Yahoo!'s Core Question

 | Mar 22, 2014 | 6:00 PM EDT  | Comments
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With news last weekend that Chinese Internet powerhouse Alibaba Group is kicking off the process to go public in the U.S., immediate attention has turned to Yahoo! (YHOO) because of the Internet company's 24% stake in Alibaba.

There was an immediate uptick in Yahoo's stock at the beginning of the week to reflect investors' optimism of a future payout to Yahoo! from the IPO-induced liquidity in Alibaba's shares. However, Yahoo! shares are still too cheap -- and it seems to be because investors are fretting about how CEO Marissa Mayer will spend her soon-to-be-realized Alibaba riches. Let's go over the numbers on why this is so.

At present, Yahoo! has a market capitalization of about $38.4 billion.

It also has the aforementioned 24% stake in Alibaba. Most people are assuming that Alibaba will go public at a value of $100 billion to $140 billion. If so, Yahoo!'s Alibaba stake is worth almost $34 billion (at a $140 billion valuation). But that's pre-tax. Most sell-side analysts discount that number by the taxes Yahoo will have to pay on it. Assuming 38%, that takes you down to a stake worth $21 billion.

Then, Yahoo also owns 35% of Yahoo! Japan. It's currently worth more than $11 billion. But take the taxes out and, again, you're down to $7 billion.

Plus, Yahoo! has about $5 billion in cash. Once Alibaba shares debut, Yahoo!'s 24% stake will drop to 12%. So half of its $21 billion stake will become cash. So, the $5 billion cash pile will grow to about $15 billion. Add up the cash and the two investments and you get a value of $33 billion. This suggests that investors place a value on Yahoo's core business of a little more than $4 billion.

That's surprisingly low given that Yahoo's core -- for all its recent struggles to get its top-line growing again -- still throws off $1.5 billion a year in earnings before interest, taxes, depreciation and amortization. That means investors are valuing the core at 3x EBITDA. Right now, though, investors place a 7.6x enterprise value to EBITDA valuation on AOL (AOL). And eBay (EBAY), with all its problems with growth, gets a generous 14x EV/EBITDA valuation. Barry Diller's IAC/InterActiveCorp (IACI) gets 11x EV/EBITDA.

And, according to a recent Reuters report, some "gray market" trades in Alibaba on the private market were placed at $255 billion. If so, Yahoo!'s after-tax stake in Alibaba is worth $38 billion -- the entire market cap of all of Yahoo!.

Why are investors valuing Yahoo!'s core business so low relative to Barry Diller's IACI, AOL's Tim Armstrong, and eBay's John Donahoe (who, ironically, is engaged in a proxy fight with Carl Icahn for not creating enough value)? I believe it comes down to a fear of Marissa Mayer's M&A plans for her $15 billion cash pile.

So far, the jury is still out on Yahoo!'s $1 billion acquisition of social-media site Tumblr last year. I believe it will prove to be a wise move in the long run. However, I believe many still question that move and essentially treat it like a wasted billion dollars. It seems to me that most people believe Mayer will start spending billions on Pinterest.com or other companies that won't pay off.

But if she is able to show investors that she'll spend a lot of the incoming cash on share buybacks as well as smart acquisitions (which surely are coming), investors will be forced to re-value Yahoo!'s core to a higher multiple. At present, it's just too cheap.

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