The Walking Dead: Blackberry, Yahoo and the Zombie Apocalypse!

I will start with a confession. I have distinctly lowbrow tastes when it comes to literature, movies and entertainment. I would much rather read a novel about a unhinged serial killer than one written by the latest Nobel Literature Prizewinner, watch The Avengers than an art film and be at Yankee stadium than the Museum of Modern Art. That may reflect the limits of my intellect and the shortcomings of my cultural education, but I know what I like, am set in my ways and no cultural gatekeeper is going to tell me otherwise. Given my plebeian tastes, it should come as no surprise that last summer, I joined my fifteen-year old son in binge-watching the first three seasons of The Walking Dead, a television show with not much of a stray line, lots of gore and few redeeming social qualities.  For those of you who have never watched the show, here is a taste:

You may be wondering why I am talking about television shows on a blog dedicated to markets, but the Walking Dead was what came to my mind in the last couple of weeks, as I watched Blackberry and Yahoo, two companies that I have posted about before, make the news. 

Blackberry announced that they were introducing a new phone, priced at $599, and aimed at getting them back into the smartphone market. Yahoo was initially not in the news, but Alibaba, a company that Yahoo owns 22.1% of, was definitely the center of attention at its initial public offering on September 19. While Alibaba opened to rapturous response, its stock price jumping 38% on the offering date, Yahoo’s stock price strangely dropped by 5%, the day after. By the end of last week,  Yahoo had been targeted by an activist investor, taken to task for not managing its Alibaba tax liability and pushed to merge with AOL. Since I have owned Yahoo for the last few months, I have a personal financial interest in trying to make sense of the dissonant behavior and I am afraid that  the Walking Dead is the best I can come up with as an explanation.

The Life Cycle and beyond

A few months ago, I posted on the life cycle that businesses go through and argued that companies are born, grow, mature and decline and that it is often both expensive and pointless to fight the cycle.

The life cycle view of the corporate world may be simplistic, but it is surprisingly powerful in analyzing the evolution of corporate governance and different investment philosophies. Thus, there are some who argue that while an autocratic CEO can be a hindrance in a mature or declining company, he or she can be an asset early in the life cycle, and that success goes to those who are strong on narrative, early in the life cycle, but that the numbers people dominate later.

In a series of posts, I looked at the challenges of managing and investing in companies across the life cycle, including a few in the most depressing phase, which is during decline.  I also conceded that there are examples of rebirth and reincarnation, where companies find a way back from decline (IBM in 1992 and Apple in 1999). In most cases, though, companies in decline that try to spend their way back to maturity have little to show in terms of earnings and growth for the billions of dollars spent on investments, acquisitions and R&D.

The Walking Dead Company

In drawing a parallel between human beings and corporations on the life cycle, I think I missed a key difference. Human beings die, no matter how heroic the medical attempts to keep them alive may be. Corporations on the other hand can survive well after their business models have expired, the Walking Dead of the business world, and can create damage to those vested in and closest to them. Here are the characteristics of these zombie companies:

1. Broken Business Model: The company's business model is dead, with the causes varying from  company to company: management ineptitude, superb competition, macroeconomic shocks or just plain bad luck. Whatever the reasons, there is little hope of a turnaround and even less of a comeback. The manifestations are there for all to see: sharply shrinking revenues, declining margins and repeated failures at new business ventures/products/investments.
2. Management in Denial: The managers of the company, though, act as if they can turn the ship around, throwing good money after bad, introducing new products and services and claiming to have found the fountain of youth. In some cases, the company may change managers at frequent intervals during the death spiral, but they all share in the denial.
3. Enabling Ecosystem: The managers are aided and enabled by consultants (who collect fees from selling their rejuvenating tonics), bankers (who make money off desperation ploys) and journalists (either out of ignorance or because there is nothing better to write about than a company thrashing around for a solution). 
4. Resources to waste: While almost all declining companies share the three characteristics listed above, the walking dead companies are set apart by the fact that they have access to the resources to continue on their path to nowhere and have to be kept alive for legal, regulatory or tax reasons. Those resources can take the form of cash on hand, lifelines from governments and/or capital markets that have taken leave of their senses.

The challenges that you face as an investor in a walking dead company is that you cannot assess its value, based upon the assumption that the managers in the company will take rational actions: make good investments, finance them with the right mix of debt and equity and return unneeded cash to stockholders. To get realistic assessments of value, you have to assume that managers will sometimes take perverse actions, investing in low-probability, high-possible-payoff investments (think lottery tickets), financing them with odd mixes of debt and equity (if you are on the road to nowhere, you don't particularly care about who you take down with you) and holding back cash from stockholders. Incorporating these actions into your valuation will yield lower values for these companies, with the extent of the discount depending upon the separation of management from ownership (it is easier to be destructive with other people's money),  the capacity of managers to destroy value (which will depend on the cash/capital that they have access to and will increase with the size of the company) and the checks put on managers (by covenants, restrictions and activist investors). At the limit, managers without any checks, given enough time, on their destructive impulses can destroy all of a company's value, if not immediately, at least over time. For value investors, these companies are often value traps, looking cheap on almost every value investing measure but never delivering the promised returns, as managers undercut their plans at every step. 

Blackberry’s future: Staring into the Abyss

In fact, I argued in a post in December 2011 that Blackberry (then called Research in Motion) needed to act its age, accept that it would never be a serious mass-market competitor in the smart phone market and settle for being a niche player. That post, which occurred when Blackberry had a market capitalization of $7.3 billion, argued that Blackberry should give up on introducing new tablets or phones and revert to a single model (which I termed the Blackberry Boring) catering to paranoid corporates (who do not want their employees accessing Facebook or playing games on smart phones). I also suggested that Blackberry settle on a five-year liquidation plan to return cash to stockholders.

I was accused of being morbid and overly pessimistic, but here we are three years later, with Blackberry’s market cap at $5.3 billion. In the three years since my last post, the company has spent $4.3 billion in R&D,  while its annual revenues have dropped from $18.4 billion in 2011-12 to $4.1 billion in the last twelve months and its operating income of $1.85 billion in 2011-12 has become an operating loss of -2.7 billion in the trailing twelve months. Blackberry’s new model may be a technological marvel, but the smart phone market has moved on, where a phone is only as powerful as the ecosystem of apps and other accessories available for it is. If it was true three years ago that Blackberry could not compete against Apple and Google in the operating system world, it is even truer today, when either of these mammoth companies can use petty cash to buy Blackberry. (Apple’s cash balance is $163 billion, Google’s cash balance is $63 billion and Blackberry’s enterprise value is $4.1 billion). Perhaps, I am missing something here, but I really don't see any light in the smartphone tunnel for Blackberry and even if I do, it is the headlight of an oncoming locomotive.

The options for Blackberry, in my view, are even fewer than they were three years ago. At this stage, I am not sure that even the niche market option is viable any more. I see only two ways to encash whatever value is left in the company. The first is to hope that a strategic buyer (which to me is a synonym for someone who will pay far more than justified by the cash flows) with deep pockets will see some value in the Blackberry technology and buy the company.  The second is a more radical idea. In a world where social media companies like Facebook, Twitter and Linkedin command immense value, with each user generating about $100 in incremental market cap, Blackberry should consider relabeling itself as a social media company, create a Blackberry Club, where those with Blackberry thumbs can stay connected. Outlandish, I know, but why not?

Do you Yahoo? 

On May 10, 2014, I posted on Yahoo! and valued itscomponent parts: its operations in the US (Yahoo US), its 35% holding of Yahoo Japan and its 22.1% holding of Alibaba. I first valued it on an intrinsic basis at $41.19:

Note that these numbers reflect my estimates of intrinsic value, which generated $146 billion for Alibaba's equity.  I then revalued it on a relative basis at $39.19, but this valuation reflected a pricing of Alibaba at $118 billion.

I closed by arguing that the stock seemed under priced at $ 34 and that I would use it as my proxy bet on Alibaba.  The stock initially stalled but as the Alibaba IPO became imminent, Yahoo’s stock price rose to $42.09 at close of trading on Thursday, the day before the IPO:

Alibaba went public on Friday, September 19, and its market capitalization jumped to $230 billion.  I updated my valuations and prices of Yahoo, Yahoo Japan and Alibaba in the table below:

Updated using trailing 12-month values

Note that both the intrinsic and relative values of Yahoo have increased over the period, almost entirely due to an increase in Alibaba's intrinsic value.  It is true that Yahoo did have to sell 124 million shares (actually good news, since that amounted to only 5.1% of Alibaba shares, when initial estimates suggested that the would have to sell about 9%)  worth of Alibaba stock on the IPO date at the IPO price of $68, giving it a net cash balance of about $ 8 billion on Monday, after allowing for a tax liability of $3.3 billion on the Alibaba stock sale. Updating the intrinsic value picture to reflect this, here is what I get:

Allowing for both the higher cash balance and the re-estimated intrinsic values for the three businesses, my estimate of intrinsic value of $46.44 per share for Yahoo is higher than the current price of $40.66. If you don't trust my intrinsic value estimates, here is a simpler and far more powerful picture of where Yahoo stands today. Using today's market prices for Yahoo's holdings in Alibaba and Yahoo! Japan and adding the net cash balance that Yahoo has, net of taxes due on the shares sold on the IPO date, the value per share is $52.14.  At its current price, the market is attaching a value of -$12.22 billion (-$11.48/share) for the operating assets in Yahoo US.

It is tough to imagine that this is a market oversight, since the market values of Yahoo Japan and Alibaba are easily checked and the cash balance is not really subject to debate. I am more inclined to view this as a Walking Dead discount, reflecting investor concerns, merited on not, that  Yahoo's management might do something senseless with the cash, and incorporating the reality that liquidation is not a viable or a sensible option today. Why? Liquidating Yahoo's holdings today will require cashing out of the Yahoo Japan and Alibaba holdings today, resulting in a total tax bill of $16.3 billion and a value for the equity per share of $34.18.

What now? 

As an investor in Yahoo, the question I face is whether the discount that the market is applying to Yahoo is reasonable. While I believe that Marissa Mayer can do serious damage to me as investor, by embarking on ambitious expansion plans with the cash, I also believe that she will be checked by activist investors along the way.  I will continue to hold Yahoo, at least at its current price, and hope for the best. That, to me, would require that Ms. Mayer recognize that Yahoo is really a shell company with two very valuable holdings and very little in actual or potential operating value. Perhaps, she would consider returning all cash to stockholders, reducing the workforce in the company to one person and giving that person a dual-display terminal and let him/her just watch the market value of Alibaba on one and Yahoo Japan on the other. That is my best case scenario and it is unfortunate, but true, that my value per share will move inversely with Ms. Mayer's ambitions.

Attachments
Master Spreadsheet for Yahoo (with holdings)
Intrinsic value of Yahoo US
Intrinsic value of Yahoo Japan
Intrinsic value of Alibaba