Yahoo: Marissa Mayer’s clock is ticking (and that’s a good thing for shareholders)

Yahoo (YHOO) was by far my largest holding on the long side for the better part of all 2014. I had a fairly simple (and somewhat consensus) view: that the core search business, weak as it was, was largely immaterial to the stock’s prospects before the Alibaba IPO; that excitement would build regarding Alibaba’s valuation and the implications for Yahoo’s large stake; and that the Alibaba IPO would go extremely well. I articulated these views in an article on Seeking Alpha and did well on the stock, buying mostly in the low-mid $30s and exiting around the Alibaba IPO in the low-mid $40s. Since then I have kept half an eye on the story and moved on to fresher pastures, since – while still cheap – the stock’s main catalyst had come and gone.

YHOO popped back onto my radar last night after plunging 8% into the close on some vague reports out of someone at the IRS that the company’s contemplated tax-free spin-off of its remaining Alibaba stake – one of Marissa Mayer’s key tasks in her promise to create more value for shareholders – could be derailed by the IRS changing its stance on these kinds of spin-offs (really, closing a loophole). By my calcs, the difference to YHOO stock between a post-tax and pre-tax Alibaba position is ~$6-7 per YHOO share, so the ~$3.5 decline in the stock on this news adequately reflects the uncertainty on the tax issue. What it doesn’t solve, however, is where the stock goes from here.

To recap briefly: the case for investing in YHOO stock has been a sum-of-the-parts (SoTP) cheapness for years. To some extent, this is true: if you back out the Alibaba (BABA) and Yahoo Japan (4689.T) stakes – even assuming full taxation (at 25%) – and deduct net cash, even a paltry 4x EBITDA multiple on the core business (about half what Verizon paid to acquire AOL recently, and quite a distressed multiple) gets you to ~$39/share. And if you assume YHOO can do the BABA/YJ spin-offs in a tax free manner, fair value on the stock is closer to $48/share. Anything more than that for the core business (and in an acquisition scenario, the multiple would indeed be higher), would be gravy. As per below (source: YHOO filings, my estimates):

yahoo 1

Of course, there are a few counterpoints to this easy optimism. One is the inherent nature of the cheapness: YHOO’s core business has been in structural decline, and presumably will remain so; as such it has always traded ‘cheap’ and what is to change that now? The other, more persuasive point to me is that whereas buying YHOO last year in the low-mid $30s involved buying the SoTP at a price still cheap to the implied private market valuation of BABA (at the time, I speculated $130bn), Alibaba now trades at a whopping $217bn with arguably cloudier near-term prospects. To put it another way – BABA could correct downwards by ~20% quite easily, still be much more expensive than it was a year ago, and make YHOO’s current ‘cheapness’ quite illusory.

On the other hand, there are deeper reasons to be optimistic on YHOO around $40 a share. For one: it appears unlikely, even now, that YHOO shareholders suffer full taxation on both their BABA and YJ stakes. Some of the stakes are held offshore, beyond the IRS’ grasp, while the recent noises from an IRS official were not official rulings nor pronouncements; indeed, with the BABA spin slated to go through this year, it could squeak by before the rules are changed, if they are changed. And even if the rules do change, YHOO management would be idiotic to continue with the spin and would likely try to pursue another angle to remove the tax burden (perhaps selling the stake back to the respective companies, or including more substantial assets in the SpinCo to pass the new rules for tax-free status, etc).

Thinking more deeply, though. there are further value levers for the company to pull. Starboard Value, a successful activist investor, had been pushing not only for the tax-free spin of Alibaba (and Yahoo Japan), but also the merger with AOL (AOL) to pursue cost synergies. Personally I never liked that idea – the marriage of two Internet 1.0 businesses – but since AOL has now agreed to be acquired by Verizon (VZ) it is off the table. But YHOO still has an incredibly bloated cost structure for a business struggling to generate growth – so Starboard is right to imply there is plenty of fat to cut.

Consider: YHOO has 12.5k employees but will post just $4.3bn of revenue this year ($345k/employee). AOL has a third as many employees (4.5k) but generates over half as much revenue ($2.7bn), or $590k/employee, close to double YHOO’s efficiency. And while clearly not a perfect comp, Google generates $60bn in revs on an employee base of 55k, for just over $1mm/employee. Clearly scale helps Google and the business is not all search/display advertising (though it is, mostly, search); but just by looking at AOL, it’s quite clear a new manager at YHOO would look to clear the decks, fire a good portion (25%?) of the workforce, and tighten the expense budget considerably.

This leads to the biggest potential wild-card upside for YHOO shareholders: potential new management. If the tax-free spin of BABA fails, and if Tumblr/Yahoo Mobile growth remains anemic, there is a decent, non-zero chance that Marissa Mayer is either forced out and replaced by value-oriented managers, or decides to shop the company to appease the activists who – rightly – would be baying for her blood. By my judgement, she probably really only has a few more quarters of leeway. While her stewardship of the BABA transaction (through IPO at least) was solid and she has repurchased a lot of stock, she hasn’t demonstrated any ability to regenerate the business and engineer growth. She has been at Yahoo for almost 3 years now and has had ample time to recast the company as she sees fit; but frankly, it has not arrested the decline. If I was a YHOO shareholder (and currently I’m not), I would be hoping beyond hope that the BABA spinoff fails and activists use it to oust Mayer, give up on her imperial dream of rebuilding a once-great business, and install a new, value-conscious manager who will either tighten the company’s belt aggressively, or break it up and sell it off for parts (or maybe a bit of both). In that scenario, the stock should crest $50 pretty easily.

Disclosure: no position in YHOO

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