The declining fortunes of Yahoo! (YHOO) have been well documented and have led to management changes, calls by activist shareholders for further changes-- including on the board of directors, and share underperformance since 2006. Although the way forward is extremely difficult, I am bullish on Yahoo!'s shares at a recent price of about $15. I agree with many-- if not most-- observers that Yahoo! is a broken company. But Yahoo! is not broke (on the balance sheet), which gives management time to repair the damage. And because shares are so beaten up, if the rehabilitation of Yahoo! succeeds to any meaningful degree, it will lead to above market returns for shareholders.
My bullishness on Yahoo! centers around three possible good outcomes. As has long been rumored, management may complete a sale of the company on terms favorable to current shareholders. Another outcome would be for management to make acquisitions and/or sell assets to transform the company away from online advertising, which it is clearly losing to Google (GOOG) and Facebook (FB). A third scenario emerges now that founder Jerry Yang has left the board and former CEO Carol Bartz has been replaced by Scott Thompson. Management may finally establish a clear strategic direction to generate returns for shareholders by improving operations to boost earnings and cash flow growth with corresponding expanding multiples.
Yahoo!'s litany of challenges and problems include losing market share in online search and display advertising, revenue growth lagging the overall online advertising industry, failure to grow its audience and their usage, and an exodus of engineering, sales, and executive talent,
product delays and sales difficulties. This is combined with a rocky beginning to the search engine partnership with Microsoft (MSFT), which began in 2009, and showed difficulty in converting searches into paid clicks, to name the most obvious. Poor income statement performance also demonstrates what is wrong with the company. In 2011, overall revenue excluding payouts to content and distribution partners (traffic acquisition costs) declined 3% versus 2010, display revenue declined by 4%, and search query volume shrank by 4%.
Yahoo!'s relationship with Microsoft is very interesting given the failed bid by the software giant to acquire Yahoo! in 2008 for $44.6 billion, or about 2.4x the $18.8B the company is valued at today. In 2008, the rationale for Microsoft's bid was that the deal would transform its internet business by giving Microsoft 1) dominance in Web banner ads used by corporate brand advertisers; 2) access to more than 500 million people monthly to Yahoo!'s sites and Yahoo Mail, the No. 1 consumer e-mail service; and 3) improve the weak position of both companies in the web search market where, according to comScore data, Yahoo! was second at 16%, Microsoft was third at 3.7% and Google dominated at 77%. This bid was richly valued for Yahoo! at about 57x forward earnings, almost triple the 20x multiple that Google fetched on its forward earnings at the time. The deal was ultimately scuttled, even after being raised by about $5 billion, due to Yahoo!'s demand that the offer be raised another $5 billion to a total of $54.6 billion. This rejection by Yahoo! increased expression of discontent against Jerry Yang which ended with his resignation in early 2012.
I believe given the continued evidence of Yahoo!'s deteriorating competitive position, presence of new management, and exit of Jerry Yang, at this time the company would be much more open to a fairly valued buyout offer, much less one that was as rich as the Microsoft deal in 2008. Buyers today are scarce and offers are likely to be at less than intrinsic value given the current economic environment and, more importantly, Yahoo!'s much worse position compared to 2008. However, I believe that high cash balances on most tech companies' balance sheets will spur merger and acquisition activity going forward. Yahoo!, with more than 650 million unique visitors each month, could be a prime target at a reduced price.
Transforming the company by either shedding or acquiring assets, or some mix of both, is also a way for Yahoo! to create value for shareholders. The company has divested some non-core businesses and technologies, which has removed some expenses and caused improvements in operating margins in 2011. And with a strong balance sheet which has no long term debt, $2.1 billion cash, $8.4 billion of tangible net worth, stable and strong liquidity and leverage (current ratio is at 2.9x, financial leverage is at 1.2x), Yahoo! can dip into the acquisition pool to reposition its assets in a way that current management can more fully exploit.
Tangible net worth includes Yahoo!'s 42% ownership stake in Alibaba Group and its 35% stake in Yahoo!Japan. Analysts advise caution in evaluating Yahoo!'s book value given the murkiness of the $4.8 billion valuation of these holdings. But even excluding its value altogether, Yahoo! has about $3.6 billion of tangible equity, meaning the company is not going to collapse any time soon.
Before being hired as Yahoo!'s CEO, Scott Thompson served as president of the PayPal unit of eBay (EBAY), which followed his tenures as chief technology officer at PayPal, executive vice president of technology solutions at Visa's Inovant subsidiary, and chief information officer of Barclay's Global Investors. His background in the technology side of the business supports his stated intention to refocus the company on innovation, increase revenue in search, and leverage proprietary data to create new revenues.
Another move in the direction of improving core operations was last year's hiring of Blake Irving as chief product officer. Should these new managers succeed in turning around the operations of Yahoo! and increase earnings and cash flow, the multiples paid will expand accordingly. The current price to earnings multiple is about 19x, which is nearly half the 36x average multiple since 2005. Similarly, the price to earnings to forward growth multiple stands at about 1.2x now, which is about 30% below the average 1.7x multiple since 2005. Earnings per share are estimated to be flat at $0.82 in 2012 and to grow by about 13% to $0.93 in 2013. Instead, if earnings grow by 25% to $1.03 in 2013, applying a price to earnings multiple of 25 gives a share price of more than $25 for a return of more than 70%.
So, while the obstacles facing Yahoo! are numerous and steep, I believe aggressive investors will find that the outsized reward from any of these possible good outcomes is enough to risk holding shares at the current price of about $15.