster and make better decisions" and "thinking really creatively about how to build new businesses that leverage our trusted relationships with users," the memo had little in the way of concrete details about how Thompson and his fellow executives would turn the company around (as a side note, the bolding was actually a part of the memo, as written by Thomspon, and it is prominent throughout the memo). And the memo did nothing to address rampant rumors of job cuts, something that we feel must be dealt with quickly. A workforce paralyzed by fear of losing their jobs is a demoralized workforce, and employee morale is essential in any company's success. Rumors are swirling that Yahoo is preparing to lay off thousands of employees. Further evidence of the turmoil at Yahoo is word that the company is preparing to sell its advertising technology unit, in order to spare those workers from layoffs. The core idea behind this move is to turn a cost center into a revenue source. This deal has halted official layoff announcements, as management tries to see if it can negotiate a sale of this unit. While we think that this effort to save jobs is noble, it underscores the turmoil that is currently at Yahoo, and the cloud of uncertainty that is maddening to both Yahoo employees and investors. And then there is the lawsuit against Facebook (FB).
We turn now to the most recent, and most controversial event involving Yahoo; its patent infringement lawsuit against Facebook. Simply put, we think this move was a mistake, for several reasons.
- The patents being asserted are flimsy: In its complaint, Yahoo is asserting 10 patents related to the internet and advertising. These patents may be Yahoo's, but they all come from a time before the true commercialization of the Internet, and Facebook could get them thrown out over prior art with enough time and effort.
- It smacks of desperation: No amount of bullish sentiment can cover up the fact that Yahoo has been adrift for some time. The company is in desperate need of good news, and management clearly thought that suing Facebook would help. That mindset demonstrates the pressing need for a change in leadership at the top. No competent executive or director of Yahoo should have ever allowed this lawsuit to occur. The fact that Scott Thompson allowed for this calls into question his sense of judgment.
- Yahoo crossed the unspoken line: As renowned venture capitalist Fred Wilson pointed out, Yahoo crossed the unspoken line when it sued Facebook, the line being that Internet companies do not sue one another over something as bogus as patents. Nearly every Silicon Valley company knows that the American patent system is broken, as evidenced by the unceasing wave of patent lawsuits in the smartphone industry. One of the patents Yahoo is asserting in this case is essentially a patent on ad-supported websites. As Yahoo puts it, "Yahoo's Advertising Patents claim effective methods of advertising, or generating advertisements that relate to users individually and monitoring advertising clicks for potential click fraud." By that logic, Yahoo can sue every ad-supported website in the United States, something that is a clear absurdity. Yahoo, in its desperation, is acting in a way that is beneath Silicon Valley, and we think that the fact management and the board ignored this speaks volumes to the need for leadership change.
Many pundits and commentators have also stated that Yahoo is merely repeating what it did with Google (NASDAQ:GOOG) before that company's IPO back in 2004. But, these 2 cases are not the same, and that further tarnishes Yahoo's arguments. In the 2004, case, things were much different. In 2004, Google settled a lawsuit with Yahoo brought by Overture, a search engine Yahoo bought. Overture had patented the process of auctioning of search advertising. While Google clearly innovated on that idea, it is undeniable that the core technology belonged to Overture. Overture sued in 2002, and Google settled in 2004. The settlement called for Yahoo to receive 2.7 million shares of Google in exchange for a perpetual license to the patents. And this is where the tradition of incompetence appears once again, this time in an almost comical way. Securities filings show that at one point, Yahoo owned as many as 8.2 million shares, all of which it chose to sell in 2004 and 2005, for a profit of $1.4 billion Had Yahoo held on to those shares, they would be worth $5.1 billion, or nearly $4 per Yahoo share. Not only did Yahoo lose ground to Google, but it failed to extract maximum profits from that market shift.
So how can we still be long shares of Yahoo, given the mismanagement that has, and is taking place at the company? First, the cash and Asian stakes together are worth more than where the company is currently trading at. Secondly, the company is still solidly profitable and earnings are growing, even if the bulk of that growth is due to its Asian assets. And third, Daniel Loeb.
The Proxy Battle & Yahoo's Future
Daniel Loeb is the manager of Third Point, a hedge fund with almost $9 billion in assets that is Yahoo's largest outside shareholder, with 70.5 million shares (a stake of 5.8%). Loeb has a history of shareholder activism, and is one of the most vocal investors in the market. He does not bother to hide his opinions when he feels that a company's management is underperforming, and his letters have become famous for their candor and biting tone.
Loeb's newest target is Yahoo. He has been vocal about his opinions of the company for some time, but Yahoo has been anything but receptive to his demands. Now, the situation has advanced to a potential proxy battle. In a letter to CEO Scott Thompson, published in full on AllThingsDigital, Loeb lays into Yahoo, accusing the board of stonewalling him and ignoring his nominees for the board of directors. Loeb does include a sort of compromise in the letter, proposing to have outgoing director Gary Wilson [former CFO of Disney (NYSE:DIS) and Marriot (NYSE:MAR)] stay on as chairman for a year, but the letter quickly turns into another direction.
Loeb has nominated himself, former NBC CEO Jeff Zucker, former MTV COO Michael Wolf, and Harry Wilson, of Goldman Sachs, Blackstone, and the Auto Industry Task Force. We fully support this slate of directors, for it is clear that the current board, even if it is free of Yang and Bostock, is incapable of taking the decisive action needed to truly turn Yahoo around. In his letter, Loeb makes a compelling case for why his slate should be on the board. These 4 proposed directors bring advocacy, media experience, and restructuring experience, all of which Yahoo desperately needs, especially given the fact that its CEO is not from a media background. However, Loeb argues that Yahoo is ignoring this. In his letter, he accuses Yahoo of stonewalling him, and not to subtly suggests that this slate of directors will be "well-received" by shareholders. Loeb intends to file his proxy statement with the SEC in a matter of days, triggering a full blown proxy battle.
Yahoo's board currently has 11 members on it. Chairman Bostock, Vyomesh Joshi, Arthur Kern, and Gary Wilson are all stepping down (although Loeb has proposed Wilson stay on as chairman). Yahoo has already appointed Amoroso and Maynard Webb as new independent directors. The question that needs to be addressed now is whether or not Dan Loeb and his allies can take control, for their proxy battle will have little effect if they cannot influence the course of events at Yahoo. We think it is doable. Should Loeb succeed, there will be 4 directors in his camp. We do not think Loeb would recommend Gary Wilson to stay on as chairman if he did not think Wilson would side with him. That is 5 votes. Even if the board stays at its present size, it should not be difficult to secure another vote amongst the remaining directors to begin effecting true change at Yahoo.
Without knowing Loeb's intentions, his proxy battle is meaningless. Loeb has made it clear that he wants to refocus Yahoo, and that is why his proposed slate of directors has 2 media executives on it. Furthermore, Loeb has outlined a clear vision for Yahoo's stake in Alibaba. Frankly, at this point, we think that it does not matter what Yahoo does with the Alibaba stake. If it is sold, Yahoo will have billions to return to shareholders due to the cash-rich split, even if the structure of the deal is skewed in favor of the private equity companies working with Alibaba. And if the stake is retained, Yahoo's earnings will keep growing as Alibaba and the Chinese e-commerce market continue to grow. By 2015, China's e-commerce market is set to overtake that of the United States, and Alibaba is the undisputed industry leader, with a 49% market share in the B2B e-commerce space. UBS sees Alibaba's valuation reaching $65 billion in a 2013 IPO ($13 of value net of tax to Yahoo) Loeb, in a letter to Third Point investors, makes clear that he wants Yahoo to retain its Alibaba stake. We agree with him, if only for the fact that he at least has a clear position on what Yahoo should do. The current board seems to be unable to reach any sort of conclusion about what to do. Inaction is the worst possible thing for Yahoo at this time. What it needs is decisiveness, and Dan Loeb has plenty of it. We fully support his slate of directors, and hope other shareholders will as well.
We initially invested in Yahoo, like many others, due to its valuation. And when you do the math, the numbers are attractive. The true value of Yahoo's Asian assets, cash, and investments are not reflected in the market at this time. We did not discuss the core search operations because no one cares about them anymore, despite the fact that they are still solidly profitable, with operating income rising 3.6% in 2011. At this point, the market sees Yahoo only as a holding company for Alibaba. We continue to believe that Yahoo has potential, and that a large amount of value can be unlocked, with the right leadership team. That is something the current board has been unable to provide. Our recommendations to Yahoo investors are thus: If you believe in Dan Loeb's chances of success, then buy, or at least hold the stock, for we believe that it is his leadership that will revitalize Yahoo and allow for the value in the company to be unlocked. And if you think that Dan Loeb will fail, then it is time to sell. No amount of bullishness on the Asian assets is worth the mismanagement and incompetence displayed by the current leadership team. They have shown themselves incapable of taking decisive action and we think that without Dan Loeb and his allies on the board, Yahoo will continue to drift listlessly. We are not selling, for we believe that Loeb will succeed, and begin to bring about the change that Yahoo so desperately needs.
Additional disclosure: We are long shares of GOOG via a mutual fund that assigns the company a weighting of 2.75%. We are long shares of MSFT, DIS, and HPQ via the SPDR Dow Jones Industrial Average. We are long shares of FB via our holdings of GSV Capital and the Firsthand Technology Value Fund.