Seeking Alpha

Yandex: Buy Now With 40% Upside

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About: Yandex N.V. (YNDX)
by: Herding Value
Herding Value
Bonds, contrarian, value, dividend investing
Summary

Today’s Yandex is a $13.8 billion market cap grab-bag of high-tech companies providing a bet on a number of high-potential business models.

Income from operations has been in a steady uptrend; growing from RUB 9.5 billion in 2015 to RUB 20.8 billion in 2018, a 21.6% CAGR.

Yandex put up some big growth numbers YTD 3Q 2019; increases of 39.3% in revenues and 48.0% in income from operations.

Political risk is a reality, but it is extremely doubtful that Putin and his allies would do anything to seriously compromise the viability of the company.

I consider the stock a buy at the current $41.95 where it is 40% undervalued.

I watched one of my favorite YouTubers, Sergey Baklykov, demonstrate carsharing in St. Petersburg, Russia. He mentioned an unfamiliar company named "Yandex" (NASDAQ:YNDX) so I tracked it down. No, Yandex is not a Russian version of Xanax or a new stretch fabric. Yandex is a Russian technology company with operations analogous to Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL). While not well-known in the U.S., this is not an obscure Internet cash-burning machine. Yandex employs about 9,500 people, reported 2018 revenues of $1.8 billion, net income of $660.1 million, and a market cap of about $13.8 billion - and it's growing at a 40% rate! Were the Russians trying to influence my 2019 investment decisions?

After some research, I bought a few shares on November 11, 2019, at $34.19 per share. As of November 29, I was up 22.7% - a rare occurrence for me. So why did a 3- to 5-year hold, value-oriented investor buy stock in the "Russian Google?" Let me explain…

Beginnings

Microsoft (NASDAQ:MSFT) had Gates and Allen, Apple (OTC:APPL) had Jobs and Wozniak, Yandex had Volozh and Segalovich. Beginning in 1993, lifelong friends Arkady Volozh and Ilya Segalovich worked together to develop a state-of-the-art internet search engine derived from an earlier Volozh project. At the time internet search was dominated by information indexing web-crawlers. The friends invented the word "Yandex" which stood for "Yet Another iNDEXer" to describe their search software.

Ilya Segalovich and Arkady Volozh

Source: theguardian.com

The Yandex.ru search engine was launched on September 23, 1997 - about a year before Google's search engine was publicly demonstrated - and presented at the Moscow Softool exhibition. In 2000 Yandex was incorporated with Volozh as CEO and Segalovich as CTO until his death from cancer in 2013.

A Grab-Bag of High-Tech Companies

Today's Yandex is a grab-bag of high-tech companies providing a bet on a number of high-potential business models. You don't have to search for the best Russian search engine, ride-sharing business, online auto classifieds or vertically-integrated TV / video / music streaming portal; Yandex has them all.

Roughly 70 different services - in many cases the Russian version of a familiar U.S. counterpart - are under the Yandex umbrella. These businesses are divided into six main segments, Search and Portal, E-Commerce, Taxi, Classifieds, Media Services, and Other Bets and Experiments.

Before we reach into the grab-bag, I need to warn you that data on the markets Yandex businesses serve is sometimes sketchy - at least for this non-Russian speaker. View this data as indicative, not authoritative.

At the end of each of the following sections, I will assign a grade to each segment.

Search and Portal

Accounting for 76% of 2018 revenues, almost entirely from online advertising, the Search and Portal division offers services in Russia, Belarus, Kazakhstan, Uzbekistan and Turkey. This part of the company is like a Russian mini-Google, even the Yandex search portal looks familiar - a lot of white space:

Source: yandex.com

Like Google's search portal, you can search the web, videos, images or full-function maps, create an email account and access a translation function. There's also AppMetrica, a marketing platform, and a web browser. Yandex has a virtual assistant called Alice - think Amazon's (NASDAQ:AMZN) Alexa - now being deployed across the company's consumer-oriented products. For mobile users, there's Yandex Search App, enhanced with Alice, with Search, Maps, News, Weather, etc. In December 2018, the app had 36 million users per month, a 100% increase over the prior year.

Yandex is in a fight with Google for market share in Russia. According to Yandex, using its own Yandex.Radar analytics, its share of the Russian search market averaged 56.6% in Q3 2019, up from 55.9% in Q3 2018, but down a bit from 56.9% in Q2 2019. I was skeptical of Yandex reporting that, yes, indeed, we're No. 1, but a little research convinced me they were on the level.

More recently, at the Morgan Stanley TMT Conference, Barcelona, Spain, November 14-15, 2019, Yandex reported its point-in-time share of the Russian search market as 57.2%.

Source: Yandex Presentation Morgan Stanley TMT Conference, Barcelona, Spain, November 14-15, 2019

Other Search and Portal offerings include Yandex.Disk with 10GB of free cloud storage, Yandex.News, the most-visited news aggregation site in Russia where, per the Yandex 2018 Form 20-F, the "selection of news is fully automated and editorial-free," Yandex.Weather, real-time weather information and Yandex.Travel, an online travel and ticketing service.

Yandex also has two consumer-oriented hardware products, Yandex.Station and Yandex.Phone. Yandex.Station, similar to Amazon's Echo, features Alice and is the first smart speaker designed for the Russian market. Yandex.Phone, an Android smartphone released in 2018, is also equipped with Alice.

GRADE: A-

Comment: Fighting off Google is an achievement - with a little help from good old Vlad - more on this later. Some of the ancillary services and products are doing well.

Taxi

Accounting for 15.1% of 2018 revenues, Taxi includes a ride-hailing business, a food delivery business and a self-driving car project. Launched in 2011, Yandex.Taxi is a fee-based ride-hailing business with operations in 17 countries. The business bulked up through the 2018 formation of a joint venture, MLU B.V., a Netherlands company, through which Yandex.Taxi effectively acquired the ride-hailing and food delivery businesses of Uber (NYSE:UBER) in Armenia, Belarus, Georgia, Kazakhstan and Russia. Currently, Yandex owns a 58.2% controlling interest. The joint venture announced the strategic acquisition of Vezyot, Russia's largest taxi company, in July 2019. Yandex.Taxi maintains solo operations in Israel, the Ivory Coast, Kyrgyzstan, Latvia, Lithuania, Moldova, Serbia, Uzbekistan, Finland, Estonia, Ghana, and Romania. The business model is more flexible than those of Uber or Lyft (NASDAQ:LYFT), operating through taxi companies, licensed carriers and individual entrepreneurs under different regulatory requirements. According to Royal Bank of Canada's (NYSE:RY) analysis of data from the Analytical Center for the Government of the Russian Federation, the "taxi" industry is expected to grow by 5.6% to RUB 709 billion ($11.0 billion) in 2019 after growing at an 8.9% pace in 2018. Growth is expected to slow to the 3.7% to 4.0% range in 2020 and then stabilize with 2.0% growth per year in the long run.

State-owned Sberbank (OTCPK:SBRCY) estimated that the size of the entire urban transportation market (taxi, carsharing, carpooling, etc.) could reach RUB 2.0 trillion by 2025, increasing at an average 15% annual rate from RUB 748 billion in 2018. In 2019, according to the Royal Bank of Canada study, taxi aggregators are projected to account for about 60% of the Russian taxi market, with Yandex.Taxi being the market leader with a 27% share. Vezyot, a recent Yandex acquisition target, accounts for 12% with Maksim at 9%, Gett at 5% and Citymobil at 1%.

The numerous rumors of Yandex.Taxi pursuing an IPO were apparently correct as The New York Times reported on November 21, 2019, that Morgan Stanley, Goldman Sachs and VTB Capital had been hired to prepare the business for an IPO.

Why brave the Russian winter when you can have food delivered? There is an expanding market; according to Statista, the Russian online food delivery market will increase at a 12.6% annual growth rate from revenues of $1.9 billion in 2019 to $3.0 billion in 2023. The fee-for-service food delivery service, Yandex.Eats, was launched in February 2018. In a 2019 Deloitte CIS Center report, restaurant employee delivery accounted for 63% of the market; Delivery Club and Yandex.Eats followed at 31% and 26%, respectively. Yandex.Eats, available in 24 Russian cities, was formed through the combination of the December 2017 Foodfox acquisition with Uber.Eats. The service is known for its bright yellow uniforms.

Source: Bloomberg.com

Competition is warming up, however, as Mail.ru (OTC:MLRYY) and Sberbank announced an agreement on November 19, 2019, to set up a 50-50% joint venture food delivery and taxi platform. Mail.ru will contribute its Delivery Club food delivery and Citymobil ridesharing businesses and Sberbank will contribute its 35% interest in Foodplex, an app for restaurant bookings. The partners plan to invest RUB 64.6 billion ($1 billion) in the new joint venture.

All high-tech companies need an autonomous car project and Yandex has one, too. Launched in 2017, the project is now in real-world testing in Russia and Israel. The technology was recently on view at CES 2019 in Las Vegas.

Source: wired.com

Adding credibility to the project, Yandex and Hyundai Mobis, one of the world's largest automotive suppliers, announced an agreement on March 18, 2019, with the ultimate goal of creating a self-driving platform for sale to any car manufacturer or taxi fleet.

GRADE: B+

Comment: Execute the rumored IPO, perhaps retaining majority control while enhancing shareholder value. At $5 billion to $8 billion, the rumored IPO price range could be more than 50% of Yandex's market cap and should force a revaluation of the other segments. Until its fleet is autonomous, it's a low margin Uber/Traditional Taxi hybrid business inside a high margin tech company.

E-Commerce

Although accounting for only 1.3% of Yandex's 2018 revenue, e-commerce is growing rapidly in Russia from a low base. According to an article entitled "Russian E-Commerce Market Grows by 26%" in the September 3, 2019, edition of The Moscow Times:

Russians have embraced e-commerce, which is growing ten-times faster than the real economy and traditional retail. Online sales currently account for about 4.5% of Russia's total retail turnover, but that has been more or less doubling every year in recent years and is on course to make up 8% of retail turnover by 2021.

According to U.S. Department of Commerce website export.gov:

Retail e-commerce sales in Russia have grown by 20% or more annually for the past seven years, according to yStats.com, one of the world's leading secondary market research companies. Continued annual growth is projected to decline, but remain in the double-digits. The Russian e-commerce market has reached 1.4 trillion rubles, according to AKIT (Association of Internet Trade Industries).

Initially avoiding the Amazon business model, in 2000 Yandex launched Yandex.Market, a website connecting consumers and businesses with product information, price comparisons and user-generated product and retailer reviews. Although Yandex claims 17 million visitors use Yandex.Market every month to find and compare products, the platform has not experienced rapid growth. For example, between 2016 and 2017, revenues, based on a cost-per-click model, grew only 5.3%.

Beginning in 2018, management began to address the slow growth of Yandex.Market. In April, Yandex sold Sberbank 45% for approximately $500.0 million to establish a joint venture. Along with an injection of capital, the sale also had an impact on financial reporting as Yandex.Market was deconsolidated and now reports as an equity investment.

In October 2018, Yandex.Market moved closer to the Amazon business model, launching Beru ("I'll take it" in Russian), a single platform online retailer with its own delivery and logistics. Revenues are derived from commissions and direct product sales. Beru struggled to gain market share during its first year of operations, ranking as the 52nd largest direct retail e-commerce site (as opposed to a marketplace) in Russia for the first half of 2019.

In November 2018, Yandex.Market launched Bringly, a cross-border marketplace that offers Russian consumers imported products. Bringly is designed to compete with Chinese competitor AliExpress, the Alibaba (NYSE:BABA) online marketplace responsible for 69% of all online purchases in Russia. Bringly uses third-party fulfillment centers for order processing and is monetized on a commission basis.

In June 2019, Yandex.Market announced a strategic alliance with China's e-commerce giant JD.com (NASDAQ:JD) to place its huge offering of consumer goods on both the Beru and Bringly platforms.

Will these new product offerings and joint ventures re-energize Yandex's e-commerce operations? There have been growing pains. Articles have appeared in the business media about clashes between Yandex and Sberbank over a number of issues including Yandex.Market. In a July 28, 2019, article entitled "Hopes of a 'Russian Amazon' Hit by Corporate Rift" the Financial Times reported:

The two sides have also clashed over Yandex.Market, on issues ranging from management and growth targets and even which performance metrics to pay attention to, according to people familiar with the joint venture. "There's no lubricant there. They fight like cats and dogs," one of the people said.

Competitors have not been complacent. Wildberries, the largest home-grown direct e-commerce retailer in Russia with over $2 billion in annual sales, reported 73% revenue growth for the first half of 2019. In June 2019, Mail.ru, MegaFon [MSX:MEGAFON.ME], Alibaba and Russia's sovereign wealth fund RDIF announced the formation of a joint venture, AliExpress Russia JV, to build on the success of AliExpress by combining their relevant businesses in Russia and neighboring countries.

There is enormous potential in Russian e-commerce and steps have been taken to reverse 20 years of modest results, but can Yandex and its quarrelsome partners develop significant, profitable e-commerce businesses?

GRADE: C-

Comment: Good idea, rather late. Partner troubles are not good for any business. Yandex should buy Wildberries - smart organic growth from the ground up.

Classifieds

Accounting for about 2.9% of Yandex' 2018 revenue, the Classifieds division is one of the newer Yandex business initiatives. The core of the division is Auto.ru (e.g., Autotrader) that Yandex bought for about $175 million in 2014. In 2017, through a strategic partnership with Hearst Shkulev Digital ("HSD"), Yandex acquired HSD's local car classifieds sites across several Russian regions; E1.Auto (Yekaterinburg), Autochel.ru (Chelyabinsk), NGS.Auto (Novosibirsk) and Аuto.29.ru (Arkhangelsk), among others. These sites were merged with Auto.ru. Other ventures include Yandex.Realty, (e.g., Realtor.com), and Yandex.Jobs (e.g., Indeed.com). These services derive revenues from online advertising and listing fees. There is little information about market share for Classifieds.

Although there is little information available about the Russian classifieds market, other players see opportunity. South African internet conglomerate Naspers (OTCPK:NAPRF) assumed 99%-control of Avito, Russia's leading online classifieds company, through a $1.16 billion investment in January 2019. Naspers initially bought a $1.2 billion stake in 2015. Through the six months ended September 30, 2018, Avito reported sales of 10.3 billion rubles or a 30% increase over the prior period with a 65.4% EBITDA margin and listings up 7.4% to 17.46 million.

GRADE: B+

Comment: High margins, high return on investment, and room for growth.

Media Services

Media Services is another small piece of the Yandex pie, accounting for only 1.3% of 2018 revenue, but OTT services - streaming media services offered directly to viewers over the internet - are a very high-potential area. According to a September 11, 2019, article in IAA Telecom Daily, entitled "Russian OTT Market Takes Off," legal online video services in Russia reported revenue of RUB 10.62 billion or $169.9 million for the first half of 2019. The forecast for total 2019 revenues is RUB 21.40 billion or $342.4 million, a 29.7% increase over RUB 16.495 billion or $263.9 million in 2018. Ivi was the market leader in revenue terms in the first half with a share of 26.4%, with second and third place Okko and YouTube claiming 14.2% and 12.3% respectively. By my calculations, Yandex came in tied at third with 12.3% of the market, a good showing considering its late entry.

Management's long-term video strategy is the creation of a vertically integrated internet entertainment company; producing content, streaming and distributing TV, videos and theatrical releases - all centered on the Russian market. We've seen this strategy roll out in the U.S. with Netflix (NASDAQ:NFLX), Amazon's Prime and now Disney (NYSE:DIS) Plus - accompanied by a stratospheric valuation for NFLX.

Yandex was slow to enter this market in force with major advances occurring in 2018. The first move was the acquisition of KinoPoisk (e.g., IMDb) in 2013, a website aggregating film reviews, industry news and user-generated comments. Video streaming capabilities were added in 2015. The site features more than 100 million movie ratings with three million new ones added per month. Revenue is generated by ads. KinoPoisk generated a certain amount of synergy with Yandex.Afisha, an online service that sells tickets to cinemas, theaters, and concerts.

Yandex.TV Program, an online schedule of broadcast, cable and digital TV channels with an option to view a limited number of TV channels online, was a preliminary step toward all-inclusive streaming of live TV. Yandex extended its strategy to TV, movie and music production with Yandex.Studio, launched 1Q 2018 to create content, co-invest in the production of content and provide marketing support to movie releases. According to a February 6, 2019, article appearing in Daily Tech:

Yandex has already produced several films, including "Draft" (budget 280 million rubles), "Without Me" (75 million rubles) and "Tvar" (release in March). Also in 2018, the company released a musical and New Year's show.

In addition, Yandex announced that it would be producing a TV show called "The Ministry" for the 2019 -2020 season.

In order to pull all the separate video-related services and sites together, Yandex launched Yandex.Live in July 2019 as the central smart portal integrating the company's existing video services. Users can watch live TV through Yandex.Live and view films from KinoPoisk, exclusive content from video influencers and live concerts and sports. An HDMI dongle allows users to stream Yandex.Live from their TVs. As the final piece, in 2Q 2018, Yandex began offering Yandex.Plus (e.g. Amazon Prime), a service providing subscribers with a bundle of multiple Yandex services, including unlimited music streaming on Yandex.Music, ad-free movies and TV-shows on KinoPoisk, discounts for taxi and car-sharing rides, free delivery for Beru customers as well as other benefits from the Yandex ecosystem. The service costs RUB 169 or about $2.75 per month.

For audio consumers, Yandex offers Yandex.Music, a music streaming service (e.g., Spotify (NYSE:SPOT)) developed by Yandex. A free, limited service ad-supported version is available in Armenia, Azerbaijan, Belarus, Georgia, Israel, Kazakhstan, Kyrgyzstan, Moldova, Russia, Tajikistan, Turkmenistan and Uzbekistan. With a subscription, Yandex.Music works anywhere in the world.

While Yandex.Music has about 20 million active users, only about 2 million or 10% have paid subscriptions. Statista reports that the paid subscription Russian music streaming market will amount to only about $142.0 million in 2019 with a very slow projected 2.1% average annual growth rate from 2019 to 2023. Assuming an estimated cost of about $2.00 per subscription - difficult to assess with the advent of Yandex.Plus - Yandex.Music possibly maintains a market share of around 33% to 34% of the paid subscription Russian music market. As with online video, piracy is widely known to have limited growth in paid subscriptions. According to the previously cited ESET survey, 34% of respondents admitted to illegally acquiring their music.

GRADE: A-

Comment: Late start (again), but a sound strategy in a market that should show strong and accelerating growth.

Other Bets and Experiments

Other Bets and Experiments is an in-house business incubator for high-tech ventures. According to the Yandex 2018 Form 20-F, management uses this division to...

…develop current successful business models and create new ones. Once an experiment becomes sizable enough, represents a new business model, and has good prospects for future development, we may decide to designate it a business unit and report it accordingly, while unsuccessful experiments may be shut down or reabsorbed by one of our other segments.

Current major projects include:

  • Zen, a proprietary algorithmic personalized content feed.
  • Yandex.Cloud, a primarily B2B cloud storage service developing along the lines of Amazon's AWS or Google Cloud.
  • Yandex.Drive, the car-sharing service featured in Sergey Baklykov's video that prompted my interest in Yandex.
  • Geolocation Services, a suite of developing location technologies.
  • Yandex.Health, a mobile application that allows Russian users to receive health advice from medical professionals 24 hours a day, seven days a week.
  • Yandex Data Factory, a suite of process manufacturing productivity tools using artificial intelligence and machine learning to increase productivity, reduce costs, and improve energy efficiency. Clients include Intel (NASDAQ:INTC), AstraZeneca (NYSE:AZN), CERN, Magnitogorsk Iron and Steel Works [MCX:MAGN.ME], Gazprom Neft (OTCQX:GZPFY) [MCX:GAZP.ME], and Schlumberger (NYSE:SLB).

GRADE: A-

Comment: Innovation and creativity are the future and management enshrined it here - a la Google.

The Street is Optimistic About 2019 Earnings

Yandex started trading on the NASDAQ in 2011 at an IPO price of $25 per share, about nine years after the company was incorporated as a standalone entity. When considering an investment, I expect 20-year old high-tech companies to report consistent and growing profits, especially those operating in volatile political environments. While income from operations has been in a steady uptrend, growing from RUB 9.5 billion in 2015 to RUB 20.8 billion in 2018, a 21.6% CAGR, net income has bounced around as dollar-denominated amounts held by Yandex have suffered swings in currency valuation.

Looking at recent results, there's been strong, steady growth in Search and Portal revenues plus explosive revenue growth in everything else. This is Slide 8 from the Yandex 3Q 2019 Quarterly Supplementary Materials:

Source: yandex.com

As the two tables (top and bottom) on the right show, Search and Portal pays the bills with consistent 20%-plus revenue growth and 45%-plus adjusted EBITDA margins. The explosive growth in revenues for the other segments has not been accompanied by explosive profitability, but most of the product lines in these segments are relatively new and not all strategies have been fully executed. In fact, it was not that long ago that management realized that Yandex could not be a one trick pony, notice the one number COO/CFO Greg Abovsky stresses in his boilerplate statement from the 3Q 2019 Press Release:

Our core business continued delivering strong results and demonstrated solid margins, while our business units and experiments maintained triple digit revenue growth, and now represent 36% of consolidated revenues.

Now, if only that 36% of revenues generated some profits…

Yandex put up some big growth numbers YTD 3Q 2019. In the table below, the first green highlight, 39.3% revenue growth for the first three quarters compared to the prior period, was probably enough by itself to send the stock on its current run. Operating expenses, the first yellow highlight, increased 37.7%. Almost 50% of the increase in operating expenses was due to a RUB 14.1 billion or 58.6% increase in cost of revenues. RUB 4.7 billion or about 33.3% of this amount consisted of higher costs in the Taxi segment that management blamed on "an increase of costs related to our corporate Taxi offering and the logistics costs related to food delivery." In general, Taxi revenues are considered commissions when services are provided for individuals and reported as net revenue, but for corporate clients, Yandex acts as the principal in transactions and recognizes both revenues and cost of revenues on a gross basis. RUB 7.0 billion or about 50% of this amount was an increase in other costs of revenues, mainly reflecting costs related to Yandex.Drive, investments in Media Services content and IoT initiatives.

Revenues are growing faster than expenses, resulting in our next green highlight, a nice RUB 6.4 billion or 48.0% pop in income from operations for YTD 3Q 2019 over YTD 3Q 2018. The difference in revenue and expense growth rates, however, declined from 3.9% for 2018 to 1.6% from YTD 3Q 2018 to 3Q 2019. Behemoth Alphabet, about twice the size in revenues, managed a 2.6% difference in growth rates for the same period in 2019.

For some comparative perspective, consider the following table:

Over the 2014-2018 period, Yandex had an advantage over both Alphabet and Baidu (NASDAQ:BIDU) in revenue growth, but lagged Alphabet in operating income growth. More recently, however, comparing 3Q 2018 to 3Q 2019 as presented in the table above, Yandex crushed its much larger peers in growth in both revenues and income from operations. Yandex bulls should note that with even slightly better expense control income from operations would soar.

The next green highlight, the RUB 28.2 billion impact of the Yandex.Market deconsolidation is directly related to the yellow highlight underneath. In 2018, Yandex sold 45% of Yandex.Market to Sberbank for RUB 30.0 billion, reporting a RUB 28.2 billion deconsolidation gain on sale and an increase in operating income as Yandex.Market's losses moved into other income where they contributed to the RUB 2.7 billion increase in losses from equity method investments. The impact of this joint venture was 1) to secure needed funding and a strong, but as we've seen, quarrelsome partner and 2) to improve Yandex's core operating income - a key focus for analysts and investors - at the expense of less transparent equity method investment income.

Finally, the next three yellow marks highlight three numbers no one cared about; net income before taxes was down RUB 25.1 million or 56.3%, net income was down RUB 28.5 million or 70.6% and diluted EPS was down RUB 84.93 per share or 70.5%.

Why did no one care? The Yandex.Market deconsolidation, rich and increasing share-based compensation expense and a blip up in the effective tax rate are masking the company's underlying profitability and earning power. We can get a better idea of what investors and the Street might be thinking if we adjust both YTD 3Q 2018 and YTD 3Q 2019 results:

When we've placed both periods on a comparable basis adjusted income from operations increases to RUB 24.8 billion or 25.3% above the reported mark - and a RUB 8.3 billion or 50.4% increase over the comparable period adjusted number. Yandex begins to look like it merits a higher stock price.

The first item to note is that adjusting for share-based compensation; RUB 4.9 billion YTD 3Q 2018 and RUB 7.1 billion YTD 3Q 2019, completely overwhelms the re-consolidation of Yandex.Market. For example, re-consolidating Yandex.Market penalizes YTD 3Q 2019 income from operations by only RUB 2.1 billion (about $35.1 million). Yandex's rather rich RUB 7.1 billion or $114.2 million share-based compensation expense was equal to 36.6% of YTD 3Q 2019 net income before taxes compared to 28.2% for Alphabet for the same period. Apparently, Russians make good capitalists after all.

The impact on other income is all due to Yandex.Market, backing out the RUB 28.2 billion gain on the deconsolidation in 2018 and adding back the RUB 2.2 billion estimated loss from equity method accounting in 2019. The gain on sale and subsequent deconsolidation made period to period comparisons difficult and could be criticized as a bit of accounting sleight-of-hand, but I believe the joint venture was a good idea as building out an e-commerce ecosystem will 1) consume cash and 2) produce losses for a few years. As we've seen, however, perhaps another partner would have been more…congenial.

When we put it all together as adjusted net income before taxes, RUB 19.5 billion YTD 3Q 2018 and RUB 26.6 billion YTD 3Q 2019, a RUB 7.2 billion or 36.7% increase, we can finally appreciate the true earning power of Yandex.

Adjusting for a comparable tax rate, Yandex adjusted net income was up RUB 4.5 billion or 29.0% over the comparable period, as adjusted. That translates into an increase in adjusted diluted EPS of 29.4% - pretty sporty. And that's not all to consider…

40% Undervalued

Valuation is a black art and valuation of internet companies is the darkest corner of that black art. Typical valuation ratios are uninformative for a company like Yandex. A few Seeking Alpha authors have tried sum-of-the-parts and DCF valuations. For Yandex, however, I prefer a combination with a DCF for the sizable, predictable cash flows of the Search and Portal segment folded into an overall sum-of-the parts valuation. As always there are caveats here; 1) net segment non-operating assets are assumed to be included in any sale, 2) operating leases are treated as debt per current orthodoxy, and 3) I made numerous broad assumptions only a team of overly caffeinated Ivy League MBAs could hope to track down for improved accuracy.

I think the Search and Portal segment alone is worth about $45.73 per share - 77.5% of the total per share value of $59.02. Here's a simple way to bracket the per share values:

At $41.95 per share on November 29, 2019, there's a 9.0% discount to the value of Search and Portal alone and a 40.7% discount to the total value of Yandex.

On November 18 - a curious choice of date (see the following section on the "Putin Put") considering other announcements - the board authorized the buyback of up to $300 million worth of Class A shares. This is only about 2% of the market cap, but equates to half a year's average Yandex NASDAQ trading volume and should put upward pressure on the stock price.

The Putin Put

No discussion of a Russian company would be complete without at least a brief mention of the political reality. Vladimir Putin and his political affiliates, the United Russia party and the All-Russia People's Front, a coalition of parties and political organizations, control the government and major decisions in Russia. Yandex, however, is viewed as an important source for technological leadership and progress within Russia. It is extremely doubtful that Putin and his allies would do anything to seriously compromise the viability of the company, but they will maintain ultimate control.

Source: en.kremlin.ru

The Russian government may regulate the company in ways that harm the interests of foreign shareholders, but there often appears to be an attempt to strike a balance between perceived national interests and open markets. Recent events demonstrate that the preferred modern method is to mask tightened control with bureaucracy.

In July, Anton Gorelkin, a young Duma member of Putin's party, submitted a bill limiting foreign ownership of "significant information resources" to a maximum of 20%. Yandex shares dropped double digits in a day. The "stick" had been applied during a period when Yandex was in talks with the Russian government. Within weeks, the proposed limit had been raised to 49%, but the message had been sent to Yandex management.

Then on November 18, Yandex announced "targeted amendments" to the company's corporate governance structure. The amendments resulted from negotiations in which Putin himself was rumored to have participated. The result was greater state control over Yandex, with the company agreeing to create a Public Interest Foundation ("PIF") inheriting the Priority Share formerly wielded by Sberbank. The 11-member PIF board will include three members of Yandex management and 8 members drawn from government-controlled universities and other institutions. The PIF will have a veto over any share consolidations above 10% and the right to place two directors on the Yandex 12-person board. One of the PIF directors will have the right to nominate four directors to the Yandex board as a member of the board nominating committee. In effect, the government, through the PIF, will control 6 of the 12 Yandex directors. The two PIF directors will sit on a special public interest committee which will exert control over operational decisions involving 1) the sale or transfer of material intellectual property or Russian users' personal data to non-Russians, 2) changes to internal policies on protection of Russian users' personal data and 3) entry into agreements with a non-Russian state or international intergovernmental organization. The PIF will also be allowed to "temporarily" remove the Yandex CEO under "certain exceptional circumstances."

Class A shareholders were given the right to approve certain transactions including any significant issuance of shares - possibly controlling dilution. Another point of contention was the 48% of Class B voting shares owned by Volozh. If Volozh should bump into a polonium-laden umbrella, instead of immediate conversion to Class A shares, his shares will be held by a family trust and not convert for two years. Mr. Volozh also agreed to a two-year lock-up of 95% of his Class B Shares. The "reason" provided was that the lock-up provided an "additional layer of assurance" of no abrupt change in the company's voting structure. One has to wonder what is expected to happen within two years.

Surprise, surprise! After the amendments were announced, Gorelkin withdrew his proposed bill, tabling it until a later date.

Sometimes, however, the Russian government puts its thumb on the scale in favor of Yandex. In 2017, Alphabet lost an antitrust case in Russia. Previously, when consumers bought an Android phone, the default search engine was Google - with no notification of any other options. As part of the settlement with Russia's Federal Antimonopoly Service, Google created a choice window to allow users to select a default search engine upon first launch. When the choice window was introduced Google controlled about 60% of the Android phone search market, one year later in August 2018, Yandex announced that both companies now had an equal 49% of the market.

Placing all this in perspective, Yandex corporate governance is surprisingly transparent.

Conclusion

If you can tolerate the political risk, the heavy hand of the Russian government should not dissuade you from an investment in Yandex. Largely foreign institutions, for example, own roughly 80% of the Class A shares.

There are many merits:

  • Leading Russian search portal plus a grab-bag of high-potential, high-tech investments.
  • Superior revenue and core operating earnings growth - 39.3% and 48.0% YTD 3Q 2019 over YTD 3Q 2018.
  • Excellent forecast 2018-2019 comparisons for revenues, income from operations and adjusted EBITDA.
  • 40% undervalued based on a sum-of-the-parts valuation of $59.02 per share.
  • The possible Taxi IPO should unlock $5 to $8 billion of shareholder value and force a re-consideration of the value of the other business segments.
  • The $300.0 million share buyback will act to buoy the stock price.
  • Good diversification. Who owns a Russian stock?
  • Corporate governance more transparent than much bigger, more famous Chinese companies.

There are several considerations and, unusually, none are financial:

  • Political risk created by Vladimir Putin and the Russian government.
  • Finite size of the Russian Federation market. Will Yandex have any international scope?
  • Strong domestic and foreign competition in many business segments.

What to do now?

To reiterate, I am typically a 3- to 5-year hold value-oriented investor, but I will be keeping my finger on the "Sell" trigger with this stock. Yandex is approaching its last high of $43.75 set March 8, 2018. The three-year chart below shows the broad trading range of the stock over the past three years.

ChartData by YCharts

Today's Yandex is not the Yandex of 2018, however, and I consider the stock a buy on 40% undervaluation at the current price. The catalysts that sent the stock on its recent run were the strong 3Q 2019 results combined with an acceptable end to the negotiations with the Russian government. The next catalyst to higher value is the Taxi IPO.

What could go wrong? Postponement of the Taxi IPO, re-introduction of Gorelkin's bill or a similar one to the Duma, disappointing year-end results, perhaps more competition entering the market.

I would urge re-evaluation at two points, $45 per share and $55 per share and, ceteris paribus, look to sell when, and if, the stock approaches what I consider fair value at $60 per share.

Disclosure: I am/we are long YNDX. 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.