Yahoo is Massively Undervalued

Early Sunday morning February 10, 2008 Matthew Karnitschnig reported in his Wall Street Journal article that:

Yahoo Inc.'s board plans to reject Microsoft Corp.'s unsolicited $44.6 billion offer to acquire the Web giant, a person familiar with the situation says.

After a series of meetings over the past week, Yahoo's board determined that the $31 per share offer "massively undervalues" Yahoo, the person said.

The article goes on to say that “The company is unlikely to consider any offer below $40 per share …”

SOME BACKGROUND
This is my second post on the Microsoft-Yahoo! deal. The first Microsoft: Why Shell Out $45 Billion? published last week, investigated Microsoft’s financial dilemma. Compared with Google (NasdaqGS: GOOG) I found that Microsoft was overspending on Selling & Marketing in accordance with Gerstner’s Rule in High-Tech Industries: the cost per dollar [CPD] of revenues. I concluded that:

Like Eddie Foy, Jr. sang in the 1954 hit Broadway play The Pajama Game, 11¢ doesn't buy a hell of a lot ... till you multiple it by MSFT’s nearly $58 billion 2007 revenues. That produces an eye-popping net competitive redundancy of $6.367 billion … all of which is associated with MSFT’s Selling & Marketing expenses.

This post looks at the proposed deal from the perspective of the Yahoo! board using a sharper measure of enterprise marketing performance from Chapter 6 “The Rule of Maximum Earnings” of my book Competing for Customers and Capital.

YAHOO! FUNDAMENTALS
This analysis compares Yahoo’s actual to its optimal sales, expenses and earnings during the most recent four quarters. The actual values were taken from EDGAR Online I*Metrix reports. Optimal values were calculated from the financial accounting data. These theoretical values occur when a company optimizes expenses by earning exactly what it spent to produce its last dollar of revenue. The costs of producing revenues are described in my audio slide show “Enterprise Marketing Expenses.”

There’s a huge difference between enterprise Marketing, with a big M, and traditional marketing. In that audio slide show I define enterprise marketing expenses as …

… all the costs of the people and programs that influence how consumers, customers and investors think, act and feel about a company.

The following table reports Yahoo’s share of revenue, sales revenue, cost of revenue, enterprise marketing expenses, and earnings in a strategic group with Microsoft and Google. Yahoo! had not yet filed its December 2007 financial statements so its data are for the quarter ending September 2007.

Yahoo’s optimal share of group revenues was almost double its actual share: 16.5% compared with 8.4%. Optimal share would have translated into $13.4 billion in sales revenue compared with actual revenue of $6.8 billion.

Generating these additional sales would have required on the order of $2.7 billion in additional cost of revenue. In Yahoo’s 2006 financial statement, the management discussion said:

Cost of revenues consists of traffic acquisition costs and other expenses associated with the production and usage of the Yahoo! Properties, including amortization of acquired intellectual property rights and developed technology.
 
Traffic Acquisition Costs (“TAC”). TAC consists of payments made to affiliates who have integrated our search and/or display advertising offerings into their websites and payments made to companies that direct consumer and business traffic to the Yahoo! Properties (page 39).

This management discussion also reported the cost of revenues in 2006 was $2.676 billion. And TAC were $1.866 billion or 69.7% of revenue costs. This explains why Yahoo’s cost of revenue was more than twice those of Microsoft (20.0%). Unlike Microsoft, Yahoo! wholesales its solutions 70% of the time.

The values reported in this table assume the cost of revenue would continue to account for 41.3% of Yahoo’s nearly two-fold increase in revenues during the time it took to achieve this optimal level. In addition, to do this the company would have increased enterprise marketing expenses from $3.1 to $6.7 billion or about 115%.

MASSIVELY UNDERVALUED?
Optimal revenues of $13.4 billion would point to a market cap of around $78 billion based on a value/revenue ratio of 5.81.  With 1.39 billion shares outstanding this suggests a price in the mid $50 range. This strikes me as far enough above his offer of $31 a share to conclude that Mr. Ballmer did indeed "massively undervalue" Yahoo!. What do you think?

Thanks for visiting.

As always your comments are welcome.

~V

Comments

[Victor Cook]

Richard,

So maybe Microsoft did massively undervalue Yahoo! Thanks for the insights and the useful links.

~V

[Richard Lewis]

Victor, one large Yahoo investor, Legg Mason, which owns 80 million shares of the company--that comes to about 9 per cent Yahoo--said in a recent statement that MSFT should up its bid. The Legg Mason spokesman, Ben Miller, fund manager of Legg Mason Value Trust, cited reports (which he could not confirm) that MSFT and YHOO had been discussing a combination for well over a year. MSFT had been prepared to pay over $40 per share previously. One of my colleagues at ITT Technical Institute, where I teach, who has close ties to MSFT, characterized the MSFT offer as a "lowball."

Miller assessed the deal as a "strategic imperative" for MSFT. He put the fair value of YHOO as between $31 and $40. Miller went on to describe Yahoo as a “uniquely valuable asset.” His view, that Microsoft will “do what it takes to acquire it,” (Waters & Authers, February 12, 2008) fits with recent news reports that MSFT now plans a hostile bid for YHOO, going directly to the stockholders (Nuttall & Waters, February 10, 2008). This strategic imperative comes from what the Financial Times characterizes as MSFT’s “desperation” to reduce Google’s long and growing lead in Internet search and utilities (Lex, February 10, 2008). MSFT’s in-house strategy has failed, as your analysis has described. In such an instance, acquisition looms as a way to achieve competitive capability.

Nuttall, C., & Waters, R. (2008, February 10). Microsoft set to approach Yahoo shareholders. FT.com. Retrieved February 13, 2008, from http://www.ft.com/cms/s/8ca13fba-d80d-11dc-98f7-0000779fd2ac,dwp_uuid=e78ced54-d0bd-11dc-953a-0000779fd2ac.html

Waters, R., & Authers, J. (2008, February12). Yahoo investor warms to Microsoft’s advances. FT.com. Retrieved February 13, 2008, from http://www.ft.com/cms/s/42fb39d8-d9a2-11dc-bd4d-0000779fd2ac,dwp_uuid=e78ced54-d0bd-11dc-953a-0000779fd2ac.html

Lex. (2008, February 10). Yahoo’s last stand. Retrieved February 13, 2008, from http://www.ft.com/cms/s/1/a63ff48c-d80a-11dc-98f7-0000779fd2ac,dwp_uuid=e78ced54-d0bd-11dc-953a-0000779fd2ac.html

[cucu]

Since Microsoft intends to ask shareholders of YHOO if they want to sell for $31, then they should also ask shareholders of MSFT if they want to buy YHOO for $31.
As a MSFT shareholder, I would not approve the acquisition. YHOO's stock was 18$ before the offer. So, if YHOO didn't want to sell for $31, then, OK, next offer is $25. Regarding the calculations above, I think they are all wrong. Nobody would pay 50$ for a stock worth 18$.