Going against conventional wisdom is never easy. Such is the case with the stock of Yahoo! (YHOO). The bearish thesis for Yahoo! is one that many are familiar with. It is also a thesis that is very old and stale. It is with this introduction that I introduce a new way to look at the stock and its attractive risk-reward prospects.
Why should we be interested in Yahoo’s stock?
- New Management- This cannot be worse than the last in terms of value creation. CEO Carol Bartz and her new management team appear committed to divesting ancillary businesses, while focusing more on Yahoo’s portals, online content, and its display advertising business.
- Yahoo’s Asian Investments- The Company has a 35% stake in Yahoo! Japan and a 40% ownership stake in Alibaba Group. These are off-balance sheet investments and must be considered when valuing shares of the company. Last quarter the company valued these holdings at $6.75 a share ($9.5 bil) based on prevailing market quotes.
- Cash per share- The Company is holding approximately $3.00 a share on its balance sheet.
- Yahoo Stub- If you take out the value of the company’s Asian Investments and its cash, we are left with a $5.26 price for Yahoo’s core business operations. These operations consist of Yahoo’s search, display and fee businesses.
During 2008 & 2009, EBITDA and free cash flow became constrained due to a decline in the online advertising market. This environment, coupled with share losses in search and a management upheaval has been the cause of much uncertainty. Fiscal 2010 should see a more normalized advertising market and benefits from a stabilized management team. The divesting of non-core assets, such as Hot Jobs was also a recent step in the right direction. The search deal with Microsoft provides Yahoo! with an ability to increase its operating income and decrease its capital expenditure program moving forward. Yahoo! estimates, based on current levels of revenue and current operating expenses, that this agreement could provide a benefit to annual GAAP operating income of approximately $500 million and capital expenditure savings of approximately $200 million. Yahoo! also estimates that this agreement could provide a benefit to annual operating cash flow of approximately $275 million. These factors, as mentioned above, should drive EBITDA, FCF, and Net Income over the 2010-2011 time period.
I believe a normalized EBITDA of $1.5 billion is a number the company can achieve. I also feel an upside surprise of $2 billion EBITDA in the 2011 year is not a stretch. With approximately 1.4 billion in outstanding shares, I get an estimate of $1.07 in normalized EBITDA per share and $1.43 of EBITDA in 2011. Using these numbers I derive EBITDA multiples of 4.95 and 3.72.
Competition – “A Comparative”
We know Yahoo is no Google and the market recognizes these facts. Based off of depressed estimates in 08 and 09, the core business of Yahoo traded at 6.48 times EBITDA to a comparative of 17.66 for Google. An analyst could easily justify that Google’s EBITDA and Net Income is rapidly growing and they deserve the higher multiple. The multiple gap narrowed during 2010 as Google continues to grow. (please request for spreadsheet)
The market, however, is lumping Yahoo’s core business in with the likes of Valueclick, Earthlink, United Online, and AOL. The multiple for Yahoo’s core business and Valueclick are actually quite similar. However, Valueclick is a pure player in display advertising and has no search component. Valueclick also does not have Yahoo’s vast portfolio of online properties.
The comparative multiples to businesses such as AOL also bear scrutiny. AOL and its dial-up brethren are still very reliant on their subscriber base for cash flow. EBITDA multiples will naturally be lower, due to year over year EBITDA declines. One must question whether these companies can stem EBITDA declines by capitalizing on display and search advertising. Looking at each business separately, I feel Yahoo deserves a higher multiple then most of its peer group aside from Google.
The bear case plays out and the Asian investments are worth less than the company anticipates. A $4 price provides a large margin of safety for these assets. The core business continues to trade at $5 with a distressed EBITDA multiple. Add back cash and you get a worst case share price of $12.
Advertising spending picks up and Yahoo recognizes cost savings on the Microsoft search deal. These catalysts will drive EBITDA to $1.07 per share. I apply an 8 times EBITDA multiple to Yahoo’s core business. This values Yahoo’s core business at $8.56 (8*1.07). Adding back cash ($3) and the $6.75 for the Asian investments I get a stock price of $18.31.
The company is able capitalizes on all the above mentioned catalysts and achieves over $2 billion ($1.43 per share) in EBITDA by 2011. We apply an 8 times EBITDA multiple and get $11.44 for Yahoo’s core business. Yahoo’s Asian investments turn out to be worth $8 dollars a share as the Asian growth properties demand a premium. Add the sum of the parts and we achieve a $22.44 appraisal value.
I feel the best case scenario for an independent Yahoo would occur when applying a 10 times EBITDA multiple to its $2 billion 2011 EBITDA estimate. The justification for a higher multiple is due to the fact that Yahoo! has a business model that requires relatively little capital. Add back the cash ($3) and Asian investments ($8) and I get a share price over $25.
Free Call Option
The market is not even considering the chance that Microsoft could come back to the table and purchase Yahoo!
Conclusion: A 12-month price target of $22 (47% upside) is reasonable. The online advertising space is still growing and YHOO does not face the same risks as some of its counterparts. YHOO can stabilize its EBITDA margins and possibly move back to growth in the coming years.
Disclosure: LONG YHOO