Why I Don’t Imitate Dan Loeb’s Yahoo Bet

Hedge Fund News: Dan Loeb, Phil Falcone, CitigroupYahoo (NASDAQ: YHOO) was one of the pioneers of the internet, providing some of the first hosting services for the everyday user in the United States, Europe, and elsewhere. That said, its market capitalization has essentially remained unchanged from its market cap in 1999, which was around $20 billion. Its share price has been static since the high-tide of the recession in early 2008, not venturing outside of the $10 to $20 range.

What is the story behind Yahoo’s lack of momentum, and will it end any time soon? To my eyes, Yahoo is a project stock—it is well-positioned but needs lots of work. That said, I await management guidance (and substantive action) regarding the forward mission of Yahoo and its company goals before I would invest in Yahoo.

Valuation and Earnings

Yahoo’s present price of around $15.50 is slightly less than its 52-week high of about $16. Yahoo maintains a relatively normal fundamental valuation. Its forward P/E is 16, which is greater than the broader S&P Internet Technology index value of about 12. Google (NASDAQ: GOOG) has a forward P/E in this range. This might suggest a flimsy valuation for Yahoo, but its former CEO Scott Thompson and present interim Ross Levinsohn have begun to recognize what the company has to do in order to rebuild its business. Earnings for the first quarter 2012 were 28% higher year-over-year for the company. If this pattern of earnings growth continues, the company’s shares might find added momentum.

The price/tangible book value of Yahoo is 2.2, whereas it is 3.5 for Google. From this, one can see that Google’s “goodwill” value factors strongly into its share price—accounting for its patents and its general grip on the market—giving Google shares a special boost in comparison to Yahoo. This is the X-factor that Yahoo is missing at the moment. Intangible assets drive the internet’s superstars—and decreases in them can shoot internet companies out of the sky. AOL’s (NYSE: AOL) market capitalization plummeted to $20 billion from $220 billion after a large goodwill write-off following its report in 2002 that it had lost $99 billion over the previous fiscal year.

Don’t Mind the Past

At base, Yahoo is trying to work past a failed vision of what the internet would become. Gone are the days of GeoCities, where users could create their own customized web page, and the days of one-stop-shop content aggregators for news, finance, sports, email, and the like. The vision of the internet that succeeded was not the “home-base” model that AOL and Yahoo provided, but the “show me the world model” to which Google search dedicated itself. The former model involves a massive amount of original content produced by a single website; the latter model involves no original content but allows users complete control in accessing and structuring the third-party content that is available. Today, our first inclination when we’re on the internet is to “Google it,” not to “find it on Yahoo.”

Yahoo makes a large portion of its profits on advertisements. These advertisements are displayed both next to its dedicated search engine, Yahoo Mail, and display pages on Yahoo Sports, Yahoo Finance, and Yahoo News.  Since 2008, the total amount of Yahoo users has grown from 550 million to 670 million. In 2011, revenue per 1,000 page views was $1.50, and I expect the number to rise to around $1.60 in 2012. Google and Facebook (NASDAQ: FB) are the primary competitors in the per-click advertising market.

Rethinking Advertisement Strategies

Since we have seen no indication from management that it wishes to alter the basic format of the company’s business, Yahoo needs to create a unique online environment that offers a dynamic service or interface to its users. Has Yahoo made strides in the area yet? A failed forced takeover by Microsoft (NASDAQ: MSFT) in 2008 led to a more minimal arrangement with Yahoo over internet search features. Microsoft’s Bing search algorithm is now being used to power Yahoo’s search engine. In 2008, Yahoo Search maintained an 11% market share—the same year in which Yahoo demanded an outlandish $38 per share from Microsoft to acquire the company. Now, Yahoo Search maintains a meager 6.5% market share, and a much-decreased share price. For Yahoo’s business to succeed, it needs to see success on its search engine, and I am pessimistic that present strategies alone will even allow the company to maintain its present market share.

In another sense, Yahoo is actually well-positioned—with proper future management—to make a second run in the online world. The company has the third-largest online presence in the United States, still boasting over 170 million unique visitors every month. Furthermore, the company maintains a 35% stake in Yahoo Japan, which has an estimated value of $8 billion. Yahoo also holds significant stake in Alibaba Group that, among other businesses, supports TaoBao and AliPay—both of which are similar to eBay and PayPal, respectively. Recently, Yahoo sold half of its share of Alibaba for $7 billion, and most of the proceeds are expected to go to investors. AOL has made similar moves, selling unprofitable holdings in France and Germany, as well as the messaging service ICQ.

Much of the future lies in partnerships. Yahoo has recently partnered with CNBC to broadcast high-quality, comprehensive business news to its collection of media. As mentioned, Yahoo’s search partner is Microsoft. AOL has taken part in a search partnership with Google. Yahoo and AOL are very much the “small pawns” to the Microsoft and Google macro strategy, but both companies stand to gain from what is perhaps their only opportunity to meaningfully up their search advertisement revenues.

It’s The Content, Stupid

As far as I can tell (and who really can?), Yahoo is still banking on the remnant population of users who want their internet content, email, and search all under one roof. In the end, Yahoo will live and die by its content, assuming no change in its overall strategy. In this sense, it shares interesting qualities with Facebook. Both companies underwent surges in their share price—during the late 1990s for Yahoo, from 2009 to 2012 for Facebook, as recorded on SecondMarket.com (a forum for venture capital investment). Both companies gobbled up no-name smaller entities along the way, with limited added value from these acquisitions (remember Facebook’s acquisition of Drop.IO? Share Grove? Probably not.). Some have argued that this amounts to a commonality between Facebook and Yahoo, further noting that Facebook will experience its plummet as well.

But not so fast. Facebook has 900 million regular  users. And there are reasons to expect that they will stay put. First, Facebook’s content is partially user-generated based on specially designed strictures such as the “like button” and the “sharing” feature. Users can be very creative in their posts, or they can be completely passive. What is critical, though, is that many view Facebook as an extension of their overall social presence. This is what Yahoo’s GeoCities was supposed to be but never was. Facebook’s content is truly unique—personal posts are not available elsewhere. Until Yahoo supports dynamite content that is uniquely interactive, it is hard for me to see the point behind an investment in Yahoo. The recent trickle of partnerships, though a helpful and welcome addition to Yahoo’s universe, will not aid a business that is completely lacking in creative vision—vision that is not lacking in other internet companies eager to acquire Yahoo. That’s why I don’t imitate Dan Loeb’s Yahoo bet.