Starboard Value, an aggressive activist shareholder that’s taken aim at several tech companies, has bought a large stake in Yahoo and written a letter to CEO Marissa Mayer saying it seeks to “unlock tremendous value for the benefit of all Yahoo shareholders.”
A tie-up with AOL would make a lot of sense according to the investor group, a combination that has been suggested numerous times over the years by other investors and analysts. And as Re/code has previously written many times over the last months, the Alibaba IPO has meant new scrutiny on the leadership of the Silicon Valley Internet giant.
Starboard took a shot at AOL two years ago by trying to shake up its board and questioning CEO Tim Armstrong’s leadership. The move didn’t work out for Starboard, which lost the bid to install its own directors.
AOL declined to comment on Starboard’s demand/suggestion.
Not surprisingly, AOL shares jumped on the news, though the price is moving back down again. Via Google Finance:
Perhaps a bit more surprisingly, Yahoo shares are also up. Maybe traders are simply excited to have a reason to play with the stock in the post-Alibaba IPO era:
Starboard’s argument, or at least its broad strokes, have garnered instant approval from investor and columnist Eric Jackson, a former Mayer fan turned critic: “I’m happy Starboard sees the obvious value here,” he says, via email. “If I was Marissa, I would be getting on the phone with Masa and Jack and figuring out my own solution to create value for shareholders and control my own destiny.”
Here’s the full text of Starboard’s pitch:
September 26, 2014
Marissa A. Mayer, President and CEO Yahoo! Inc. 701 First Avenue Sunnyvale, California 94089
cc: Board of Directors
Starboard Value LP, together with its affiliates (“Starboard”), is currently a significant shareholder of Yahoo! Inc. (“Yahoo” or the “Company”).
By way of background, Starboard Value LP is an investment management firm that seeks to invest in undervalued and underperforming public companies. Our approach to such investments is to actively engage and work closely with management teams and boards of directors in a constructive manner to identify and execute on opportunities to unlock value for the benefit of all shareholders. Our principals and investment team have extensive experience and a successful track record of enhancing value at portfolio companies through a combination of strategic refocusing, improved operational execution, and more efficient capital allocation.
The purpose of this letter is to highlight several opportunities to unlock tremendous value for the benefit of all Yahoo shareholders. These opportunities include:
Unlocking the substantial value from Yahoo’s non-core minority equity stakes in Alibaba Group Holding Limited (“Alibaba”) and Yahoo Japan in a structure that delivers value directly to Yahoo shareholders in a tax-efficient manner;
Realizing substantial cost efficiencies by reducing expenses throughout the Company, specifically with a goal of reducing losses in the Display business by between $250 and $500 million;
Halting Yahoo’s aggressive acquisition strategy which has resulted in $1.3 billion of capital spent since Q2 2012 while consolidated revenues have remained stagnant and EBITDA has materially decreased; and
Exploring a strategic combination with AOL, Inc. – a company we know well – which could improve Yahoo’s competitive position, deliver cost synergies of up to $1 billion, and potentially facilitate the realization of value from Yahoo’s non-core equity stakes with minimal tax leakage.
We believe that the execution of these initiatives would produce tremendous value for shareholders, and are squarely within the control of the Company’s management and board of directors (the “Board”). We look forward to engaging directly with you to discuss the details of how these actions can be implemented in a timely manner.
Yahoo’s main assets include its core Search and Display advertising businesses (“Yahoo’s core business”), its non-core 15% stake in Alibaba, the world’s largest e-commerce company, and its non-core 35.5% stake in Yahoo Japan, Japan’s leading Internet advertising company.
There has been tremendous excitement around Alibaba and its IPO. Even after the previous ill-timed and tax-inefficient sales of Alibaba stock, Yahoo’s remaining stake in Alibaba is currently worth more than the entire enterprise value of Yahoo. When adding Yahoo Japan, these two minority equity interests are worth approximately $11 billion, or $11 per share more than the current enterprise value of the Company. This is before ascribing any value to Yahoo’s core business, intellectual property, or real estate holdings, and clearly shows the dramatic valuation discrepancy that currently exists at Yahoo.
This substantial valuation gap is likely due to the fact that investors currently expect Yahoo to continue its past practices of (a) monetizing its non-core minority equity stakes in a tax inefficient manner and (b) using the cash proceeds from such sales to acquire businesses at massive valuations with seemingly little to no regard for profitability and return on capital. If these two issues are addressed such that the non-core minority equity stakes are monetized in a tax efficient manner and Yahoo’s aggressive acquisition strategy is halted, Yahoo’s current stock price would imply negative $11 billion of value for Yahoo’s core business. Over the next twelve months, Yahoo’s core business is expected to produce over $4 billion in revenue, $1.2 billion in EBITDA, and $600 million of free cash flow. Obviously, ascribing negative value to this large and profitable business is nonsensical, demonstrating to us the market’s significant skepticism about the Company’s current strategy.
We believe that Yahoo’s core business is valuable. However, given some recent operational challenges, we would expect it to trade at the low end of industry multiples. Comparable advertising companies currently trade in a range of between 6x and 11x next twelve months EBITDA. Assuming a very conservative multiple of 5.5x EBITDA, which represents approximately a 10% free cash flow yield, this implies a value gap of almost $18 billion or $18 per share from the current share price (assuming the non-core assets can be monetized tax efficiently):
Clearly Yahoo is deeply undervalued relative to the sum of its parts. We believe this value gap can be closed with minimal tax leakage and without delay based on actions within the control of management and the Board. We believe it is incumbent upon management and the Board to take immediate steps in committing to remedy this valuation discrepancy. We have provided additional detail below on the substantial value-creation opportunities at Yahoo that we believe should be immediately explored and executed.
Yahoo’s Non-Core Minority Equity Investments
As we highlighted above, it appears investors currently expect the Company to continue their practice of monetizing these investments in a tax inefficient manner. Although management has made cursory and non-committal statements regarding Yahoo’s intention to explore more tax-efficient ways to monetize these investments, investors are clearly not convinced that this will be accomplished. We believe management should immediately and clearly articulate how it intends to deliver value from these investments to Yahoo shareholders in the most tax-efficient and expeditious manner. Until clarity is provided with respect to Yahoo’s equity investments, investors are likely to assume that Yahoo will continue to monetize its equity stakes in an inefficient way.
With the assistance of tax counsel and independent tax advisors, we have explored a number of alternative structures that, if implemented, could deliver value for these minority equity investments directly to the shareholders of Yahoo with limited tax leakage. Other companies with analogous minority ownership stakes have recently and successfully implemented similar tax-efficient structures. Importantly, we believe these structures can be implemented in a relatively short timeframe, do not necessarily involve multiple jurisdictions, and can be announced in short order without running afoul of the existing underwriting or lock-up agreements with Alibaba and the underwriters.
As shown in the table below, the difference in value to shareholders of Yahoo between a fully taxed monetization of Yahoo’s minority equity holdings and a tax-efficient separation equates to $16 billion in value, or $16 per share of Yahoo.
Given the potential for value creation through a tax-efficient monetization of Yahoo’s non-core minority investments and the likely impact it would have on share price, it must be the top priority for management and the Board. We believe this opportunity is the best possible way to create significant value for shareholders with the least amount of risk. We have done significant work on potential structures that would allow for a tax-efficient monetization of Yahoo’s minority equity holdings and look forward to sharing the details of this work with you.
Yahoo’s Core Business
Although Yahoo’s stock price performance over the past few years has been strong, we believe the main reason for this performance has been the significant increase in value of Yahoo’s stake in Alibaba. The appreciation in Alibaba’s valuation, which Yahoo purchased in 2005, has masked the poor performance of Yahoo’s core business. As shown in the table below, since new management was appointed in Q2 2012, revenue in Yahoo’s core Search and Display businesses has been stagnant, yet SG&A and R&D expenditures have grown by a staggering $390 million, in turn, causing EBITDA to decline by 19%.
The $1.3 billion spent on acquisitions has clearly not delivered value to shareholders. Not only do we believe that many of the acquired companies were, and still are, losing a considerable amount of money, but we also believe that these acquisitions, on a combined basis, have failed to deliver material revenue growth. In fact, we believe that a number of the acquired start-ups have actually been shut down after being acquired by Yahoo.
Our analysis indicates that Yahoo’s display business, where management’s efforts and acquisitions have been focused, may be losing over $500 million in EBITDA per year:
We believe such unacceptable financial performance has resulted from a combination of the Company’s large investments in content and new products along with a continued decline in Display advertising pricing and a bloated cost structure.
As a standalone company, our research indicates that Yahoo could pare its cost structure by between $250 and $500 million without a material loss of revenue. This cost-cutting opportunity is consistent with the business plan that current management reportedly prepared at the time of joining Yahoo, but which has never been implemented.
Exploring a Strategic Combination with AOL
While a cost reduction program could lead to significant value creation, this opportunity pales in comparison to the synergies that we believe Yahoo could unlock in a combination with AOL. In fact, like Yahoo, we believe AOL’s Display business also continues to lose a substantial amount of money:
Based on our analysis, we believe that a combination of Yahoo and AOL could offer synergies of up to $1 billion by significantly reducing the cost overlaps in their Display advertising businesses as well as synergies in corporate overhead. Importantly, we believe the combined entity would be able to more successfully navigate the ongoing industry changes, such as the growth of programmatic advertising and migration to mobile. In addition, we believe a combination could also lead to revenue growth opportunities given the broader user base, higher quality content, better technology assets, and enhanced relationships with advertising agencies.
Interestingly, based on our research and the legal advice we have received on how to unlock the value of Yahoo’s equity holdings, we believe a merger of AOL and Yahoo’s core business may be one of the best ways to both fully seize the cost reduction opportunity and also to tax efficiently monetize Yahoo’s non-core equity holdings. We trust the Board and management will do the right thing for shareholders, even if this may mean accepting AOL as the surviving entity in a combination, should that be the best and most tax efficient structure.
The management and Board of Yahoo have a tremendous opportunity to create significant value for its shareholders. We believe the combination of (i) unlocking the value of Yahoo’s non-core minority equity stakes in a tax efficient manner, (ii) preserving shareholder capital by halting the current aggressive acquisition spree, and (iii) improving the profitability of Yahoo’s core business on a stand-alone basis or, ideally, in a merger with AOL, would result in a significant appreciation of Yahoo’s stock price.
Yahoo’s recent strategy of focusing on acquisitions has not worked. Yahoo’s stock price has merely been buoyed by the strong growth in value of Alibaba. We understand that the likely result of monetizing Yahoo’s non-core minority investments in the most tax efficient manner likely means that the Company will not have access to those proceeds to be used towards acquisitions. However, even if the Company were to deliver all of the value from its non-core minority investments directly to shareholders without receiving any additional cash proceeds, it is important to note that Yahoo would still have $7 billion in cash and cash equivalents (after returning to shareholders approximately 50% of the Alibaba IPO proceeds) and significant debt capacity which would be more than sufficient for any future capital needs for investments or acquisitions. To be clear, while Yahoo is trading at such a deep discount to the sum-of-its-parts, we do not believe the Company should be pursuing acquisitions of companies at high multiples of revenue as it has done repeatedly in the past.
We hope, and expect, that the management team and the Board will execute on the suggestions in this letter. We look forward to speaking with you in more detail about Yahoo’s opportunities and the potential structures the Company can utilize to create value for the benefit of all shareholders.
Jeffrey C. Smith
Starboard Value LP
This article originally appeared on Recode.net.