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Did Microsoft 'Massively Undervalue' Yahoo?

by: Victor Cook February 11, 2008 | about stocks: MSFT / YHOO    

Victor Cook

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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-Yahoo Deal: A Question of S&M Synergy, published last week, investigated Microsoft’s (MSFT) financial dilemma. Compared with Google (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! (YHOO) 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?

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This article has 6 comments:

  •  
    Feb 11 06:29 AM
    When perceived value far exceeds realized value the risk increases significantly. In order for anyone to achieve a 10% return on the current 44B bid, Yahoo earnings would need a 6x increase or at 78B a 10x. Of course this is tech where realized value doesn't count for much. By the way Yahoo's actual return for the year was around 6% on 12B of assets.
    Reply
  •  
    Feb 11 08:14 AM
    The problem for Yahoo is that it is teetering on the edge right now. It's value as an ad network is slipping as both the number of advertiers and number of affilliates is in decline. This is a death spiral and stopping it can be almost impossible if it gathers momentum. If they want to stay in the game, and away from MSFT, they will have to make a deal with either AOL or Google. Neither option is attractive. Google would be the better option but this is directly opposite to what they have been trying to do for the past year and Google's terms would essentially take them out of the network business anyway, leaving them with the display business, which they abandoned when the let Wenda Millard and Greg Coleman go last year
    Reply
  •  
    Feb 11 08:15 AM
    The problem for Yahoo is that it is teetering on the edge right now. It's value as an ad network is slipping as both the number of advertiers and number of affilliates is in decline. This is a death spiral and stopping it can be almost impossible if it gathers momentum. If they want to stay in the game, and away from MSFT, they will have to make a deal with either AOL or Google. Neither option is attractive. Google would be the better option but this is directly opposite to what they have been trying to do for the past year and Google's terms would essentially take them out of the network business anyway, leaving them with the display business, which they abandoned when the let Wenda Millard and Greg Coleman go last year
    Reply
  •  
    Feb 11 08:15 AM
    The problem for Yahoo is that it is teetering on the edge right now. It's value as an ad network is slipping as both the number of advertiers and number of affilliates is in decline. This is a death spiral and stopping it can be almost impossible if it gathers momentum. If they want to stay in the game, and away from MSFT, they will have to make a deal with either AOL or Google. Neither option is attractive. Google would be the better option but this is directly opposite to what they have been trying to do for the past year and Google's terms would essentially take them out of the network business anyway, leaving them with the display business, which they abandoned when the let Wenda Millard and Greg Coleman go last year
    Reply
  •  
    Feb 16 03:43 PM
    User 127562,

    Those required multiples will depend in large part on how investors perceived the future value of Yahoo! cashflows given on the strategic direction management took to achieve optimal earnings. Will they not?

    ~V
    Reply
  •  
    Feb 16 03:53 PM
    Ted,

    Thanks for your comment. I agree Yahoo! appears to have limited options, most of which are unattractive.

    Tomorrow evening I'll post an article, "Yahoo's Audacious Option!," which proposes taking the company on a different path to its future. I’d like to get your comments on that story before I post it. If you’re interested please send an email address to me. Thanks

    ~V
    Reply
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