Shares of Yahoo! (YHOO) fell 5.4% in Friday's session. The reason? The company's new CEO Marissa Mayer, said to re-evaluate the company's plans with the billions in cash the firm receives from selling a 20% stake in Alibaba. After reaching a deal in May, Yahoo pledged to use the cash for dividends or share repurchase plans.
Yahoo has been in trouble for a long time. The fact that the company had four new CEOs in merely two years is just is not the cause, but just a manifestation of its deeper problems. Mayer replaced interim CEO Levinshon recently, after former CEO Thompson resigned earlier this year, regarding inquiries into his academic records.
The lack of a coherent strategy resulted in a steady decline in the company's revenues. Revenues fell from $7.2 billion in 2008 to just $5.0 billion in 2011. Net profits rose from $418 million to $1.05 billion, or $0.83 per share. Note that earnings growth is caused by the "equity investments", notably the 40% stake in Alibaba. If we exclude the profit contribution of these investments, operating earnings totaled $800 million for the full year of 2011. This would result in roughly $500 million in net profits, for Yahoo's operating activities.
The company has about $1.9 billion in cash and equivalents on its balance sheet and operates without any meaningful debt for a net cash position of $1.9 billion.
Alibaba, A Bright Spot
In May of this year, Alibaba and Yahoo reached a deal in which the latter would sell a 20% stake in Alibaba. The deal values Yahoo's 20% stake at $7.1 billion. Yahoo will receive $6.3 billion in cash and $800 million in newly issued Alibaba preferred stock. The sale allows Alibaba to proceed with its IPO plans.
Yahoo acquired a 40% stake in the company in 2005. It paid $1 billion and gave up its Chinese businesses. With hindsight, the deal looks great.
Back Of The Envelope Calculations
Based on Friday's closing price of $15.15, Yahoo is valued at $18.0 billion. If we subtract the net cash position of $1.9 billion, the valuation of its operating assets drop to $16.1 billion. Next, we subtract the proceeds of the 20% stake in Alibaba at $7.1 billion. This values Yahoo's assets and the remaining 20% stake in Alibaba at $9.0 billion.
The $7.1 billion deal was reached at a time of great optimism in the internet sector, as Facebook (FB) was about to make its public debut. Even if we value the remaining stake in Alibaba at a 30% discount, or at $5 billion, the operating assets of Yahoo are valued at merely $4 billion.
So let's make up three scenarios:
1. Yahoo will sell the remaining stake in Alibaba and return all cash to shareholders. If Yahoo could sell the remaining 20% stake for a similar $7.1 billion valuation, it could return $13.4 billion in cash to its shareholders. Shareholders could receive a special dividend of $11 per share. Furthermore they would still hold a $800 million preferred stock stake in Alibaba, the firm's current cash position of $2 billion and the operating assets of the firm.
2. Yahoo will return part of the cash and reinvest the remainder in the business. Yahoo could decide to use the proceeds from the 20% stake sale for a special dividend or share buyback. It could maintain the 20% stake in Alibaba until the future IPO and then use the proceeds to make future investments or acquisitions. This scenario gives management time to formulate a credible strategy, and avoid a "rushed" deal.
3. Yahoo will not make meaningful cash distributions to shareholders and instead use the massive proceeds to acquire new businesses and/or invest in its current operations. This scenario keeps investors awake at night as they feel the company might overpay for growth.
The fact that Yahoo's shares fell a little over 5% on Friday, and wiped out $1 billion market capitalization in the process, is simply the result of investors discounting the cash proceeds of Alibaba. Let's assume the company decides to give shareholders $7 billion from Alibaba's 40% stake, and invest the remainder $7 billion by acquisitions. Mayer's comments simply urge investors to discount some of these cash proceeds as they fear Yahoo is overpaying in possible acquisitions. Assuming a $7 billion acquisition target is realistic, they fear the company might pay over as much as 15%.
Long term investors can definitely find value here. Despite the dwindling operations of the firm, the normal operations still generate net profits of $500 million per annum. We might attach a $5 billion valuation to them. Furthermore, the firm has $2 billion in net cash, and its Alibaba stake is valued at $14 billion. This values Yahoo at $21 billion, or roughly $18 per share.
Are investors discounting the firm's prospects too much? Investors seem to be very afraid that the company might overpay in acquisitions. However, Yahoo actually exists in its current shape as a result of a $1 billion investment in Alibaba, made back in 2005. Its $1 billion investment, and giving up its Chinese activities, turned into a cool $14 billion valuation today. Not too shabby right? While Yahoo's operating track record might not be that great, its investment record is fine.
Furthermore the discussions got the OK from board member and activist hedge fund manager Dan Loeb.
Investors who panicked a little too much on Friday, might provide long term shareholders with an excellent entry point.