Yahoo! A puzzle, a mystery and an enigma

In my last post, I estimated Alibaba's value and concluded that its growth and profitability put it on a pathway to make it one of the most valuable IPOs in history. In this post, which I view as a companion, I am looking at Yahoo, a company that has effectively become a proxy for Alibaba, especially leading up to the initial public offering. To illustrate, Yahoo’s quarterly earnings came out on April 15, and it reported flat revenues and declining earnings. Bad news, right? However, its stock price jumped on the earnings report, as embedded in it was good news about Alibaba's revenue growth in the last quarter of 2013. In fact, in the context of valuing Yahoo! in my valuation class, I borrowed phraseology from Winston Churchill and described Yahoo! as a puzzle, coupled with a mystery and wrapped up in an enigma. Yahoo!, the parent company, is the puzzle (especially in how quickly it lost its dominance in the United States, and why), with a mystery (its 35% stake in Yahoo! Japan, which is prospering while the parent struggles) and an enigma (the 22.1% share of Alibaba). 

Note: Press stories estimate Yahoo's holdings at 22.6% or 24%, depending on whether you use diluted or primary shares. I used the 523.6 million shares that Yahoo owns in Alibaba and my estimate of 2368.67 million shares outstanding in Alibaba, including restricted stock units, in Alibaba to arrive at 22.1%.

Setting up the valuation

To value shares in Yahoo, you have to estimate the value of its US operations, but that is only a small piece of the overall value, since Yahoo owns 35% of Yahoo Japan and 22.1% of Alibaba. Neither holding is consolidated, and the way in which the accounting works effectively means that the key operating numbers that you see in Yahoo’s financial statements (revenues, operating income) will not reflect either of these holdings. To illustrate the tangled web of values, here are the steps to get to the value of equity in Yahoo:

Yahoo: The sum of the parts

Thus, to value equity in Yahoo, you have to value Yahoo, Yahoo Japan and Alibaba separately, and after aggregating your holdings in each company's equity (100% of Yahoo, 35% of Yahoo Japan and 22.1% of Alibaba), you also have to net out any taxes that will come due on capital gains if Yahoo plans to or is required to sell any of its holdings. In the case of Alibaba, it has no choice, at least on a part of the holding, since it will be required as part of a prior agreement to sell 208 million shares after the IPO. 

If you are interested in Yahoo as an investment, there are three ways in which you can approach the analysis.

1. You can estimate an intrinsic value for each of the three pieces and add them together to come up with a composite intrinsic value. Now that Alibaba has filed its prospectus, you have the financial statements for all three companies.
2. You can price each of the three pieces, by looking at a key metric (revenues, earnings, book value) and applying a multiple to it, based on how other companies like it (and that is a subjective call) are being priced in the market. 
3. You can cheat and use the market pricing of one or more pieces to see how much you are paying for the rest of the company. In other words, you can check to see if the market is being internally consistent in its pricing of the pieces.

The Puzzle: Yahoo and its fall from dominance
I started with the parent company, a pioneer in the online search/advertising business that has long since been pushed to the sidelines by Google. Revenues have been declining at Yahoo! (US) over the last few years, going from $7.2 billion in 2008 to $4.68 billion in 2013 and the contrast with Google over the last decade is striking:

Yahoo versus Google: No mas!

The much heralded ascension of Marissa Mayer to the top of the company has not resulted in a turnaround in revenues, though the company continued to be profitable, generating $590 million in 2013 (translating into a pre-tax operating margin of 12.6%). If there was any positive news about Yahoo! in its most recent report, it is that ad revenues have stopped falling and that they increased 1.7% over the same quarter in the last year, though total revenues declined slightly and operating income dropped; the company generated $422 million in operating income on revenues of $4672 million in the twelve months ending March 31, 2014.

Intrinsic valuation: Assuming that Yahoo! will return to dominance or even get back to moderate growth is a reach. I will, however, assume that Ms. Mayer will find a way to stop the bleeding and that the company will muddle along as a mature company with stagnant revenues and stable margins. I assume a nominal growth rate of 1% for the next 5 years for Yahoo!, increasing to 2.75% in year 10, I estimate a value of $4.38 billion for its operating assets, but adding its substantial cash balance of $4.6 billion and netting out its debt of $1.6 billion, I derive a value of equity of $7.37 billion for the parent company.  You can download the parent company valuation by clicking here. (I used the last 10K filed by Yahoo and updated the numbers using the most recent 10Q).

A relative valuation (pricing): You can anchor your relative valuation of Yahoo! to revenues, EBITDA or operating income. Perhaps, the simplest way to do this would be to apply the median EV/Sales or EV/EBITDA  multiple for the sector (internet software and services) to Yahoo's metrics to estimate a value for just the parent company's operating assets. 

Yahoo: Estimated Enterprise Value using Median Multiples from Internet software & services

While it is tempting to apply these median multiples in the sector in internet software & services business to Yahoo’s revenues, you will get absurdly high values, since most of the companies in this sector are expected to have high revenue growth in the future,  and Yahoo! has little or no expected growth. In particular, we would expect Yahoo to trade at a much lower revenue multiple than its competitors. To get an adjusted revenue growth, we plotted EV/Sales against revenue growth for all internet stocks in the chart below:

EV/Sales versus Expected revenue growth: Internet software & services

There are outliers in this relationship, with higher revenue growth companies trade at higher multiples of revenues. (Twitter is one of the outliers in the graph, but this graph was prepared before Twitter's fall from grace last week. It is not as much of an outlier any more.)  In fact, the best fit line yields the following (and you can download the raw data used for the regression here):

EV/Sales = -0.94 + 21.21(Expected revenue growth) + 15.06 (Operating Margin)

R squared = 54.5%

Given Yahoo's expected revenue growth rate of 1% and current operating margin of 9.02%, we would forecast an EV/Sales ratio of only 0,63 for Yahoo .
EV/Sales Yahoo = -0.94 + 21.21(.01) + 15.06 (.0902) = 0.63

Applying this multiple to Yahoo’s revenues ($4.672 billion) yields $2,948 billion for Yahoo’s enterprise value, and adding the cash balance ($4.6 billion) and subtracting out debt (1.6 billion) yields a value of equity of $5.9 billion. Note that this is the value of only the parent company, since the revenues from the cross holdings (Yahoo Japan and Alibaba) are not incorporated into Yahoo’s revenues.)

Market price: Given the stock price of $33.76 at the time of this post, we have a market capitalization of $34.8 billion for Yahoo in May 2014, but that reflects the market’s assessment of the value of equity in the company with its cross holdings.

The Mystery: Yahoo! Japan
While Yahoo! has struggled in the US market, Yahoo! Japan has had more success in the Japanese market, as evidenced in the graph below:

Yahoo! Japan - Historical Performance

While there was a slowdown in 2012 and 2013, the company has been able to post a compounded annual growth rate of 22% in revenues and earnings in the last decade.

Intrinsic valuation: Estimating an intrinsic value for Yahoo! Japan, with a 5% growth rate in revenues for the next 5 years and much higher operating margin (40%) than Yahoo, yields an intrinsic value of $17.9 billion for the operating assets and $21 billion for its equity. You can download the valuation of Yahoo Japan by clicking here.

Relative valuation/pricing: Using the same regression on online companies that I used to value the parent company, I estimate an EV/Sales multiple of 7.91 for Yahoo! Japan, based on its expected revenue growth of 5% and operating margin of 51.72%.

EV/Sales Yahoo Japan = -0.94 + 21.21(.05) + 15.06 (.5172) = 7.91

Applying this multiple to the revenues of $3,929 million in 2013, we estimate a value of $31.1 billion for Yahoo! Japan’s operating assets. Adding cash and subtracting debt yields a value of equity of $34.2 billion for Yahoo! Japan.

Pricing: Yahoo! Japan is a stand alone and publicly traded entity, with a market capitalization of $23.2 billion in May 2014.

The Enigma: Alibaba

The final piece of the valuation is Alibaba, in whom Yahoo! has a 22.1% stake. Until last week, we were valuing Alibaba primarily through the financials that Yahoo was reporting for the company, since it was private and unlisted. With the prospectus now in the public domain, we can be more specific in both the intrinsic and relative valuations of the company.

Intrinsic value: Rather than rehash the intrinsic valuation of Alibaba, I will direct you to my last post, where I valued Alibaba's equity at $145 billion, post IPO. That valuation is built on the assumptions of revenue growth slowing to 25% (on an annual, compounded basis over the next 5 years) and a target operating margin of 40% (below the current operating margin of 50%). You can download the Alibaba IPO valuation spreadsheet by clicking here.

Relative valuation/Pricing: The second is to use the revenue and net income numbers, in conjunction with estimates multiples obtained by looking at other companies in the business and adjusting for Alibaba’s higher growth and profit margins. The table below lists PE and Price to Sales (which is a inconsistent multiple, but one we are stuck with since we have no debt and cash numbers) for sectors that may or may not match Alibaba’s business model:

Median Multiples: Advertising, Retail and Online Retail

The range of values that you obtain, using these multiples for Yahoo!, is immense, from a low of $6 billion (using EV/Sales of general retail) to a high of $285.6 billion (using a PE ratio of US online retailers). The bankers will undoubtedly gravitate towards earnings-based multiples and samples of internet firms as comparable firms during their roadshow. Using the EV/Sales regression that I used to value Yahoo! and Yahoo! Japan, with an expected revenue growth of 27% (from valuation) and operating margin of 49.07%:
EV/Sales Alibaba = -0.94 + 21.21(.27) + 15.06 (.4907) = 12.18

Applied to Alibaba's revenues of $7,911 million in 2013, adding the value of cash, cross holdings in Weibo & other online ventures and expected IPO proceeds of $27,963 million and netting out debt ($6,670 million) yields a value for Alibaba's equity of $117,623 million.

I would not be surprised if Baidu, the only other large, publicly traded Chinese online company that is structured similarly to Alibaba (as a Variable Interest Entity) is used for comparison and its pricing ratios are applied to Alibaba's metrics to arrive at value.

Baidu Multiples Applied to Alibaba; Enterprise values adjusted for cash, cross holdings and debt

On second thoughts, given how low these values are, relative to the rumored IPO numbers, it is entirely possible that bankers will avoid talking about Baidu as much as they can, since it will not fit their pricing story. 

Pricing: Alibaba is not a publicly traded company yet, but there is no shortage of estimates of how much the company will be valued at after its IPO. The rumored IPO estimates of equity value (http://www.bloomberg.com/news/2014-02-05/alibaba-s-average-valuation-rises-to-153-billion-after-earnings.html) range from $150 to $200 billion.

The Bottom line

At this stage, we have three paths we can follow to estimate the value per share in Yahoo, which entitles you to a full share in the parent, 35% of the equity of Yahoo! Japan and 22.1% of the equity in Alibaba. In each case, I have netted out the taxes that Yahoo will have coming due on the 208 million shares of Alibaba that it will have to sell. Pulling together the numbers for all the valuation/pricing of the individual companies, here is where we stand:

1. All intrinsic value: Using the intrinsic value estimates that we have for the three companies in the mix, we can estimate an intrinsic value per share for Yahoo:

The taxes were computed based on the capital gains, the difference between the assessed equity value for Alibaba and the book value (from Yahoo's 10K) for these shares. Using intrinsic value estimates for all three companies, the value per share is $41.19, making it under valued by 18%, relative to the prevailing price per share ($33.76).
2. All relative value: Using the relative value estimates that we have for Yahoo, Yahoo Japan and Alibaba, we derive a relative value per share for Yahoo:

On a relative value basis, the value per share is $39.19, making it under valued by 14% at its current price.

3. Pricing break-even: There is a third twist that can be used to value Yahoo's equity. You can use the market pricing of Yahoo Japan and Alibaba to back out the value that the market is attaching to the parent company's operating assets. Since Alibaba is not public yet, this will require use of the estimated IPO value numbers (I will use $150 billion for the base case), but once Alibaba becomes a public company, the pricing will be the market value.

Using the expected IPO value of equity of $150 billion, the conclusion you arrive at is that the market must be attaching a negative value to the parent company's operating assets. To the extent that this may just reflect the possibility that we are misplacing the Alibaba IPO, I estimated the value of Yahoo operating assets as a function of the value of Alibaba equity after the IPO.

Imputed value versus Intrinsic value

The results here are consistent with both the intrinsic and relative value assessments. Unless the Alibaba post-IPO equity value is less than $104 billion, it looks like Yahoo is mispriced, relative to how its holdings are being priced. 

What next?

While I remain concerned about the overall valuation of companies in the sector, Yahoo seems mispriced on every basis, intrinsic, relative and market pricing. I am aware that there are risks (as with any investment) and there are three concerns that I have:

1. Cross holding complexity: Yahoo is a case study in why valuation becomes difficult in the presence of cross holdings. In particular, the accounting for cross holdings, though it has its own internal logic, creates inconsistencies across financial statements that both confuse and trip up investors. In the case of Yahoo, the cross holdings in Yahoo Japan and Alibaba are recorded using the equity approach. The net result of the accounting is that the operating numbers for Yahoo (revenues, EBITDA and operating income) reflect nothing from these holdings whereas the net income and book value of equity do reflect the cross holdings . So what? For those investors who are dependent upon enterprise value multiples (EV/EBITDA or EV/Sales), applying either of these multiples to Yahoo numbers, adding cash and subtracting debt, i.e., following conventional practice, will yield a value of equity far lower than the market capitalization of the company because you are effectively attaching no value to its cross holdings. It is true that you may be able to use net income as your base, since it includes the income from the cross holdings, and apply a PE ratio to it, but that PE ratio will have to reflect the composite expectations across three companies (Yahoo, Yahoo Japan and Alibaba) on growth and risk.
2. The tax bite may get larger: I have assumed the minimum tax bite in my valuations, since it really makes no sense for Yahoo to liquidate its cross holdings now, unless it is forced to, as it is in the case of the 9% of Alibaba that it has to sell. It does not need the cash, its investors should get the pass-through value and it certainly does not want to pay the tax bill early. There are two scenarios, though, where this assumption may break down. First, if the market prices for Yahoo Japan and Alibaba skyrocket and Yahoo's price does not, the gap that we highlighted in the last section may get bigger. In fact, if it gets big enough, Yahoo may be forced to monetize the gap, i.e., sell its holdings in Yahoo Japan and Alibaba, pay the taxes, and still have money left over for its stockholders. The second relates to Yahoo's relationship with Alibaba. It is possible that Alibaba may be uncomfortable with Yahoo's continued large stock ownership and find a way, legal or extralegal, to get Yahoo to sell. 
3. The "do something quickly" discount: There is a bias both among analysts and financial journalists towards CEO action over inaction, towards quick action over more deliberate choices and towards growth over retrenchment. Leading into the Alibaba IPO, there has been a drumbeat of articles like this one, this one and this one that are full of advice for Ms. Mayer about what she should do with the cash windfall that Yahoo will have after the IPO. Most of these articles suggest ways in which Ms. Mayer can use the cash to return Yahoo to its glory days. I think that Yahoo has lost the fight to Google and should concede gracefully. Rather than throw good money after bad, my suggestion is that Yahoo do the following: (a) concede that growth in its core business will be too expensive to go after, cut back on growth investments and run itself as a mature business (essentially what I have assumed in the intrinsic valuation), (b) work on making the performance and the pricing of its cross holdings more transparent to investors and (c) return the excess cash to investors. The upside of doing this will be that the gap between price and break up value may shrink, benefiting stockholders. The downside is that Ms. Mayer loses a chance (albeit one with low odds) to go down in history as the CEO who brought Yahoo back from the dead.

The cross holdings and the confusion they breed among investors it both an ally and a hindrance, an ally because it is one reason why the stock (in my view) is mispriced and a hindrance because it may take a while for the mispricing to become evident. Alibaba's IPO may seem an obvious catalyst but market corrections don't always follow the logical path. The tax issue is a nagging problem, but the company seems cognizant of the tax overhang and negotiated with Alibaba to reduce the number of shares that it would have to sell after the IPO. Finally, Ms. Mayer seems to be saying all the right things, talking about how how she plans to be a "good steward of capital", but talk is cheap and the pressure to go for bigger and better will be difficult to resist. On balance, none of these risks is enough of a deal breaker for me. Not only is there a gap between price and value with Yahoo but there is one between price (that the market is attaching to Yahoo) and price (that the market is attaching to Yahoo! Japan and Alibaba) and as a newly minted Yahoo stockholder, I am hoping that one or the other of these gaps will close.

Yahoo! Equity Valuation: Master spreadsheet (is linked to individual company valuations below)

Yahoo! Parent intrinsic valuation

Yahoo! Japan intrinsic valuation

Alibaba IPO intrinsic valuation

Raw data for relative valuations (Online companies - fundamentals and multiples)