Wednesday, September 21, 2011

Yahoo!: The Perils of Whale Watching

By Eric Jackson09/21/11 - 06:00 AM EDT

NEW YORK (TheStreet) -- Earlier this spring, when Yahoo!(YHOO_) was bumping along around $16 a share, David Einhorn bought the stock.

When he revealed the new holding on May 2, the stock jumped. A few days later, it closed at $18.65 a share. Investors were finally ready to buy in to the Yahoo! sum-of-the-parts story which suggested the stock was worth in the mid- to high-$20s.
According to Einhorn's first quarter letter:
"The Partnerships established a new position in Yahoo! at an average cost of $16.93 per share. The company developed an extraordinary anti-shareholder reputation in recent years, beginning with its ill-advised decision in early 2008 to turn down Microsoft's(MSFT_) equally ill-advised (and ill-timed) bid to buy the company for $31 per share.
"Now, under new management, YHOO has taken some increasingly shareholder-friendly steps. It has given up competing with Google(GOOG_) in the web search business, a move which is improving free cash flow by reducing capex and operating expenses. It is using the improved cash flow to step up share repurchases (the company bought back more than 7% of its outstanding shares in 2010). YHOO is also taking steps to unlock value from some of its Asian assets in a tax efficient manner, including its 35% stake in publicly-traded Yahoo Japan.
"YHOO currently has $3 per share of net cash on its balance sheet and has approximately another $8 per share of value in its two minority equity stakes of publicly traded companies in Asia (Yahoo Japan and Assigning a conservative valuation (5x current year EBITDA) implies $18 per share for just the core businesses and the publicly traded securities and cash.
"We believe that Yahoo's most valuable asset is its 40% stake in Alibaba Group's still-private holdings, which are separate and distinct from its ownership in the publicly-traded, which we are essentially getting for free. Among Alibaba Group's privately held Chinese internet assets is a company called Taobao, which is the leading eCommerce website in China. More merchandise was sold on Taobao last year than on eBay, and Taobao's merchandise sales are growing 100% annually. We would not be surprised if YHOO's 40% stake in Alibaba Group alone was ultimately worth YHOO's entire current market value. YHOO stock ended the quarter at $16.68 per share."
Of course, shortly after that euphoria came over the stock, Yahoo! disclosed that it had lost control of its ownership stake in Alipay through a footnote in a 10-Q at least 45 days after it first knew about it. (Fantastic governance, guys.)

That set off a three-month decline in the stock. By July 7, Einhorn had had enough and wrote to his investors:
"Shortly after [our] purchase, the value of the Chinese assets came into doubt as the CEO of the Chinese unit hived-off a valuable subsidiary into a corporation that he personally controls. From there, the finger pointing started going in every direction. This wasn't what we signed up for. We exited with a modest loss."
The pain for Yahoo! shareholders didn't end until Aug. 8, when the stock bottomed out at $11.09 with 60 million shares trading that day.
Coincidentally, that date was the first day that Dan Loeb bought 2.5 million shares of Yahoo! for his Third Point hedge fund. He continued buying for the next month until he became the company's third largest investor owning over 5% of the company.
Dan disclosed his 5% activist stake in the company two weeks ago and wrote to the board of Yahoo! then that:
"We firmly believe that there is much to be gained from a successful and rapid transition in management, as we are convinced that Yahoo is grossly undervalued. We have followed Yahoo for many years, and our analysis suggests that at a share price of $13.61, with $2.49 per share in tax adjusted net cash, $3.10 per share and $5.24 per share of after-tax values for the Yahoo! Japan and Alibaba Group stakes respectively, core Yahoo is left at an implied value of $2.78 per share or 2.2x 2012 EBITDA.
"With more effective and focused management, one could realistically envision a re-rating to at least 7.0x 2012 EBITDA, driving a target of over $19.00 per share. When coupled with tax efficient outcomes for its Asian assets, an additional $3.00-4.00 per share stands to be realized. Continued share count reduction via buybacks and other potential capital structure optimization alternatives would further bolster the Company's stock price.

" In addition, based on our discussions with industry experts and entrepreneurs, we believe that with new management, there is significant further value in leveraging Yahoo's globally trusted franchise and platform for a range of new products and innovations.

"Focusing specifically on the Alibaba Group, the mid-term value potential for this stake alone could represent another $5.00 per share of upside. The e-commerce interests housed under the Alibaba Group umbrella hold the dominant positions in the "B2B" (63% of 2010 market share according to Marbridge Consulting), "C2C" (85% share) and "B2C" (51% share) Chinese e-commerce markets. Alibaba Group's Taobao business is essentially Ebay and Amazon on steroids in terms of market share and revenue growth.
"According to Goldman Sachs, the Chinese e-commerce market was $75 billion in 2010, with a 3-year forward compound annual growth rate of 43% compared to the $193 billion U.S. market with compound annual growth of 14% over the same period. We currently estimate a pre-tax value for Alibaba Group of $25 billion. Given Alibaba Group's growth potential and market share, it is entirely conceivable that Yahoo's 40% fully diluted stake in Alibaba Group could double in value over the next 2-3 years, highlighting its tremendous value."
With certain value-enhancing steps, in other words, Loeb sees a company worth $28 a share. And I think he's being conservative when he says Alibaba Group would be worth $25 billion today. More realistically, it would be worth between $40 billion to $60 billion today -- depending how frothy the market was at the time.
So how can you have two equally smart and capable hedge fund managers come to such different conclusions about the same company?
You can see both have the same basic assumptions for the tangible part of the business. It's just that Einhorn assumed Alibaba Group was worth zero after the Alipay fiasco (or at least the risk attached to that asset was too high for him to keep holding). On the other hand, Loeb saw Alibaba Group as worth $25 billion. He also indicated that the relationship between Yahoo! and Alibaba Group could be saved (after getting rid of most of the Yahoo! board).

In fact, at a conference last week in New York in response to a question from Lee Cooperman (who also owned Yahoo! earlier this year), Loeb hinted that he'd personally been in touch with Jack Ma and something was in the works with him making a play for Yahoo! or its Alibaba Group stake.

I think the bottom line here -- and it's my educated guess -- is that Einhorn had done less research on Yahoo! than Loeb and just could handle the idea of looking like a fool in front of his investors if Ma did something crazy or Yahoo!'s board did something dumb.
Einhorn isn't alone in that view. On Aug. 8 -- the same day Loeb was jumping on Yahoo!'s stock at 52 week lows -- I met with 3 large investors in New York who were looking at Yahoo! All three wouldn't touch the stock, despite my strong urgings to the contrary.
They all talked about Ma as a loose cannon and how they'd look terrible in front of their investors if he screwed things up.
When I argued why I believed he wouldn't, one investor barked back: "Yeah but that's just your opinion. I need assurances. We can't put a billion to work on this with an opinion backing it up."
Loeb did.
Look, I don't begrudge Einhorn or others who passed on Yahoo! because of either strong risk management hurdles or insufficient comfort based on their research to date. Every firm has to know when they'll take a pass on something.
However, it was that hesitation on the part of others which was Loeb's (and other longs') opportunity. The difference between the potential return and the potential risk was -- in his view -- much more highly skewed to the upside than the downside.
The bottom line is that you cannot just follow so-called "whales" and how they trade a stock. Do your own due diligence. Form your own opinions. Invest accordingly.
[Jackson was long YHOO at time of publication]

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