Phoenixes do rise from the ashes, as evident by the fabled revival of Apple (AAPL). Technology investors generally focus on growth and avoid these potential phoenix opportunities as too risky to justify the time and energy. Yahoo's (YHOO) missteps are well-documented and whether the company represents a value investment that may award investors like Apple or simply keep falling like Newton's Apple, is one of the most debated ideas in technology. So, let's add my opinion to the debate.
Yahoo was founded in 1994 by co-founders Jerry Yang and David Filo, whose combined stake in the company's common equity is still slightly above 7%. The company grew rapidly during the 1990s and its stock price soared to an all-time record of $118.75 on January 3, 2000, during the dot com boom. Yahoo became the most successful of the web portal companies to emerge during the 1990s, and it successfully defended itself from the occasional attempts by Microsoft (MSFT) to break into the portal space. As Yahoo grew, it made a series of acquisitions in the belief that web users would prefer a one-stop website for their news, gossip and search activities.
A simple look at Yahoo's 2011 revenue ($4.9 billion versus $6.3 billion in 2010) shows a fairly dramatic decline in revenue, but this is primarily due to the search agreement that Yahoo signed with Microsoft. Excluding this agreement, revenue appears roughly unchanged from 2010. It should be noted that Microsoft offered to buy all of Yahoo in February 2008 for $31 a share, or approximately 100% over Yahoo's recent share price of $14.75. Jerry Yang, Yahoo's Co-Founder famously turned the offer down as too low a valuation for the company.
Carol Bartz was hired to turn around Yahoo in 2009 either by making Yahoo a true competitor to Google (GOOG) or by repositioning the company as a content provider that could make profitable use of Yahoo's previous acquisitions. Carol Bartz was fired as CEO of Yahoo on September 6, 2011 due partially to Yahoo's continued weak performance, but primarily for clashing with Yahoo's ingrained culture. The Board of Yahoo handled the firing badly and Bartz's subsequent reaction gave Yahoo unwanted and largely unneeded media attention.
On January 4, 2012, Yahoo announced that Scott Thompson would be the new CEO. Thompson was formerly the President of PayPal, a division of eBay (EBAY). Although PayPal has a strong hold on the internet payment business, its parent's performance has been mediocre in recent years. It is still too soon to assess whether Thompson's experience at PayPal will be a positive event for Yahoo's operating performance. Investors may note that Bartz was a highly regarded CEO when she ran Autodesk (ADSK), a business that, like PayPal, is not directly comparable to Yahoo.
During the 2000s, Google emerged with a competing model to Yahoo's cluttered multi-stream approach. Google eschewed Yahoo's all-in-one website with a clean and elegant website that focused initially almost entirely on search. The result was that search volume quickly migrated from the remaining search sites to Google. As of April 2012, roughly 80% of searches are conducted via Google, with Yahoo having less than a 7% market share. Google has worked to diversify its business model by targeting operating systems for smart phones. Its Android operating system is a direct competitor to both Microsoft and Apple. Microsoft and Apple have responded primarily to Google and Yahoo indirectly with approaches that have varied over time and by company.
Microsoft launched Bing and the site has built approximately a 5% market share in searches, and Microsoft continues to modify its Windows operating system to work with mobile devices. Apple has fought Google over patents, but has shown almost no interest outside of its Safari web browser in web searches or large scale advertising revenue initiatives.
Both Google and Yahoo face new competition for advertising dollars from Facebook (FB) (initial public offer expected in May 2012) and Linkedin (LNKD). Advertising dollars are not unlimited. For branded advertisers, Facebook, and to a lesser intent Linkedin, offer a propelling proposal given their high level of user activity. Currently, Yahoo relies primarily on a pay per click model that was easily replicated by Google, but it is not as obvious that the model will be attractive to competitors such as Facebook. Google's advertising success over Yahoo was largely driven by consumers who were actively looking for a product. On Facebook, consumers are less concerned about searching for a product and more about interacting with friends, which may bode well for both Google and Yahoo in the paid for click segment.
In addition to direct search competition from Google, Yahoo's content driven approach places the company in competition for ad dollars from traditional media companies with significant online operations like Disney's (DIS) ESPN.com and the various online offerings of News Corporation (NWS).
Yahoo's valuation is both a product of its future cash flow and its investments in Alibaba (ALBCF.PK) and Yahoo Japan. The most important of these minority investments is Alibaba, where Yahoo holds a 42% stake. Alibaba is a leading Chinese internet firm. Many investors and even professional equity analysts consider an investment in Yahoo to be a play on Alibaba. Unfortunately, Alibaba's value is not readily apparent and I would argue Alibaba is more a venture capital investment than an established equity investment like Yahoo. Secondly, Yahoo Japan will likely be sold by Yahoo, but the valuations that this sale will attract are unknown.
Given uncertainty with Alibaba and Yahoo Japan, Yahoo's common equity remains similar to purchasing a call option. This belief is based on the assumption that equity investors today have the opportunity to purchase Yahoo, a clearly struggling business, that may have potentially high rewards, but its ultimate termination value remains unknown.
Ignoring the Yahoo Japan and Alibaba stakes, the underlying cash flow value of Yahoo can be roughly determined. Yahoo maintains a relatively strong balance sheet with approximately $2 billion of cash and marketable securities against roughly $143 million of long-term capital leases and debt. Netting the cash against the debt leaves a cash per share value of $1.56. Cash from operations continues to be strong at $1.3 billion for 2011 and free cash flow is approximately $700 million per year. My basic valuation, excluding Yahoo's Asia investment, provides a value for the continuing assets of $10.20 per share. Combine this with the value of the balance sheet cash and Yahoo excluding Asia is worth approximately $12.05 a share.
The remaining issue is what to value its Asian investments at. Yahoo uses the equity method to value its Asian investments and the 2011 10-K showed a value of approximately $4.74 billion or $3.70 per share. This is likely the low end of the valuation, and when combined with Yahoo's standalone value, gives a bottom range estimate of a little over $15.75 a share.
The most likely buyer of Yahoo's Alibaba is either Alibaba itself or its founder Jack Ma. Alibaba's shares do trade on various global exchanges and the equity value is approximately $8.4 billion, which would imply Yahoo's stake is worth $3.5 billion, or roughly 40% over Yahoo's book value for the investment. Assuming Yahoo Japan has the same premium and Yahoo's Asian investments are worth approximately $5.20 a share for Yahoo's overall valuation. This puts the high end of the valuation range at roughly $17.25 a share.
I believe that Yahoo's valuation is between $15.75 and $17.25 a share. This assumes no success in the turning around company, but also does not assume significant declines in free cash flow. Yahoo is a highly speculative investment when viewed from its ability to grow. If the company paid a dividend, this risk would be greatly reduced, but unfortunately, the company does not. Equity investors considering Yahoo need both the ability and willingness to accept a high level of risk, but Yahoo's overall risk is primarily driven by potential market rather than credit risk, as credit risk is minimal in the intermediate term. In my opinion, a 30% margin of safety would be warranted, which would provide a target purchase using the mid-point of the valuation range of $11.55 or lower.
Apple proved that technology companies can rise from the dead, but whether Yahoo has the same ability remains to be seen. At a recent stock price near $14.75 share, Yahoo trades below my estimated range of fair value of $15.75 to 17.25 a share. Downside risk is somewhat mitigated by Yahoo's Asian investments and its balance sheet cash, but upside is also limited by a lack of clear growth opportunities. The stock is not particularly overvalued, but equity investors should consider waiting for a pullback to below $11.55 before investing.