Background: Yahoo Inc. (YHOO) reported earnings mid-week and at the same time, the question of what it earned is not straightforward. The company earns significant revenues out of Asia. There is also the fact that it, and the financial media, have gotten themselves far away from a consensus that generally accepted accounting principles in the United States mean anything. Thus, one can look at Yahoo! Finance or other popular financial sites and find the following data for earnings trends:
|Earnings History||Jun 13||Sep 13||Dec 13||Mar 14|
|EPS Trends||Current Qtr.
|7 Days Ago||0.37||0.39||1.57||1.79|
|30 Days Ago||0.37||0.39||1.58||1.80|
|60 Days Ago||0.37||0.39||1.58||1.80|
|90 Days Ago||0.39||0.40||1.65||1.78|
However, the company did not come close to actually earning the stated 38 cents on an operating basis (all data are per share where relevant).
Introduction: Yahoo! needs little introduction as a company. It is one of the most famous names on the Internet. It is both a media and tech company. Its dual or triple nature has led to changes of strategy, and operationally it has been left in the dust over the past decade as upstarts such as Facebook (NASDAQ:FB), Google (NASDAQ:GOOG), Twitter (NYSE:TWTR) and others have come on amazingly strongly. However, Yahoo! has been rescued by its prescient equity stakes in its Japanese subsidiary Yahoo! Japan (OTCPK:YAHOY) and, especially, Alibaba Group. The latter is bidding fair to be the single most valuable Internet company in the world. Right now it might be #2 only to Google.
Because Yahoo!'s corporate prospects and Alibaba's real equity value to Yahoo! shareholders are both crucial to Yahoo!'s value and buy-sell-hold decisions, this article takes a detailed look at both matters now that Yahoo! has reported on Q1.
It is important to understand that Yahoo! reports on its Asian subsidiaries with a one quarter lag, so while the company told us how the March quarter (Yahoo!'s Q1) went, it told us about the December quarter for Alibaba Group (which I will call Alibaba here for convenience) and Yahoo! Japan.
Let's begin with Yahoo!'s business status.
Discussion - Yahoo!'s business operations: Yahoo! actually had a poor quarter from a P&L standpoint, but there were reasons for both hope and concern for shareholders. Here's why. Yahoo! divides its business into three categories: search, display and other. It also receives significant income from Asia. From the company's press release:
|Q1 2013||Q1 2014||
|GAAP revenue||$1,140 million||$1,133 million||(1)%|
|Revenue ex-TAC||$1,074 million||$1,087 million||1%|
|GAAP income from operations||$186 million||$30 million||(84)%|
|Non-GAAP income from operations||$224 million||$149 million||(33)%|
|GAAP net earnings per diluted share||$0.35||$0.29||(17)%|
|Non-GAAP net earnings per diluted share||$0.38||$0.38||0%|
The operations were poor from a profit standpoint, with GAAP profits down a huge 84%. However, net earnings were only down 17%, mostly reflecting a great deal of income from Asia. Why were earnings down so much when revenue ex-TAC (TAC = traffic acquisition cost)?
Because Yahoo! spends heavily both on sales and on product development, as seen in this metric, also from the press release:
|Three Months Ended|
|Cost of revenue - traffic acquisition costs||66,068||45,909|
|Cost of revenue - other||278,007||280,844|
|Sales and marketing||257,019||329,846|
|General and administrative||133,421||136,493|
|Amortization of intangibles||7,365||18,340|
|Restructuring (reversals) charges, net||(7,062||)||9,487|
|Total operating expenses||954,398||1,102,551|
Just look at the massive increases in the sales and marketing and the product development lines. What was the payoff? Basically, the company held even on revenue after TAC. Management has highlighted growth in search and improvement in display, but "other" worsened quarter on quarter. From the Q1 earnings slides provided on Yahoo!'s investor relations site, one has to go to slide 9 to find that "other" revenues ex-TAC dropped $30 MM yoy, offsetting the increase in revenues in search plus display. On the conference call, CEO Mayer indicated that she was tasking CFO Goldman to get those, other revenues, moving up as well. (The company did not define them except that they are not from search or display.)
What we do know is that mobile engagement is growing strongly, and overall it does appear that the company's investments in its business are bearing fruit. Thus, even though they are focusing on non-GAAP earnings, the analytic community has liked what it has seen. To wit, from Yahoo! Finance, the trend of earnings revisions is up; though as discussed below, the prognosis for revenues from Alibaba is up as well.
If you read the earnings transcript or watch the earnings presentation from Ms. Mayer and Mr. Goldman in association with the press release and slide show, you can make up your mind about the progress of the company. My own sense is that since Yahoo! is all about the Internet and today's Internet growth is all about mobile, the current corporate focus on, and growth in, mobile Internet usage of Yahoo! sites is important. I thus look at matters optimistically. As one who has criticized IBM (NYSE:IBM) for cutting R&D to focus on EPS, I want to be consistent and praise Yahoo! for "going for it" by reinvesting in their core business. The company clearly operates in a growth business. Slide 5 nicely shows the almost monotonically-improving results in display advertising, and congratulations are in order.
Now, we know that much of the quarter's net earnings came from Alibaba. So with perhaps 40% of the company's Alibaba stock slated to be sold on the IPO, a proportional loss of income would occur thereupon. We must thus be cautious about thinking of 2015 EPS for Yahoo!
Other aspects of the company are unchanged. The balance sheet remains clean and strong.
Again, the question that investors want to know is what Yahoo! is worth A) as an operating company or B) a takeover target. This is a very difficult topic because Yahoo! is a company in transition.
Should its financial turnaround falter, I see Yahoo! as an attractive acquisition. There should be no dearth of interested parties. These parties may even include Alibaba itself, as co-founder Jack Ma said in 2011:
Asked whether Alibaba might like to pick up the ailing U.S. Internet company, Ma told an audience at Stanford University that he would be "very interested in Yahoo."
The former English schoolteacher later added that, were he to have his way, he would be eager to acquire all of Yahoo, not just the stake it owns in Alibaba.
"The whole piece of Yahoo," Ma said in answer to a question from the audience about what part of Yahoo he was interested in.
So, does one value Yahoo! based on a guess at discounted cash flow projections, or on takeover value?
My answer is, whichever is higher. I think of it this way: either the company succeeds and stays independent, and potentially succeeds in a major way, given it is an Internet company with sky-high valuation possible over time; or it is acquired. Every quarter, the major downside possibility, which is that operations turn south so badly that the brand is not worth much to an acquirer, looks less likely to me as Team Mayer produces increased viewer engagement. "Eyeballs" are up, thus many media and tech/Internet companies will be interested in paying up to control those eyeballs and keep them from competitors- or so I think, and hope.
My guess is that Yahoo!'s operations on a takeover are worth at a minimum between twice book value and triple tangible book. In other words, at least $20 a share, which also equates to $20 B. This is basically what Facebook paid to own WhatsApp, which had no revenue, no patents, and few employees. I think that Yahoo! is worth at least that amount.
The more important piece of value for now relates to the unknown Alibaba value. Let's update that topic, while discussing certain controversies that have arisen on Seeking Alpha about Alibaba.
Alibaba and YHOO: Alibaba Group has a high-margined business centered around operating two online "shopping malls," Taobao and TMall.com. It gains revenue by advertising, commissions and perhaps other fees. Massive numbers of different businesses are listed on these sites. Alibaba's operations are international but most revenue is out of China. Alibaba has stakes in other related companies. Absent its filings with the SEC for its apparent IPO this year and perhaps this spring, there have been only limited disclosures. Amongst these disclosures are Yahoo!'s disclosures. For example, on slide 16, Q4 results from the Alibaba Group are shown. Net income attributable to ordinary shareholders rose 110% from Q4 2012, from $642 MM to $1349 MM. This was on revenues of $3.058 B, up "only" 66% from Q4 2012. Whether this enhanced profitability reflects economies of scale, non-recurring loss(es) in 2012, non-recurring gains in 2013, etc. is not known.
The growth in Alibaba's estimated value and in its business prospects is substantial. Last year, I wrote bullishly about YHOO shares and Alibaba. For example, on Feb. 28, 2013, Seeking Alpha published my article titled Yahoo Stock Is Too Cheap. In it, the total value of Alibaba plus Yahoo! Japan was estimated to be $6 per YHOO share, and YHOO was around $21. After Q1 earnings revealed Q4 2012 Alibaba results, matters changed. I then reported in an April 23 article that analysts had upped their estimate of Alibaba's market value to about $80 B from perhaps $40 B. Now analysts are using much higher numbers, and are following Alibaba's earnings trends higher. Here are these trends, taken from an article on Seeking Alpha a month ago written by Victor Liang titled Alibaba Is An Exceptionally Profitable Company:
If the numbers are correct, Alibaba had a total net income of $2.81 billion between Q4 2012 and Q3 2013.
At the time he wrote that article, the average valuation of Alibaba amongst analysts polled by Bloomberg was $153 B. It is now $168 B. Carlos Kirjner of Sanford C. Bernstein is the highest, at $245 B. I do not think this is an outlandish number, and here's why. Facebook is trading at about 45X current year estimated non-GAAP earnings and perhaps a 65X multiple under GAAP that is when imputed options expense is subtracted from "earnings." Yet FB already has a billion or more users. Alibaba's international expansion is just getting rolling, and less than half of China's population is reported to actively shop online. Plus, there are numerous allied businesses that Alibaba may engage in. So there would appear to be a great deal of potential growth for Alibaba.
Let us consider the $2.81 B in Alibaba per share income earned between 10/1/12 to 9/30/13. This is roughly 4.5 times what it earned in Q4 2012 (i.e., the first three months of the period). Let us apply the same 4.5X factor to the $1.35 B it earned in Q4 2013. That gives us roughly $6 B for potential earnings for the 12 months ending September 30. But FB's P/E goes through year-end, so ending at 9/30 is being conservative.
Taking 45X $6 B gives us $270 B in valuation.
So I think the analysts are being reasonable and perhaps conservative, perhaps very conservative, in their reported $168 B average valuation. Thus I feel comfortable in going with $200 B.
If we take a $200 B valuation, then Yahoo!'s share of that is 24% or $48 B. How much should we deduct for taxes? Yahoo! is known to be thinking about not bringing all the capital gains into taxable form from selling what might be 10% of Alibaba (40% of Yahoo!'s stock in Alibaba) at the time of the IPO. While it is a guess, and arbitrary, I am thus not taking the 40% tax rate that some analysts are using for these gains. Rather, I am using 33%. This would bring the after-tax value of Alibaba down to $32 B.
YHOO is worth $37 B in the market today. The difference between $32 for my guess at its Alibaba stock's value and $37 B is approximately made up for by the after-tax value of its 35% stake in Yahoo! Japan (see below). So the rest of the company, which I believe is worth at least $20/share on a takeover, is free based on the above analysis-- which is highly uncertain, of course.
One of the issues that has been raised is whether all of Alibaba will go public, and if so, might that harm the value of Yahoo!'s stake in Alibaba. We are told that Yahoo! must sell at least about 40% of its shares in Alibaba at the time of the IPO. Whether this is true as of this moment or whether the agreement has been modified is not known with certainty. The concern is that Alibaba could stick it to Yahoo! by having only a segment of the company go public while keeping a lot of value off the market and Yahoo! shareholders. This possibility was suggested by Pamela Peerce-Landers in Alibaba's Impact On The Value Of Yahoo both in her Feb. 23 article and in her comments to the article; it has been made elsewhere by her and others.
I would hope, as an YHOO shareholder, that Yahoo! would maintain its full 24% ownership of any part of Alibaba that does not go public. We shall just have to wait and see. If any IPO haircut Alibaba imposes on Yahoo! is large, Yahoo! could respond in various ways. These might include A) not agreeing to sell its shares at the time of the IPO, forcing Alibaba to delay the IPO and/or seek emergency injunction; B) bringing suit against Alibaba; or C) trading Alibaba's shares in a manner that might be disruptive.
I just do not see Alibaba wanting to go public in New York and simultaneously being perceived as picking a fight with Yahoo! to hurt Yahoo! unfairly.
We shall simply have to see what the facts are as the IPO looms.
Another issue investors may want to watch is the relationship between Alibaba Group and the PayPal-like company Alipay that Alibaba created. Three years ago there was a controversy between Yahoo! and Alibaba over Alipay. Where matters stand or may evolve to between Alibaba and Alipay is unclear and may be material to Yahoo!.
Yahoo! Japan: Yahoo! also owns about 35% of Yahoo! Japan, which is public. The stock has entered a bear market, falling from a high of 688 yen/share this year to a current 484. This translates to an after-tax value of about $6 per YHOO share.
Whether YHOO could sell its stake at this price is not known. The company expresses no interest in doing so.
Risks: There are numerous risks to Yahoo!'s business. As noted above, Q1 was a very difficult one for its operational profitability. The turnaround in display ads is being purchased expensively. How persistent and durable will it be? What return will shareholders ultimately receive from the enhanced investment in this segment? What are the prospects for the "Other" segment(s) of the business? What is the future of Yahoo!'s search? Is it really trying to unseat Google as Apple's (NASDAQ:AAPL) iOS default search provider?
As an information portal with a variety of business foci, and with very strong competition, which will not abate, Yahoo! may not have the resources to prosper enough so that shareholders are better off if it remains an independent company. The reason I have felt the company could be invested in was because I am confident the board wants what is best for shareholders. If that means selling the company, they will do it. But there are no guarantees that the board will not end up dissipating lots of the company's money on a turnaround effort that fails.
Another risk is that relatively little is known about Alibaba, especially considering its mega-cap status. Another risk is that Alibaba does not go public, perhaps because market conditions could change and not allow it to attain the market value it wants. Competition, expensive international expansion, a large poor acquisition, and many other factors could harm its value. Perhaps it could fall out of favor with the Chinese authorities. Etc. Alibaba is going to be a high P/E, low tangible asset value stock, with all the risks attendant to those types of stocks.
So, there is nothing safe about YHOO shares. Downside price action could be substantial and permanent.
Summary: Following the disclosure by Yahoo! of Alibaba's very strong financial results in Q4, its estimated valuation has increased about 10% amongst the analytic community. Assuming these financial data conform to U.S. GAAP, then comparing them to FB's non-GAAP earnings and estimating year-ahead Alibaba earnings suggests to me that analysts may be conservative. Once again I come up with after-tax values for Yahoo!'s investments in Alibaba Group and Yahoo! Japan that are roughly equal to its total market value.
While remaining both hopeful of an operational turnaround but cautious about it, I estimate that Yahoo! should be worth at least as much as WhatsApp if it were sold to a strategic acquirer. Thus I come up with a current value for YHOO of $32 for the Alibaba Group stock, $6 for its stock in Yahoo! Japan, and $20 for the operating company including all the cash and other assets to reach a value of $58 per share.
Because this value is far above the current share price of $36.38, and acknowledging the speculative and possibly over-optimistic nature of some of the above numbers, the gap is so large that I am comfortable maintaining a large shareholding in YHOO, and possibly adding to it.
Significant risks and uncertainties apply to YHOO shares.
Disclosure: I am long YHOO, FB. 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.