Greenbackd

Today we continue our “Net Net vs Activist Legend” thought experiment, with Yahoo! Inc. (NASDAQ: YHOO).

YHOO is a stock that is not cheap on an asset basis but it does have a prominent activist investor with a 5.5% stake and two seats on the board. At its Friday close of $11.66, which is around two-thirds lower than Microsoft’s May 2008 $33 bid, YHOO still trades at a 70% premium to our $6.82 per share estimate of its asset value. Activist investor Carl Icahn’s presence on the register, however, indicates that he believes YHOO is worth more. Icahn has paid an average of $23.59 per share to accumulate his 5.5 percent stake. At $11.66, YHOO must more than double before Icahn will see a profit. He’s unlikely to sit idly by to see if that happens.

About YHOO

According to the Overview section of the company’s most recent 10Q*, YHOO “is a leading global Internet brand and one of the most trafficked Internet destinations worldwide.” Clear enough, but here is where the 10Q gets weird:

We are focused on powering our communities of users, advertisers, publishers, and developers by creating indispensable experiences built on trust.

We have no idea what “indispensable experiences built on trust” means. We’d be keen to hear your thoughts in the comments (but we digress):

We seek to provide Internet services that are essential and relevant to these communities of users, advertisers, publishers, and developers. Publishers, such as eBay Inc., WebMD, Cars.com, Forbes.com, and the Newspaper Consortium (our strategic partnership with a consortium of more than 20 leading United States (“U.S.”) newspaper publishing companies), are a subset of our distribution network of third-party entities (referred to as “Affiliates”) and are primarily Websites and search engines that attract users by providing content of interest, presented on Web pages that have space for advertisements. We manage and measure our business geographically. Our geographic segments are the U.S. and International.

According to Wikipedia, YHOO:

…provides Internet services worldwide. The company is perhaps best known for its web portal, search engine, Yahoo! Directory, Yahoo! Mail, news, and social media websites and services. Yahoo! was founded by Jerry Yang and David Filo in January 1994 and was incorporated on March 1, 1995.

According to Web traffic analysis companies (including Compete.com, comScore, Alexa Internet, Netcraft, and Nielsen Ratings), the domain yahoo.com attracted at least 1.575 billion visitors annually by 2008. The global network of Yahoo! websites receives 3.4 billion page views per day on average as of October 2007. It is the second most visited website in the U.S., and the most visited website in the world.

* We usually link to a company’s own description of its business on its website. We didn’t for YHOO because we couldn’t find on its website a concise description of the company or its business. While this may speak more to our own ineptitude, it might also be a telling sign for a “leading global Internet brand” that has struggled lately, no?

The value proposition

Before we launch into our analysis of YHOO, we have to state up front that Greenbackd’s focus is on undervalued asset situations, and preferably undervalued tangible assets. One would think that with YHOO, a “leading global Internet brand”, one would find a great deal of value in its intangible assets. Our bias for tangible over intangible assets will almost certainly lead us to a lower valuation for YHOO than another investor with a preference for intangible assets which generate earnings or cash flow.

Set out below is our summary analysis (the “Carrying” column shows the assets as they are carried in the financial statements, and the “Liquidating” column shows our estimate of the value of the assets in a liquidation):

Ordinarily, when we discount a company’s assets we get a much lower liquidating value than carrying value. In YHOO’s case, most of the tangible asset value is in the Cash and Short Term Investments which we don’t write down ($3.2B or $2.32 per share) and Long Term Investments (carried at $3.2B or $2.31 per share), which we’ve only written down to $3B or $2.19 per share for reasons we’ll explain below. We’ve written down the Property, Plant and Equipment by 85%, but it only represents a small proportion of the total tangible assets and so doesn’t have a meaningful impact on the valuation. Our usual liquidation valuation – the Armageddon scenario – for YHOO is $5.4B or $3.91 per share.

We believe that the Armageddon scenario substantially undervalues YHOO because it excludes the Goodwill in the Investments in Equity Interests (which is included in the Long Term Investments above). Including the Goodwill, YHOO’s Investments in Equity Interests amount to the following:

• a 44% equity interest in Alibaba Group valued at $2.2B
• a 1% equity interest in Alibaba.com Limited valued at $52M and
• a 33% equity interest in Yahoo! Japan valued at $6B.

Including the Goodwill figures in the Investments in Equity Interests above (but deducting the Deferred Income Tax) gives us an asset valuation for YHOO closer to $9.5B or $6.82 per share.

Icahn said in an interview with CNBC last Wednesday that he believes YHOO is undervalued and that he “opposes breaking up the company in a piecemeal sale” (NY Times’ Dealbook has the transcript). While we can only speculate as to Icahn’s investment thesis for YHOO, that statement leads us to believe he is valuing it on an earnings or cash flow basis. YHOO’s Cash from Operating Activities is impressive at $1.9B in 2007 and $347M in the most recent quarter to September. Even more impressive is that it achieved that operating cash flow on only $9.5B of equity (up from $9.1B in the prior year), which means it returned around 21% on average equity. We’ve got no idea about the future economics of YHOO’s businesses or the industry as a whole, so we can’t predict whether YHOO can continue to generate these types of returns and we won’t be speculating as to its value on an earnings or cash flow basis.

The catalyst

Icahn, who currently sits on the board and holds 5.5% of the company, will be the driving force in any deal involving YHOO. His decisions will likely be informed by the fact that he has paid an average of $23.59 per share to accumulate a 5.5 percent stake (according to this filing with the SEC). There are a number of suitors seeking to consummate a marriage with YHOO. This Wall Street Journal article (subscription required) suggests former AOL chief Jonathan Miller is talking to investors about raising money to purchase all or part of YHOO. Icahn has said that he would be opposed to a partial bid “even at a premium.” He also expressed doubts about Miller’s ability to raise the money but would be willing to listen if Miller made a “bid at a very high price”. Another possibility is Microsoft, which has recently engaged a former YHOO search and advertising executive, but Microsoft CEO Steve Ballmer told the Wall Street Journal Thursday (subscription required) that there were no talks to acquire YHOO’s search business.

Icahn has a long history of succesful activist investment, with recent high profile campaigns against  Blockbuster, Imclone, XO Communications, Mylan Laboratories and Time Warner. According to this 2007 Fortune profile, he is renowned for taking on the biggest targets while generating exceptional returns:

In its less-than-three-year existence, Icahn Partners has posted annualized gains of 40%, investors told Fortune. After fees, the investors pocketed 28%. That 40% gain trounces the S&P 500’s return of around 13%, as well as the 12% for all hedge funds calculated by research firm HedgeFund.net. Icahn Partners boasts a string of big wins in short periods. The acquisition of energy producer Kerr-McGee gave the fund a $300 million gain, or a 100% return in just nine months. Icahn Partners achieved gains of $100 million and $230 million, respectively, both in less than three months, on forcing the sales of Fairmont Hotels & Resorts and drugmaker MedImmune.

The same Fortune article suggests that Icahn’s biggest strength is his knack for picking targets:

His skill at prospecting is so well honed that in most cases he’s destined to make money from the day he buys the shares. Then it’s a matter of squeezing management to sweeten the inevitable gains.

This is high praise indeed. Given that Icahn has paid an average of $23.59 per share for YHOO, he clearly sees value well in excess of that number and will be agitating for it to be realised.

Conclusion

YHOO is not cheap on any theory of value we care to employ. It is trading at a substantial premium to its asset backing, which means the market is still generously valuing its future earnings. It is generating substantial operating cash flow and earnings, which in a better market might be worth more, but it’s not obviously cheap to us.

The best thing about YHOO from our perspective is the presence of Carl Icahn on the register. His holdings were purchased at much higher prices than are presently available and he is unlikely to sit idly by while the stock stagnates.

Buying YHOO at these prices is a bet that Icahn can engineer a deal for the company. Given his legendary status as an activist investor earned through canny acquisitions over many years, we think that’s a good bet. But a bet is what it is – it’s speculation and not investment. If speculation is your game, then we wish you the best of luck but know that the price might fall a long way if he sells out. If you’re an investor, the price is too high.

YHOO closed Friday at $11.66 and the S&P 500 Index closed at 876.07.

[Disclosure: We do not have a holding in YHOO. This is neither a recommendation to buy or sell any securities. All information provided believed to be reliable and presented for information purposes only.]