Background: One of the pioneers of the Web and one of the leading poster children for the Internet bubble of the late 1990s, Yahoo (YHOO) remains one of the great success stories of the 'Net. From its early trading in 1996, the stock has returned 21% annually, with a chart that shows three major bull moves and two bear markets to date:
My contention is that the fundamentals, the chart, the trading dynamics and the general psychology of this name favor the bulls, but because the bears have strong arguments, an analytic overview is needed that takes all the major points into account. This article will attempt to do that. I appreciate your interest and look forward to learning from your comments.
Introduction: Even though younger Internet-based companies, the names of which we know, have lately proven more dynamic, Yahoo has numerous assets and few liabilities, stemming from its early-/first-mover status from 10-20 years ago. It is how these assets are valued that forms the basis of the controversy over whether YHOO is a buy, sell (or short sale) or hold at its current price range in the high $30s.
YHOO is best valued on a sum-of-the-parts basis. Within that designation, however, important valuation decisions will be discussed that will clarify why sometimes bull and bear are talking past each other, when this does not have to be the case. The following section contains several sub-sections that explain some of the more important valuation issues, as I see them.
Discussion - Valuing YHOO:
A. Summary: YHOO is worth the value of its "hard" assets plus an intangible factor. Starting with the "hard" assets, we have $7 (tangible book), + $26 (after-tax value of Alibaba's equity) + $7 (after-tax value of its equity in Yahoo Japan, called Y!J herein) = $40/share.
What are the intangibles for YHOO worth to a strategic acquirer?
You and I cannot know, so perhaps it's reasonable to assume that YHOO is worth what WhatsApp was worth to Facebook, or about $19 B, or about $19/share of YHOO stock. (This amount is also about triple Yahoo's intangible book value of about $6/share.) Adding this to the above $40/share gives a target price to a strategic acquirer of about $60/share. This makes intuitive sense. After all, Microsoft (NASDAQ:MSFT) was willing to pay in the $33/share range to control Yahoo last decade, when there were no important Asian subsidiaries to provide so much asset value.
Let's go on to the details and controversies therein.
B. What about imputed taxes? Let's focus on Yahoo's 35% ownership of Y!J. In a nice write-up on Feb. 23 focusing on YHOO and Alibaba, Pamela Peerce-Landers ignored imputed taxes and said that Yahoo's ownership of Y!J was worth $12 per YHOO share. In this article, I subtracted 40% and came up with about $7. Yahoo has no known plans to sell its stake. What's its ownership of Y!J worth to current YHOO shareholders? $12, $7, something in between, or some other number? It's arguable.
With that said, deciding what tax rate to assign to Yahoo's Alibaba stake is more difficult. The company owns about 24% of Alibaba, and is expected to sell about 10% of its stock on the IPO, leaving it with 14%. Do we impute a 40% tax rate to all of Yahoo's Alibaba shares? Might there be a tax holiday in the U.S. that might bring in the proceeds from the sale of some or all of that remaining 14% at a materially lower tax rate? What if the company and Alibaba agree that there is no point in Yahoo selling 10% of Alibaba on the IPO, as that would simply provide more shares that other entities would sell, depressing the share price by so doing?
In thinking through these uncertainties, and taking into account the view of Peerce-Landers to not impute taxes on any unsold stock, it appears as good an approach as any to impute a 33% tax rate on the value of Yahoo's Alibaba stock.
In that case, the next question, what's that equity stake worth?
C. Valuing Yahoo's stock in Alibaba: Alibaba is growing at an enormous rate, and since its sales are not enormous, there may be a great deal of growth yet; i.e., the law of large numbers has not come close to kicking in. Yahoo discloses Alibaba's summary metrics in its quarterly filings with a one-quarter delay. Thus, Slide 18 from the company's Q4 discussion shows that in the July-September period, Alibaba's gross profit grew 58% yoy on a somewhat slower 51% revenue gain. Operating earnings attributable to common shareholders were $792 MM.
Assuming no one-time factors in those results, I'm going to assume that earnings in the current quarter, half a year later, are about $1 B. That, in turn, suggests that the March 2015 quarter could see $1.5 B in earnings. Thus, an Alibaba IPO this June could be done with the expectation of about $5 B in forward earnings from 4/1/14 to 3/31/15. Pick your P/E on that. I would expect 35-40X, or a pre-money valuation of $175-200 B.
Taking the upper bound and saying that Yahoo's 24% ownership should get a 33% haircut for taxes suggests that its market value could be $32 B. Taking $175 B for Alibaba's value gives $28 B.
D. Will Alibaba go public as a fraction of the whole, and if so, will Yahoo have to sell 10% of Alibaba on that fractional IPO? This point was argued by Ms. Peerce-Landers. But despite her cogent arguments, I just don't "see" that really happening. Thus, my answers to my own two-part question just above are 1) I doubt it, and 2) I doubt it. But we shall see.
E. What is Yahoo worth as an operating company, or is that the wrong way to value it? To those questions, my answers are 1) I don't know, and 2) Yes.
Behind firewalls, S&P Capital IQ addresses the schizophrenic nature of Yahoo. On the one hand, as an operating company, Yahoo indeed is not dynamic and deserves a low valuation. But on the other hand, I'm a physician, and at least in my (older) generation, we were trained that the single most important aspect of a medical case was the history. In this case, Yahoo's history is as definitive as can be. Investors with an appropriate, patient time frame are, in my view, making a mistake if they do not note the changes in the company since Dan Loeb forced the board to change. This activism has produced a shareholder-friendly, engaged board that will not, in my view, turn down an attractive takeover offer, as the company high-handedly did to the Microsoft offer last decade.
I think it is clear that Yahoo will either succeed operationally, or it will be for sale at the right time and right price. That is why, if I am right about Alibaba, I am comfortable with YHOO if operations do not heat up, and I will be thrilled if they do. So long as operations do not fall apart, I will expect that Yahoo will be spreading the word that it is for sale, and in anything like the current Internet environment, there will be lots and lots of interested companies. Yahoo is a combination of a tech/Internet and general media company, with a large finance kicker. So all sorts of corporations will have serious interest in some or all of the (living) corpse. Yahoo's eyeballs, brand name, patents, etc. will make it a rare, trophy acquisition.
Thus, the debate between the optimists and pessimists on how to value the company called Yahoo aside from its assets can be answered. Because of the history of how the company evolved to its current status in 2014, there is likely no turning back. Either Yahoo succeeds on its growth plans and YHOO stock appreciates for that reason, or Yahoo's days as an independent entity are numbered. At least that's how I see it.
General comments: Along with such miracles as modern medicine produces, the Internet in all its evolving mobile glory is the invention that has changed the world the fastest and most powerfully of any that affects real people in their daily lives. Broadly speaking, all that I foresaw as an early Internet adopter more than 20 years ago has occurred: the 'Net is a routine and indispensable part of our daily life. Yahoo was a big part of the excitement of the '90s, and I expect that as the Internet gets bigger and bigger, YHOO shareholders will be rewarded adequately one way or the other because of a motivated board and management team.
Risks: Almost everything argued here is speculative. Numerous macro and company-specific things could go wrong, that in total could permanently devastate the value of YHOO shares. Please be aware that YHOO must be considered to be a speculative investment, no matter how glamorous, compelling, and attractive its business niche and those of its Asian equity investments may appear to be. While most Seeking Alpha readers may be sophisticated investors, for any newcomers to investing who are reading this, please be careful with YHOO shares (note that I am not an investment adviser and cannot give investment advice).
Conclusion: I believe that YHOO has a favorable risk-reward ratio so long as financial markets remain buoyant - which could change to non-buoyant at any time. (Again, believing that risk-reward is favorable is different from believing that there is only upside potential to an investment in this equity.)
Alibaba's growth story appears strong, its U.S. peers such as Amazon (NASDAQ:AMZN), eBay (NASDAQ:EBAY), Facebook (NASDAQ:FB), and Google (NASDAQ:GOOG) all have strong support from investors, China's crackdown on bad loans in the steel and shipbuilding areas are unrelated to the growth of the Internet there, and Wall Street has been building to another major Internet IPO since the FB deal. Y!J carries on, and as discussed, core Yahoo itself can be argued to be a win-win situation for YHOO investors so long as true operational disaster does not strike.
My one-year target price for YHOO is $60+, and I think that YHOO can see $45-50 if, and this is a big "if", it reports a robust October-December quarter for Alibaba when Yahoo reports its own Q1 earnings.
Disclosure: I am long YHOO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Not investment advice. I am not an investment adviser. I may buy or sell YHOO stock or options at any time, regardless of the publication of this article.