Why Starboard believes Yahoo! is “deeply undervalued”

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Need to monetize non-core equity investments

Yahoo! Inc. (YHOO) shares jumped at the end of last month after activist fund Starboard Value disclosed its stake in the Internet company and urged it to combine its businesses with that of online portal AOL, Inc. (AOL). In a letter to Yahoo’s management and board, Starboard highlighted several proposals. The first of these was the “monetization of Yahoo’s non-core minority equity investments in a tax-efficient manner.” The fund hinted at a potential separation of Yahoo core and non-core businesses to unlock value.

Yahoo break up

Yahoo’s core and non-core businesses

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Jeffrey Smith’s activist fund said in its letter that ” Yahoo is deeply undervalued relative to the sum of its parts.” The letter added that Yahoo’s main assets include its core and non-core businesses. Its core businesses are search and display advertising. Its non-core businesses include a 15% stake in China-based e-commerce company, Alibaba Group Holding Ltd. (BABA), and a non-core 35.5% stake in Internet advertising company, Yahoo! Japan.

Yahoo sold close to 122 million shares of Alibaba during the latter’s IPO (initial public offering) last month, and received an after-tax windfall of $5.1 billion. As reported by Market Realist last month, Alibaba’s IPO saw an overwhelming response and the stock ended its first day of trading at $93.89—up 38% from the $68 initial price set by the company.

Yahoo currently owns 384 million shares, or about a 15% stake in Alibaba, and can only sell these shares after a one year lock-up period. Cantor Fitzgerald analysts, cited by a Wall Street Journal report, noted in July that the remaining shares in Alibaba are held in Hong Kong, where capital gains taxes are not applicable on share sales. So, Yahoo could sell these shares tax free and hold the cash overseas, or use it for a foreign acquisition.

Starboard believes Asian investments need to be “monetized in a tax efficient manner”

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Starboard believes a “substantial valuation gap” exists. Investors expect Yahoo’s management to continue to monetize the company’s investments in Alibaba and Yahoo! Japan in a “tax inefficient manner.” The fund believes the valuation gap can be closed if these investments are “monetized in a tax efficient manner and Yahoo’s aggressive acquisition strategy is halted.”

A tax-efficient separation will add $16 billion in value

The fund noted in its letter that Yahoo’s non-core stakes in Alibaba and Yahoo! Japan are worth approximately $11 billion, or $11 per share more than the current $37 billion enterprise value of Yahoo. It said that Yahoo’s core business is “valuable,” but the fund expects it to “trade at the low end of industry multiples” due to “operational challenges.”

Yahoo is facing intense competition in its core business from Google (GOOGL), Microsoft (MSFT), and Facebook (FB). In its analysis, the fund compared Yahoo to its advertising peers and took a conservative multiple of 5.5x EBITDA, which it said represents approximately a 10% free cash flow yield. According to Starboard’s analysis, outlined in the above table, a tax-efficient separation will create $16 billion in value, or $16 per Yahoo share.

Although Starboard only said that it has analyzed alternative structures for Yahoo, unconfirmed reports noted that the fund is expected to push for a breakup of Yahoo. A Bloomberg report said Starboard will push to create a holding company for Yahoo’s non-core Asian investments, and propose a spin off its core business operations. For the full story, read Yahoo Activist Starboard Said to Urge Breakup First, Sale Second.

Recently, Hewlett-Packard Company announced a breakup. Meanwhile, eBay Inc said it’s spinning off its PayPal unit. For more analysis, read Market Realist’s Must-know: HP spins off to form two new companies.

The next part of this series will look at why Starboard believes Yahoo needs to put a break on its “aggressive acquisition strategy.”

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