Shareholder activism works. I said the same thing eight months ago in my article "Corporate Raiding: A Revisionist Interpretation". Specifically, I pointed to the preponderance of evidence, which has shown that (1) "[t]he abnormal return around the announcement of activism is approximately 7%, with no reversal during the subsequent year" and (2), contrary to accusations of short-termism, most activist hedge fund managers engage with management for no less than a year. Better yet, (3) 17 months after the 13D filing (which discloses active ownership of 5% of an Issuer), long-term abnormal returns are around 10.5%. "Corporate raiding" is nevertheless the term that defenders of somnambulistic boards like to use to characterize active shareholders.
In light of the research, I was disappointed to see Wachtell Lipton, a prominent law firm that created the entrenching poison pill defense, issued a letter celebrating Starboard Value's defeat at AOL's (AOL) annual meeting of shareholders where the activist's full slate of nominees were rejected. The market appears to have taken a decidedly different perspective with shares down 5.7% since the result was announced. By contrast, Yahoo (YHOO) has appreciated by 12.9% and outperformed peers & broader indices since Dan Loeb of Third Point disclosed his stake. Given the similarity between Yahoo and AOL in penetrating online media after their failed bids in search, it is convenient to compare their future growth stories to Google. It is a story of two companies (Yahoo and AOL) that have failed to listen to shareholders, and one innovator that has taken the opposite approach.
AOL has struggled over the last few years with free cash flow dropping substantially from $761M in 2008 to $214M in 2011. 2011 was an unusually bad year due to negative isolated event, and the company looks cheap at a normalized and conservative free cash flow generation of $600M. The company trades at just 4x that amount. For a rough comparison, a firm is typically considered undervalued if it trades below 10x last year's free cash flow.
Management kept pointing to the strong stock returns over the last 12 months as a sign of progress, but the devil is in the details. Since Starboard Value first disclosed slightly more than 5% ownership of AOL in mid-February this year, the stock has gained 36.2%. While the sale of $1B in patents to Microsoft (MSFT) was a step in the direction, it is a step that I believe was mostly the result of Starboard's intervention in the first place.
The story is, in many respects, similar at Yahoo. Like AOL shareholders at the annual meeting, Yahoo's management failed to heed activist investor Carl Icahn's advice. Icahn insisted that the company sell itself to Microsoft , which put in a takeover bid of $31 per share. The company is now valued at nearly half of Microsoft's offer and, if anything, appears overvalued. Consensus estimates for Yahoo's EPS are that it will decline by 10% to $0.81 in 2011 and then grow by 9.9% and 13.5% in the following two years. Assuming a multiple of 17x and a conservative 2012 EPS of $0.84, the stock will depreciate slightly.
Even though Yahoo is roughly at fair value given current operations, Third Point has helped put the company in the right direction. After the then-incumbent CEO Scott Thompson was found to have lied about his credentials, Yahoo's board reached a deal with Dan Loeb. Yahoo gave Loeb and two other Third Point representatives board seats in addition to booting five directors, including Thompson. By replacing failed directors with individuals representing shareholders, Yahoo has positioned itself for value creation.
The fight with Google (GOOG) in search, however, might as well be over. Google has 81.7% of the market, more than 13x and 250x Yahoo's and AOL's share of the pie, respectively. At the same time, Google has also done an excellent job diversifying. From social networking catalyst Google+ to mobile wonder Android, Google (unlike Yahoo) has delivered time and time again. Despite the "law of big numbers", I still consider the $182B search giant significantly undervalued.
Google is the kind of company that Yahoo and AOL should aspire to. Google has created a sustainable empire that is reinforced through news portals, ebook readers, Gmail, blogger accounts, and so forth. Not every one of its apps will be a smashing success (Orkut, anyone?), but the company tries. Google glasses and automated cars may not be viable in the next decade, but it is that sense of wonder, exploration, and aspiration to be the best, to not rest on one's laurels but to shoot for the next frontier that drives value.
Technology and internet media, however, has few barriers to entry. Instead of fighting over what has been lost (search and internet media as it stands), Yahoo and AOL should do what Google does and innovate. Investments and partnerships in, say, mobile could be a start. Greater distribution on social networks would be another strong idea. While the specifics will never be clear, what is clear is that AOL and Yahoo should start listening to shareholders like Google has done for years.
Additional disclosure: We seek IR business from all of the firms in our coverage, but research covered in this note is independent and for prospective clients. The distributor of this research report, Gould Partners, manages Takeover Analyst and is not a licensed investment adviser or broker dealer. Investors are cautioned to perform their own due diligence.