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Thursday, September 16, 2010

Game Over for Yahoo (continued) or Hidden Value? Sentiment Turning on Dime?

The shifting Internet landscape makes Yahoo (YHOO) a bit different than our Casella Waste Systems (CWST), Harry Winston Diamond Corporation (HWD), and Seaspan (SSW). We're 100% certain that Casella will be hauling and recycling waste, Harry Winston will be mining diamonds and selling jewelry, and Seaspan's container ships will be steaming across the oceans in five to ten years. That said, we're 99% certain that the-Internet-as-a-important-medium will be around in five to ten years, although more advanced as technology evolves. We are also fairly certain that Yahoo will be around, although an important question remains: will the company be bigger, better, stronger? Admittedly, the answer is impossible to know for sure and given recent data points around traffic figures, many onlookers might say no. BUT, is there a way we can become comfortable owning equity in Yahoo and even buying more shares?

The other day we shared graphs, data and discussion on Facebook's rapid ascent to overtake both Yahoo and Google (GOOG) in "time spent" on the site. For sure, the "FB" community has an addictive aura to the site that draws in users through constant notifications ("friending," photo tagging, etc.) and various FB applications ("apps"). People are keen to share activities and keep tabs on other "friends." All in all, FB offers a powerful combination of features that have created a new way of content consumption.

Still, we mentioned that the game is still on for Yahoo given the company's heavily trafficked, display ad centric channels, solid balance sheet, large free cash flow and valuable equity interests in international properties. Despite the changing landscape, we see a margin of safety in shares at current levels.

Well, voila! Just like that the "Market" embraced Yahoo yesterday on nearly five times average three month daily trading volume -- from Yahoo Finance:

Why? The realization that, wow, Yahoo's international holdings might just be worth something. In this case, the Market is excited about the company's approximate 40% holding (fully diluted) in the Alibaba Group and the possibility that Yahoo may look to exit the position despite management commentary to the contrary. Please see the following WSJ article for more details: Yahoo Bulls Focus on Alibaba Talk.

Of course, the fact that the international assets have significant value is NOT new information. Former CEO Jerry Yang talked about them and included valuation data in a presentation to shareholders in June 2008 when he provided rationale against the Microsoft (MSFT) offer (click to enlarge):

A few changes since then: the 10% stake in G-Market was sold to eBay (EBAY) and the 1% direct stake in Alibaba.com has also been sold (bringing ownership to 29%. Yet, Yahoo retains the other positions. In fact, management presented the valuations for the publicly traded assets in Yahoo's 2Q10 results deck (click to enlarge):

OKAY, so we have $8.2 billion for 35% of Yahoo! Japan and $3.0 billion for 29% of Alibaba.com = $11.2 billion as of 6/30/10. The footnote says the following:
  • "Note: Our 29% stake in Alibaba.com is held indirectly through our equity interest in Alibaba Group and does not include estimates for the values of Alibaba Group’s privately held businesses. These pre-tax market values are based on public market share prices for Yahoo! Japan and Alibaba.com on June 30, 2010."
SO, we're not seeing any value for Yahoo's approximate 40% stake in the Alibaba Group which, by the way, includes Alibaba.com (online marketplaces for small businesses), Taobao.com (largest Internet retail Website in China), Alipay (leading online payment system), Alibaba Cloud Computing, and China Yahoo! THUS, we can hang our hat on additional value here, and, common sense might imply significant value.

BUT, let's only consider the $11.2 billion for Yahoo! Japan and Alibaba.com. NOW, what is Yahoo's total enterprise value (market cap less net cash on balance sheet)? Again, from Yahoo Finance:

So, we have EV = $15.8 billion less our $11.2 billion = $4.6 billion for ALL of the core Yahoo properties plus the Alibaba Group stake. How much annual free cash flow does Yahoo generate? Here's a summary cash flow statement from Yahoo Finance for 2007-09:

If we take cash flow from operating activities and subtract capex, excess cash flow for 2009A was $876 million. For the last twelve months (not shown), CFO was $1.2 billion with capex of $482 million for free cash flow of $718 million. Note that the cash flow figures do not include the equity investments in Yahoo! Japan or Alibaba, which are non-cash and reversed after being reported as "earnings in equity interests" on the income statement.

HENCE, while down from prior years, Yahoo generates tremendous excess cash flow that can be reinvested in the business, used to acquire other companies, or returned to shareholders through share repurchases (currently happening) or dividends. The company has almost no debt on the books.

Where are we going with all of this? Assuming run rate free cash flow of $700 million (no improvements in revenue, margins, or other key metrics = i.e. management fails to deliver on all guidance), we have an implied FCF yield of 15% for current equity buyers of Yahoo. This represents an entry multiple of only 6.6 times free cash flow. This multiple would be even lower if we were to assign a reasonable value to the Alibaba Group stake. Yahoo is essentially being given away.

Although Yahoo needs to adapt to the dynamic Internet landscape (= risk) to retain users and -- better yet -- increase both users and traffic, the current valuation is extremely pessimistic. The Market is treating the company as an also-ran even though Yahoo remains one of the most widely recognized and visited Internet franchises in the world. Here's U.S. traffic data from comScore (SCOR) for June 2010 - Yahoo ranked number two behind Google:

Finally, per our earlier post, Yahoo's display centric model provides a very different advertising platform for the world's mega brands than Facebook (or even Twitter). The latter need to walk a fine line to not alienate users as they strive to increase advertising revenue on their platforms to generate profits and free cash flow.

Maybe the Market will also begin to see the value in Yahoo. If Wednesday's action was any indication, sentiment may be turning on a dime, as it often does.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long CWST, HWD, SSW, YHOO, EBAY.

© 2010 Jeffrey Walkenhorst
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