September 23, 2014
Events: Idea Write-Up
- NASDAQ: YHOO
- Recent PPS: $40
- Shares Out: 1.1 billion
- Market Cap: $43.82 billion
- Cash & Investments: $5 billion
- Yahoo! Japan 35% Stake: $4.82 billion to $8.03 billion
- Alibaba IPO Proceeds: $4.97 billion
- Alibaba ~16% Stake: $21.7 billion to $36.16 billion
- Yahoo! Core: $8.23 billion
- YHOO Total FVPS: $41 to $57 per share
- Recent share price weakness driven by the loss of “tracking stock” status for BABA, rumors of a potential AOL acquisition and uncertainty surrounding the tax efficiency of future asset disposals.
- Trading for less than 70% of its tax-free break-up value with buyback capacity greater than 80% of the its market capitalization, YHOO is a financial engineer’s dream and thus ripe for activist involvement.
- While feared by the market, an AOL acquisition makes strategic sense. 1) An AOL combination would enhance YHOO’s ability to cut overhead bloat, as the combined internet properties could be spread over fewer employees; and 2) AOL would make YHOO Core more attractive on a standalone basis, driving multiple expansion and furthering the likelihood of a tax-free break-up of the Company.
- At $90 per share, BABA’s share price provides a margin of safety as well as upside potential to YHOO’s $57 tax-free break-up valuation.
- Attractive standalone 3-year IRR of ~24% per annum with significant upside risk.
Background. I have followed YHOO for several years now with it first coming onto my radar in early 2011 during the Alipay controversy. I have traded around various events since Third Point first became involved in late 2011; but, though currently labeled as an “Event” situation due to the myriad of potential medium-term financial engineering catalysts, I now treat YHOO as a quasi-permanent holding due to the tremendous long-term upside I see in BABA. Owning BABA directly would be simpler, but with BABA comprising over 80% of YHOO’s market cap, I view YHOO as a “BABA+” due to the catalytic nature of YHOO’s current asset configuration.
Opportunity. After reaching $44 in the days leading up to the BABA IPO, YHOO sold off hard once BABA began trading. The financial news attributed the decline to YHOO’s loss of “tracking stock” status for BABA, as investors can now buy BABA shares directly. This makes sense, as BABA’s other large owner, Softbank, sold off as well on the same concern. Also, long-rumored acquisition target AOL spiked from $42 to $44 late the day before the BABA IPO, further fueling YHOO selling pressure. Ancillary concerns surrounding the tax efficiency of future asset disposals and underwriters propping up BABA’s stock price have cropped up as well.
While the market is incredibly efficient at immediately incorporating information into prices, it is almost equally as inefficient at immediately pricing that same information – hence the common refrain that “the market is a voting machine in the short-term, but a weighing machine in the long-term.” In the case of YHOO, the market is correct to incorporate these various concerns, but it has now priced YHOO at a 30% discount to immediately-realizable tax-free break-up value. This discount appears unreasonable given the publicly-traded nature of YHOO’s Asian assets and the intense scrutiny now placed on CEO Marissa Mayer, as she has failed to turn around YHOO’s core business since her high-profile entrance in 2012. Mayer has already received a rich compensation package based solely on the rise in YHOO’s Alibaba investment, and has recently been selling shares alongside YHOO’s own buyback program. These actions alone likely have not gone unnoticed by the likes of Carl Icahn (a former YHOO shareholder) and Jana Partners. If YHOO management goes an uncomfortable length of time without executing the blatantly obvious shareholder-friendly financial engineering actions currently available to them, it is a virtual certainty that Mayer will again have to begin answering to activist shareholders.
SOTP & Buyback. YHOO’s value can be broken down into the following buckets:
- Cash: $9,963 million
- Asian Assets: $44,192 million
- Yahoo! Core: $8,227 million
- YHOO FVPS: $56.94
At the risk of falling into the “spreadsheet math” trap, I believe a world-class financial engineer such as John Malone would look at YHOO’s buyback capacity along the following lines:
- Adj. Cash on Hand: $5,481 million
- 2Q14 Cash – $2B min. operating cash + 50% IPO cash
- Cash-Rich Split Capacity: $29,461 million
- Two-thirds of Asian Assets valuation is available tax-free in a “cash-rich split” transaction
- Borrowing against the CRS cash portion via margin loan seems reasonable
- Leverage Target: $2,351 million
- Normalized EBITDA: $1,175 million
- Target Leverage Ratio: 2 times
- BUYBACK CAPACITY: $37,293 million
A Dutch Tender offer at a 15% premium to YHOO’s recent $40 share price, or $46, would retire 811 million shares bringing pro forma shares outstanding to 285 million – YHOO’s post-buyback tax-free break-up FVPS would then be $88 per share. Of course nothing is this easy – there are many moving parts, and the market could easily front-run such a transaction, driving the price up to a valuation-neutral level; or the market may assign a discount to post-buyback YHOO due to a large margin loan, even though there are attractive ways to hedge such an exposure.
Depending on the price, affecting an actual cash-rich split transaction would leave YHOO shareholders without exposure to BABA’s long-term upside, which is why I would prefer to see a Malone-style concurrent spin of the Asian Assets into SpinCo/margin loan-based recapitalization. Again acknowledging that it is very easy to sit on a computer and pontificate about the possibilities of financial engineering without regard for real-world complications, at YHOO’s current discount to readily-attainable tax-free break-up value, these are the types of discussions that must be had at the YHOO management level. Marissa Mayer has proven she is utterly incapable of turning the core business around, and thus has zero business diverting YHOO’s current cash hoard/buyback capacity into further “turnaround” efforts. As Eddie Lampert has proven at SHLD, precious resources spent on attempting to rescue a sinking ship is an egregious waste of shareholder value. At least in the case of SHLD Lampert has not personally profited at the expense of shareholders – Mayer has milked YHOO for tens of millions on the back of its Alibaba investment while driving the core business into the ground.
AOL. While I am not a business expert on YHOO and AOL internet properties, intuitively it would make sense that synergies could be extracted from high-traffic properties with reasonable consumer value by leveraging overlapping back-office, corporate and capacity costs. Additionally, it has been long-espoused that private equity would be interested in gutting YHOO overhead, and my guess is that a combination with AOL would make such a restructuring even easier.
According to Factset, 2014 “Street” revenue estimates for YHOO and AOL are $4,353 million and $2,546 million, or $6,899 million on a combined basis. I estimate YHOO’s normalized EBITDA margin is its 1H13 level of 27% (not the current 1H14 level of 15%, which is heavily affected by “investments” in YHOO’s “turnaround”), and applying this to 2014E revenue results in normalized EBITDA of $1,175 million. The “Street” 2014 AOL EBITDA estimate is $509 million, and pro forma combined 2014 EBITDA is $1,684 million. By targeting a modest 10% of combined OPEX, the combined YHOO/AOL entity could boost EBITDA from 24% to 32% of revenue, or to $2.2 billion.
If YHOO could generate the above-mentioned pro forma EBITDA margin of 32%, and the pro forma YHOO/AOL asset traded at 8 times pro forma EBITDA, YHOO could pay 9 times 2014E EBITDA – a 24% premium to AOL’s recent $42 PPS – and still generate over $4 per share of value for YHOO shareholders. My hunch is that there is upside to the 10% OPEX synergy target and that a YHOO/AOL combination would make an attractive acquisition target for a strategic acquirer from the media industry – as such, I fee comfortable valuing pro forma YHOO/AOL at 8 times EBITDA at a 32% pro forma EBITDA margin.
Running post-AOL YHOO through the same buyback model outlined above for standalone YHOO (minimum cash balance for YHOO/AOL assumed to be $3B versus $2B for standalone YHOO) results in a post-buyback tax-free break-up FVPS of $101 per share.
Alibaba. While corporate governance at BABA is a well-documented risk to BABA’s long-term valuation, I believe Jack Ma et al has enormous incentive to operate in the most shareholder-friendly manner possible, as becoming a global corporate powerhouse requires not only ready-access to global capital markets but also the trust of future government and corporate partners. As such, at present I believe it reasonable to value BABA without a corporate governance haircut.
Future write-ups will focus on BABA’s business and valuation in greater depth. For now, a simple 10-year DCF will suffice:
- Base-Case DCF Assumptions
- 2013 Revenue: $5,553 million
- Revenue Growth: 30%
- EBIT Margin: 35% (42% officially in 2013)
- Tax Rate: 35%
- ROE: 50%
- Terminal PE: 25 times
- Discount Rate: 10%
- FD Shares: 2.55 billion
- Valuation Scenarios
- Base-Case: $91
- 40% EBITM: $104
- 35% GR: $135
- 40% EBITM + 35% GR: $154
BABA is investing aggressively in anything and everything – Google- & Amazon-style – yet still generating huge operating margins; and mobile monetization is limited at present due to management’s desire to develop scale in the mobile arena. And while it likely will create short-term stock price volatility, I am a huge fan of Jack Ma’s extremely long-term vision, ala Softbank’s Masayoshi Son, which furthers my belief he will act in the best interests of shareholders over time (or at worst, no differently than GOOGL and FB treat their shareholders with a shareholder-unfriendly share structures), as greed and corruption do not last long.
Conclusion. While significant upside is available from creative financial engineering, an investment in YHOO at $40 per share requires nothing out of the ordinary to achieve an extraordinary return over the next three years. If standalone YHOO’s $57 fair value grows at the required 10% per annum through a combination of growth and cash accumulation, its FYE 2017 fair value would be approximately $76 per share. Assuming YHOO’s stock price trades in line with fair value within the next three years, from a recent $40 per share the 3-year IRR is approximately 24% per annum.
Full Write-Up w/ Financials: YHOO Write-Up September 2014
Financials Only: YHOO Analysis September 2014