TheStreet.com: Activist Investor: Yahoo! Mustn't Fumble Asian Assets

By Eric Jackson
08/21/08 - 12:19 PM EDT
from TheStreet.com

What will Yahoo!(YHOO - Cramer's Take - Stockpickr) and its board do next to try to win back its shareholders' support?

It's highly likely they will seek to appease disgruntled shareholders by unlocking value in their collection of Asian assets, which currently make up 35% of the value in Yahoo!'s $20-a-share valuation. But Yahoo! shareholders need to be vigilant as to how this is done, especially with regard to the nonpublic entities Taobao.com and AliPay.com (the eBay (EBAY - Cramer's Take - Stockpickr) and PayPal of China, respectively).

It's been a difficult seven months for Yahoo! shareholders, who saw their shares increase in value to $30 from $19, only to drop back to pre-Microsoft (MSFT - Cramer's Take - Stockpickr) bid levels. At the shareholder meeting earlier this month, Yahoo!'s board strongly defended itself, saying it had done everything possible to achieve a deal with Microsoft. It also laid out the case for why its go-it-alone strategy would succeed and why Yahoo! still has an enviable array of assets that neither Microsoft nor anyone else can replicate anytime soon.

Yahoo! does have great assets -- that's why I first invested in the company two years ago. However, the company's board is weak, and it has exerted poor oversight while approving lavish pay to its executives and board members. Even with Carl Icahn and his colleagues Frank Biondi and Gary Chapple joining the board, this is still largely the board that former CEO Terry Semel assembled five years ago. A board that continues to be weak has the potential to continue to make poor decisions on behalf of its shareholders. That might happen sooner rather than later.

I attended Yahoo!'s most recent shareholder meeting and asked about several governance-related incidents over the last year that I felt weren't in shareholders' best interest. For example, Yahoo! decided last August to sell its $400 million-a-year Overture Japan business to Yahoo! Japan (which was essentially a sale to Softbank, the other owner of Yahoo! Japan) for $13 million. That's a far cry from the three to five times multiple of annual revenue Yahoo! typically has paid for venture capital-backed companies such as Zimbra, Rivals and Right Media.
Such a deal seems to have greatly benefited Softbank at the expense of Yahoo!'s shareholders. (And Yahoo! hasn't offered me a detailed explanation, if there is one.) Right or wrong, this appeared to be a sweetheart deal. If this is how Yahoo! operates, it's not unreasonable to believe the company could do the same thing with its Chinese partner Alibaba.com.

Chief Financial Officer Blake Jorgensen said during the shareholder meeting that Yahoo!'s collection of Asian assets (from its stake in Yahoo! Japan, Alibaba in China, and GmarketGMKT in Korea) are worth about $7 a share to Yahoo! shareholders at today's market prices. However, as Jorgensen noted, Yahoo! maintains significant ownership (through its Alibaba stake) in two significant private Chinese companies: Taobao.com and AliPay.com.

Both Chinese companies have great potential. They already are the clear leaders in their verticals in China. (eBay just retreated from the Chinese market because of its inability to compete.) Taobao.com and AliPay.com also have chosen deliberately to grab market share in the past few years by not charging users' fees. As you can imagine, such pricing has helped their user base explode. The costs for both companies are very low and they both know they can turn the meter on at any time with a very large payback.

And so here's the governance issue: How should these assets be valued if Yahoo! wants to extract value from its stake in these private companies? If you valued them today, there is no revenue and the earnings are negative. But in two years, when each company turns its meters on and begins to generate hundreds of millions of dollars, the companies will be much more valuable.

There are two ways Yahoo! could extract value from Taobao.com and AliPay.com: Agree to a management buyout with each company's management -- most likely the management of Alibaba -- or spin off these assets to Yahoo! shareholders with the stakes in the other Asian assets.

A management buyout would be another partner-friendly sweetheart deal that would greatly enrich Alibaba insiders at the expense of Yahoo! shareholders. Therefore, a spinoff is the right thing for Yahoo! shareholders. In a spinoff, even if the shares are valued low today relative to what they will be in a few years after the private entities start charging fees, Yahoo! shareholders can decide whether to hang on to their stakes.

The management buyout approach gives Alibaba full ownership of a growing asset at a significant discount to its true inherent value. Alibaba or the management teams would gain full control of these private assets at today's artificially low prices, knowing full well they are buying an asset that will be worth three to six times as much in a very short time. There's no market risk to them achieving a higher market valuation. All they have to do is flip the switch and start charging their loyal users a small fee. I would take on that kind of risk any day.

In the case of the Yahoo!-Overture Japan deal, shareholders found out about it after the fact. It was barely mentioned in an analyst call and buried in the back of a Securities and Exchange Commission filing. Yahoo! shareholders didn't have the good fortune of a large shareholder like Capital Research calling on the company to explain itself as they did earlier this month when Capital Research brought to light the significant underreporting of shareholder discontent with the current Yahoo! board. Therefore, all Yahoo! shareholders need to pay close attention now to how Yahoo! unlocks value with its Asian assets.

Softbank got a great deal for Overture Japan. Alibaba shouldn't get a great deal for Taobao.com and AliPay.com. Yahoo! shareholders deserve to be treated fairly.

At the time of publication, Jackson was long YHOO.

Eric Jackson is founder and president of Ironfire Capital, LLC, and the general partner and investment manager of Ironfire Capital US Fund LP and Ironfire Capital International Fund, Ltd.

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Yahoo!'s Q3 Recap: No Light Really Shed on Overture Japan Sale

Congrats to Jerry Yang, Sue Decker, and Blake Jorgensen (and the rest of the Yahoo!s) for a good Q3 announced Tuesday. Yahoo! shareholders and employees alike finally feel some wind at their backs.

Yahoo! under-promised and over-delivered to the excitement of investors in the after-market which carried through Wednesday's trading. Smartly, management looks to continue this approach in Q4 by keeping their heads low and their guidance lower.

The disappointment amid the good news was net income dropping -- specifically in affiliate revenues and in international. This is troubling when the company stepped on the gas in hiring in the quarter. That's something that definitely needs to be addressed this quarter. Further streamlining the middle-upper management would be a wise place to start, as well as in cuts for Southern California.

I was hoping for greater clarity from Blake Jorgensen on the deal which closed in the quarter whereby Yahoo! sold a $395 million a year business (or at least its sales and marketing operations, if not the de facto business) in Overture Japan to Yahoo! Japan (of which they are a 34% JV partner) for $13 million -- a "very nominal" amount to quote Jorgensen's Q2 call comments.

Here were Blake's relevant comments from Tuesday's earnings call on this topic:

...[L]et me provide additional color on the impact of the Overture Japan transaction. We believe that by enabling the Yahoo! Japan sales team to present a unified offering to customers, this deal will be a significant positive to both parties in the long term. As we discussed last quarter, this transition will reduce our reported GAAP revenue and TAC in Q4 and into 2008, resulting in a modest net decrease in revenue ex-TAC.

Yahoo! Japan will pay us a service fee for providing search advertising and support services, and we expect this transaction to be slightly positive in OCF in the short term compared to our previous affiliate arrangement with Yahoo! Japan. As we mentioned in July, we received a small upfront payment and we believe that the majority of the value of this deal will be realized via our long-term relationship with Yahoo! Japan.

It's not clear to me how the transaction allows for a presentation of a more unified offering to Japanese customers than a joint sales call with someone from Yahoo! Japan and someone from Yahoo! (Overture Japan). At the end of the day, the customer was dealing with Yahoo! Japan, not Google or Microsoft, for a discussion of how they could be best served by Yahoo! Japan.

As there will a "modest net decrease in revenue ex-TAC" through at least 2008, why did Yahoo! do this deal? Jorgensen offers two reasons in his next paragraph:

1. Slightly positive OCF in the short-term, presumably through the new "service fee" paid by Yahoo! Japan to Yahoo! Yet, it's not clear how this new service fee operates and how "slightly positive" the impact on cash flow will be.

2. The assurance of a continued, longer-term relationship with Yahoo! Japan. The implication of this benefit is that the relationship conceivably could have ended. I suppose the doomsday scenario is that you would have been searching for sushi in Tokyo through Yahoo! Japan with results delivered to you by Ask's algorithm. It's hard to imagine that Yahoo! would have let itself get into such a weak negotiating position to allow that scenario.

Unfortunately, none of the Wall Street analysts chose to ask about this during the Q&A session following the prepared remarks. Therefore, Yahoo! shareholders are still left wanting a more complete explanation.

Henry Blodget was curious why international revenue growth in the quarter decelerated from 15% to 9%. Here is a hypothesis: a $395 million annual revenue business (Overture Japan) that was sold off on August 31st wasn't able to contribute $32.5 million to Yahoo!'s last month of Q3. With that extra $32.5 million, Yahoo!'s Q3 international revenue would have been $608.3 million -- or a 15% growth rate over the previous year's Q3.

On the one hand, that's some comfort to Yahoo! shareholders in guessing why the drop. However, it still doesn't help us better understand the rationale for the Overture Japan deal in the first place.

Let's hope we don't have to wait until shareholders can push aside the analysts to ask these questions for themselves at next year's Yahoo! Annual Meeting.

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Follow-Up on Yahoo! Japan Deal for Overture Japan

In posts earlier this week, I questioned why Yahoo! had sold Overture Japan to Yahoo! Japan for $13 million when that business was doing $395 in annual revenues.

One of the rationales for the deal, explained by Blake Jorgensen on the last earnings call, was that there would be better alignment of the sales teams by combining them.

One of the questions I raised was why -- when Yahoo! Japan and Overture Japan are in the same Minato City neighborhood in Tokyo. Yahoo! Japan office is in Roppongi Hills Mori Tower, 10-1, Roppongi 6-chome, Minato-ku, Tokyo and Overture Japan's office is in 4-3-1, Toranomon, Minato-ku, Tokyo.

A colleague of mine in Tokyo confirmed the proximity of these offices:

"Roppongi and Toranomon are very close. It will take 6 minutes train and 3 to 8 minutes walk."

So, this move would be the equivalent of taking one team located in, say, Santa Clara and aligning them with another team in Sunnyvale. That would make sense if Yahoo! didn't already have expertise in working with teams spread around the state (between Burbank/Santa Monica and Sunnyvale), as well as around the world.

The point is that there must be something else much more significant behind doing this deal for Overture Japan now at this price. Shareholder will be looking for greater clarity on the next call in about a week.

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More Questions on "Sale" of Overture Japan KK to Yahoo! Japan

Last week, I published a post (in response to a suggestion from a Yahoo! "Plan B" supporter) focusing on the recent sale of Overture Japan KK by Yahoo! to Yahoo! Japan. I complained that the sale price of just over $13 million was way too low for a company that did $395 million last year.

I was contacted by Yahoo!'s Investor Relations (IR) team the next day. I signed an earlier NDA with Yahoo! (due to previous discussions I've had with them this year) which prevents me from disclosing information they reveal to me which isn't public. Therefore, I want to respect that, but I did speak with them yesterday and had an opportunity to further press my case that they share more information to shareholders. They attempted to better explain the deal to me. Obviously, they believe this is a good deal for shareholders and they made their case for it. However, I -- and shareholders -- need more information from the company before coming to a conclusion.

So I call upon Yahoo! to share more information on this deal publicly -- even before the Q3 earnings call -- so that all shareholders can review it. The way this transaction has happened -- with only a release to date from Yahoo! Japan and no public comment from Yahoo! since then -- creates questions in the minds of shareholders that Yahoo! shouldn't allow to linger.

There was nothing in Yahoo!'s last 10-Q on the Overture Japan sale because the deal hadn't closed yet. The only public comments to date on this subject came from Blake Jorgensen during the last earning call. Here is a summary of those comments:

Let me spend a moment on our pending deal with Yahoo! Japan. We've been working towards transferring ownership of the sales operations of Overture KK in Japan to Yahoo! Japan. We're excited about this transaction because it should allow us better alignment of search and display advertising sales in Japan, making the business more competitive and essentially securing a favorable and very long-term revenue stream to Yahoo!.

The terms are not yet final, but once the deal closes, you will see several changes in our financial statements. We will no longer pay TAC to Yahoo! Japan and they will instead pay us a service fee, which we expect will be included in our marketing services revenue. As a result of the transaction, our GAAP revenue is expected to be between $200 million and $250 million lower in the back half of 2007 and TAC will come down commensurately.

Revenue ex-TAC will decrease modestly under the new structure as the new service fees will largely offset the lost affiliate revenue. The impact to operating cash flow is expected to be broadly neutral near term, but accretive for both companies long term, versus our prior arrangement. The transaction is structured to deliver value through a long-term service fee arrangement with only a very nominal upfront payment to us.

So, given only these details of the transaction (which are here), my questions as a Yahoo! shareholder to Blake are as follows:

• Why did Yahoo! do this deal in the first place? How are Yahoo! shareholders better off today versus prior to August 31st (when the deal was announced)? Better "alignment" sounds great, but why can't you get people aligned when they work in very close proximity in the same Tokyo neighborhood? Yahoo! Japan office is in Roppongi Hills Mori Tower, 10-1, Roppongi 6-chome, Minato-ku, Tokyo and Overture Japan's office is in 4-3-1, Toranomon, Minato-ku, Tokyo (in other words, the same Minato neighborhood). Beyond alignment, and given that Yahoo! received the "very nominal" $13 million for Overture Japan and that Yahoo!'s go-forward "revenue ex-TAC will decrease under this new structure," why do this deal? How are Yahoo! shareholders better off?
• Was Yahoo! at Risk of Losing the Paid Search Business for Yahoo! Japan? The only reason I can imagine for doing this deal from the Yahoo! perspective is the risk that they might lose the "favorable and very long-term" business from Yahoo! Japan. However, if that's true, how could Yahoo! have let itself get into that position in the first place? It seems inconceivable that Yahoo! -- when it was first negotiating an agreement with Softbank 10 years ago to set up Yahoo! Japan -- would allow Softbank (or Yahoo! Japan) to turf out Yahoo! in the future in favor of using a competitor for some services. In Yahoo!'s defense, the company didn't compete with Google 10 years ago and didn't have any idea that paid search would be as big an area as it is. Perhaps it is possible that Yahoo! Japan had this "out card" and decided to play hardball with Yahoo! If this is true, it raises questions about how Overture Japan's relationship was set up in the first place with Yahoo! Japan after Yahoo! acquired Overture in 2003.
• Is there a difference between "transferring ownership of the sales operation of Overture Japan KK to Yahoo! Japan" and selling Overture Japan KK to Yahoo! Japan for US$13 million? Blake's language specifically doesn't state that this is a sale. However, if Yahoo! has transferred ownership of the sales operation to Yahoo! Japan, what's left of Overture Japan KK? Isn't this a de facto sale? If it is a sale, how does Yahoo! justify this "very nominal" sales price of $13 million for a $395 million a year business?
• How does this deal in and of itself create more cash-flow for Yahoo! and Yahoo! Japan in the long-term? The language above from Blake implies that Yahoo!'s near-term revenue ex-TAC will take a hit, although cash flow will be "broadly neutral." Yet, both companies are supposed to see the deal be long-term accretive for cash flow. This deal appears to be about moving around how revenue, costs, and marketing service fees are reported from an accounting perspective, but I haven't yet seen such a deal between two JV partners which in and of itself made more money (or cash flow) to be shared between the partners than what existed before the deal. If this is the case here, how does the deal create more cash flow for both long-term?
• How are Revenue and TAC calculated between Yahoo! and Yahoo! Japan? As of March 31st, 2007, Yahoo! Japan had a trailing 6 months of revenue of $945 million (or about $1.9 billion annualized). Yahoo! recognizes 34% of this revenue itself on a trailing basis (as per its ownership stake in Yahoo! Japan) -- or $642 million of the annualized amount. That's roughly 10% of Yahoo!'s overall annual revenues. Yahoo! Japan reports TAC of about 28% of its revenues of $529 million of the earlier annualized amount. More light needs to be shed on how these two companies calculate revenues and costs both ways through their JV and what is changing under this new agreement. Blake's comments suggest that Yahoo!'s revenues ex-TAC will decrease from this deal, but that Yahoo! Japan will increase its service fees to Yahoo! He also says that affiliate revenue to Yahoo! will decrease. Can we get some more details on how all of this will actually play out? Is Yahoo! Japan -- in addition to sharing 34% of its revenues with Yahoo! -- also paying Yahoo! a fee for use of Overture Japan, which is additional revenue to Yahoo!? If so, how significant is this to Yahoo!? Is this the revenue that will now become the "service fee" under this new agreement reported as "marketing services revenue" by Yahoo!? Until we really understand what is happening under the terms of the deal, it's difficult for a Yahoo! shareholder to judge the benefits or negatives of the deal.

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Did Softbank Get a Sweetheart Deal from Yahoo! for Overture Japan?

One of the supporters of our "Plan B" for Yahoo! Group, David Sollers, recently contacted me to share some analysis on the recent sale by Yahoo! to Yahoo! Japan of Overture Japan. The whole issue of this sale has been ignored by analysts and the press. I would hope that Sue Decker and Blake Jorgensen would address this issue and clarify it in a few weeks on the Q3 earnings call. I'm sharing with the larger "Breakout Performance" community...

On August 31, Overture Japan was sold to Yahoo! Japan (a joint venture between Yahoo! Inc and Softbank Corporation of Japan - Y! Inc has 34% stake in Yahoo Japan).

While there was no information at all anywhere on Yahoo!'s site (it should have been on the Press Room section of the corporate site), it was something that Yahoo! Japan made a big deal out of in the Japanese language press.

Even the English version of Yahoo! Japan's investor relations press releases site includes this announcement (pdf document): http://ir.yahoo.co.jp/en/release/20070831/ . In that PDF document, the terms of the sale are detailed.

Now, while I was against the sale of Overture Japan to Yahoo! Japan on principle (because it is a large market - second only to the US - where Yahoo!/Overture still has a larger market share than Google in paid search), the ridiculously low share price is something that all YHOO shareholders should be upset about.

According that press release, Overture Japan, which had revenues of JPY 45.767 billion (US$ 395 million), was sold for JPY 1.557 billion (US$ 13.426 million). That is a price-to-sales ratio of 0.034 for a profitable company with great sales growth (2005 and 2006 figures for Overture are detailed in the press release - and while net income decreased from 2005 to 2006, that can only be due to one-time charges and/or expenses which are not like to re-occur in 2007, most probably investement in hardware needed for the launch of Panama).

When was the last time you heard of a profitable company being sold off for a small fraction of its annual revenues? That price-to-sales ratio is so low that someone at Y! Inc ought to be fired. At least that is my reaction, and I would expect other shareholders to be similarly outraged.

If Y! Inc valued itself that this price-to-sales ratio (instead of the 5.3 at which it is currently valued), they'd be selling a share of YHOO for less than 20 cents per share!

Why was Overture Japan sold at this kind of "fire sale" price? Y! Inc definitely cannot be that badly in need of cash.

Let's take a look at some of Y! Inc's recent acquisitions:

• Blue Lithium: Y! Inc paid $300 million for this company which is estimated to have annual revenues of roughly $100 million (source: http://money.cnn.com/2006/09/15/technology/disruptors_bluelithium.biz2/index.htm ). That a price-to-sales ratio of 3. Ok, reasonable.
• Zimbra: Y! Inc paid $350 million for this company which is estimated to have annual revenue of $6 million (source: http://www.news.com/8301-10784_3-9780434-7.html?part=rss&subj=news&tag=2547-1_3-0-5 ). That values the company at price-to-sales ratio of 58.3, so Y! Inc must have some pretty rosy expectations about the growth that Zimbra will see over the next couple of years.
• Overture (now Yahoo! Search Marketing) was bought by Y! Inc for $1.6 billion in cash and stock in October 2003 (here's a press release from Y! Inc's Press Room: http://yhoo.client.shareholder.com/press/releasedetail.cfm?ReleaseID=119517 ). For that year Overture was expected to have revenue of $1 billion (as Overture became a fully owned subsidiary of Y! Inc, separate figures for Overture were not filed). This valued Overture at price-to-sales ratio of 1.6.

So by measure of these acquisitions, Y! Inc did indeed sell Overture for a price that was way way way to low. If we value Overture Japan at the same price-to-sales ratio that Y! Inc paid for Overture just four years ago (which is probably a reasonable valuation), we arrive at a sale price of $631 million.

So Y! Inc has sold off a profitable subsidiary for $13.4 million, when the price should have been in the range of $500 million to $1 billion.

Shareholders want to know why Masayoshi Son of Softbank received such a good price for such a valuable ad engine?

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