Starboard Delivers Letter to Yahoo's CEO and Board of Directors

NEW YORK, March 9, 2015 /PRNewswire/ -- Starboard Value LP (together with its affiliates, "Starboard"), a significant shareholder of Yahoo! Inc. (NASDAQ: YHOO), today announced it has delivered a letter to Yahoo CEO Marissa Mayer and Yahoo's Board of Directors.

The full text of the letter follows:

March 9, 2015

Marissa A. Mayer, President and CEO
Yahoo! Inc.
701 First Avenue
Sunnyvale, California 94089

cc:        Board of Directors

Dear Marissa,

We are pleased that Yahoo! Inc. ("Yahoo" or the "Company") has announced its intention to execute a tax-free spin-off of its stake in Alibaba.  We believe that the separation of this valuable asset is a good first step towards creating significant value for the benefit of all Yahoo shareholders.  However, we continue to believe that there are other opportunities to create value, highlighted in our previous letters and communications with you, which management and the Board of Directors (the "Board") should also commit to execute.

Since Yahoo announced its intention to spin-off its stake in Alibaba, there has been substantial discussion and speculation in the investment community as to why Yahoo's stock price reaction to the announcement was so muted and why the stock continues to trade at such a deep discount to the sum-of-its-parts valuation.  Based on our discussions with members of the investment community including shareholders, research analysts, and industry executives, we strongly believe this discount has little to do with the probable success of the Alibaba spin-off and instead is directly related to substantial skepticism about management's and the Board's willingness to take aggressive action to improve the Core Search and Display Advertising Business ("Core Business"), and unlock value from Yahoo's remaining non-core assets.   

Yahoo's current valuation discrepancy cannot be solved just with the Alibaba spin-off.  Yahoo is in need of a major overhaul.  It is time for management and the Board to take a holistic view of the Company's challenges and opportunities, and develop a comprehensive plan to maximize shareholder value.  In the paragraphs below, we have outlined our updated views on (i) the current and future potential value of Yahoo; (ii) the performance of the Core Business; (iii) intellectual property and real estate; (iv) the Yahoo! Japan stake; and (v) capital allocation. 

The Current and Future Potential Value of Yahoo

We believe that Yahoo remains deeply undervalued and that the announcement of the spin-off of Yahoo's stake in Alibaba into a new entity ("Spinco") has made it an even more compelling investment opportunity.  The spin-off announcement has removed uncertainty on the path to realize the full value of Yahoo's Alibaba stake, and, once completed, will result in increased transparency to shareholders regarding all of Yahoo's remaining assets.  Based on our analysis, described in detail below, we believe Yahoo currently trades at a steep discount to the sum-of-its-parts valuation.  

Applying a 7% discount to Yahoo's Alibaba stake, which we believe is prudent based on our analysis of similarly structured holding companies that have traded over the last twenty years^[1], Yahoo's current share price implies that Yahoo pro-forma for the Alibaba stake spin-off ("Yahoo Stub") is currently valued at approximately $11.2 billion – a discount of 50% to our estimate of fair value (described below) for this group of assets which is comprised of net cash, the Core Business, the Yahoo! Japan stake, intellectual property ("IP"), and real estate holdings.

In our view, Yahoo can resolve this obvious valuation discrepancy through changes that are within the control of the Company and the Board.  We believe these changes, outlined in this letter, can unlock $11.1 billion of shareholder value or $11.70 per Yahoo share.  This would imply an increase of 27% from Yahoo's current stock price (assuming a constant Alibaba stock price) or equivalently, approximately a 100% increase in the value of the Yahoo Stub, which we consider a compelling investment, with limited downside risk, and with a clear path to value creation.

The Performance of the Core Business

Yahoo's recent financial performance is unacceptable.  Over the last two and a half years, since the current management team was hired, Yahoo has spent approximately $4.8 billion in acquisitions and product development costs.  Despite these massive investments, Yahoo's consolidated revenue and Adjusted EBITDA excluding Yahoo! Japan revenues and other non-cash revenues ("EBITDA"), declined by 3% and 27% in 2014, respectively.  Even more troubling, the Company's first quarter 2015 guidance perpetuates a continuing pattern of declining profitability and lower margins.  It is also perplexing that just four months ago during the third quarter earnings call management affirmed that "EBITDA levels are at a low point and [the Company expects] to see improvements with revenue growth in 2015…" and, just a few months later, guided to a Q1 2015 EBITDA decline of almost $130 million year-over-year, or over a 60% decline.

Despite these glaring issues, management has shown extreme reluctance to right-size Yahoo's cost structure and achieve appropriate profitability in the Core Business, and has instead indicated that it will continue making acquisitions.  We believe taking immediate and aggressive action to reduce costs is critical.  Continuing to delay cost reductions will only exacerbate the additional revenue decline expected in 2016 and 2017 due to the end of the Technology and Intellectual Property Licensing Agreement (TIPLA) amortization and the expiration of the Search agreement with Yahoo! Japan, which together we believe will result in a $350 million drop in EBITDA.^[2]  We believe Yahoo's Core Business should be highly profitable, but unfortunately it is currently saddled with an enormously bloated cost structure.  

The Company's apparent lack of urgency to address this serious issue is troubling.  The Core Business turnaround was the primary reason that the current management team was hired in 2012. While valuable, the Alibaba stake spin-off and the repurchase of over 350 million Yahoo shares with capital generated by previous sales of Alibaba stock in no way diminishes management's responsibility to improve the profitability and value of the Core Business, whose progress, or lack thereof, should be closely scrutinized by the Board.

We believe Yahoo's growth in Mobile, Video, Native, and Social ("MaVeNS") reflects a fundamental industry change that cannot be separated from the legacy advertising business' decline. As indicated by the industry growth, more and more users who were previously connecting to Yahoo properties through their PCs are now spontaneously connecting through their mobile devices. Therefore, the growth in MaVeNS' revenue, by itself, does not necessarily prove the success of the Company's investments in these new businesses. In fact, we believe this growth would have occurred in substantial part even without large investments by Yahoo, as the industry growth figures indicate. The ultimate measure of success is increased consolidated revenue and profitability, neither of which Yahoo has achieved so far and, of which, as indicated by Yahoo's share price, we believe investors are justifiably skeptical.

The prerequisite to successfully navigate a changing industry landscape is management's ability to objectively assess a company's industry position, strengths, weaknesses, and probability of success.  The history of corporate America is littered with a long line of companies that relinquished their leading industry position and spent enormous resources attempting to reinvent themselves and ultimately failed. In our view, continuing to invest huge sums to alter Yahoo's competitive position in markets or product categories where the Company has little history of past success will prove an expensive endeavor likely to produce sub-scale businesses, with potentially little competitive advantage, and suboptimal profitability.  Instead, we believe Yahoo should strive to achieve the scale and cost efficiencies that are necessary to survive in an increasingly commoditized and price-competitive internet advertising industry.

By implementing significant cost reductions, Yahoo could successfully navigate a changing industry landscape and unlock the full value of the Core Business which we believe is $5.7 billion or $6.00 per Yahoo share, before any additional value created from the monetization of intellectual property and real estate assets.

Our extensive due diligence has led us to believe that Yahoo can reduce at least $330 and up to $570 million of excess costs (per year).  This action would merely offset the $490 million increase in operating expense that occurred over the last two years, and bring the Core Business' profitability back to levels achieved prior to the current management team's hiring. In fact, we believe the cost reduction opportunity could be significantly larger than our assumptions because the $490 million increase in operating expense highlighted above was layered onto a cost structure that, in our view, was already bloated by $350 to $500 million.  

We believe the primary lever to achieve this efficiency goal is a rationalization of the expenses for products, content, and initiatives that have little prospect of contributing meaningful revenue in the reasonably near future. Reducing costs to create value means making strategic choices.  We believe the time has come for Yahoo's management and Board to narrow Yahoo's focus to areas where it can demonstrate a high return on investment and sustainable competitive advantages.  We believe Yahoo's inability to identify significant cost reduction opportunities has been due to Yahoo's current desire to aggressively invest in product areas or other initiatives where Yahoo, in our view, has a low probability of ultimate success. 

The Value of Intellectual Property and Real Estate

Beyond improving the Core Business, we believe Yahoo can create additional value for shareholders through a licensing program for its broad intellectual property portfolio and a monetization of all or part of the Company's valuable real estate assets.  Collectively, we believe these assets are conservatively worth $1.7 billion or $1.80 per Yahoo share in excess capital that the Company should return to shareholders. 

Yahoo's intellectual property portfolio features patents for email, web, search, and advertising that are highly regarded in the industry.  Our research, including discussions with reputable intellectual property consulting firms, corroborates our view that there is significant value in these assets despite previous sales of intellectual property, prior licensing deals, and existing encumbrances.  We believe that through a robust licensing effort Yahoo could immediately realize at least $600 to $700 million of value from these assets (net of tax), and potentially more as the existing licensing deals expire.

So far, however, Yahoo has monetized only a small part of its intellectual property portfolio via sales or licensing deals, often in related party transactions with Yahoo! Japan and Alibaba. These deals, which generate accounting gains and non-cash revenue that optically improve the Company's EBITDA, have nothing to do with the Core Business activities.  Yet, Yahoo does not exclude these one-off gains from its recurring Core Business EBITDA. Even more oddly, Yahoo refers to IP sales or licensing revenue as 'cost benefits' and records them as an expense reduction, even if these revenues are clearly unrelated to the Core Business' activities and its true operating expenses remain the same.  Therefore we believe that, instead of selling or licensing a small part of its IP portfolio to cosmetically improve the poor profitability of the Core Business (as also recently highlighted by the media^[3]), Yahoo should initiate a fulsome review of its intellectual property portfolio with the assistance of an external advisor, to explore opportunities to maximize the value of these assets.

In addition to substantial intellectual property assets, Yahoo also has an extremely valuable portfolio of real estate.  We believe the Company should explore opportunities to monetize these assets at a time when real estate prices have soared to unprecedented levels.  Yahoo's real estate assets are mainly comprised of its US campus and approximately 750,000 square feet of data centers.  Our research indicates that Yahoo's real estate holdings are worth up to $1 billion in total value (pro-forma for capitalized rents and net of tax).  Importantly, a sale of the Company-owned real estate assets does not have a direct impact on the operations of the Core Business as these transactions could be executed as sale-leasebacks in which Yahoo could remain the sole tenant.

The total opportunity derived from monetizing Yahoo's intellectual property and real estate assets is $1.7 billion, or approximately $1.80 per share, as indicated below. 

The Yahoo! Japan Stake

We recognize and appreciate the remarks made during the fourth quarter conference call about the Company's desire to monetize the Yahoo! Japan stake in a tax-efficient manner.  We expect that Yahoo will articulate as soon as possible how and when it intends to unlock the full value of this large asset which, following the completion of the Alibaba spin-off and meaningful return of capital, we estimate will represent approximately 48% of the market cap, and 52% of the enterprise value of pro-forma Yahoo.  We believe a tax efficient separation of this asset can create $2.6 to $3.1 billion of value which, by way of reference, is the same value that Yahoo could create by approximately doubling the $580 million Core Business' EBITDA.

In our view, a spin-off of the Yahoo! Japan stake could be structured, depending on Yahoo! Japan's governance provisions pertaining to Yahoo's board seat, similarly to Liberty Broadband – a structure well known by the market, and which both the IRS and SEC have already blessed – or, alternatively, structured in a similar way to the Alibaba spin-off.  We believe the creation of a new, separately listed entity comprising the Yahoo! Japan stake alone can create at least $2.6 billion in value, or $2.70 per Yahoo share.   

In fact, we believe that the tax-free spin-off of the Yahoo! Japan stake in a separate entity has the potential to create more value than just the tax savings, even after applying a 5% holding company discount^[4] to this new entity.  Yahoo currently receives approximately $250 to $260 million of extremely high margin revenue from Yahoo! Japan, which we believe could be transferred to (or passed through) the newly listed entity containing the Yahoo! Japan stake. These operating earnings, currently included in Yahoo's consolidated EBITDA, are incorrectly valued by the market at the same multiple used to capitalize the Core Business EBITDA.  Since approximately $95 million of these cash flows have grown approximately 30% over the last three years (gross of currency movements), we believe that, once included in a separate entity with improved disclosure, these cash flows will garner a meaningfully higher multiple than if they are included in the Core Business.  Despite the currency headwinds currently depressing the value of these cash flows in U.S. dollars, we believe this will create approximately $600 million of value in addition to the tax savings on the Yahoo! Japan stake, bringing the total value created from a Yahoo! Japan separation to approximately $3.1 billion or $3.30 per Yahoo share, as detailed below: 

Capital Allocation

In our view, shareholders remain extremely concerned about the possible uses of Yahoo's current $5.4 billion in net cash.  Although we recognize and appreciate that the Company has repurchased $3 billion of stock since the Alibaba IPO, we believe there is no reason for Yahoo to continue to hold over $5 billion in net cash. 

At the inception of the current management's tenure in July 2012, the Core Business consensus sell-side average valuation (including Yahoo! Japan revenues), was $6.9 billion.  Since then, that consensus valuation has dropped to $6.5 billion – a decline of over $400 million which clearly ascribes no value to the $4.8 billion in acquisitions and product development expenses incurred over the same period.  This represents a poor track record of acquisitions and cash flow reinvestment.  This also explains why we, like many others, have serious concerns regarding the possible use of the Company's $5.4 billion net cash balance.

Therefore, we believe that Yahoo should return an additional $3.5 to $4.0 billion of cash to shareholders through additional share repurchases.  Pro-forma for this repurchase and the return of proceeds from the monetization of IP and real estate assets, Yahoo would still have approximately $1.4 - 1.9 billion in net cash, at least $400 million in free cash flow pro-forma for cost reductions (excluding the Yahoo! Japan revenues and dividends), and abundant debt capacity (with interest rates at generational lows) to use for any strategic acquisitions or investments.

**********

In conclusion, we appreciate the ongoing dialogue we have had with you, other members of management, and members of the Board.  We also believe that the announced spin-off of the Alibaba stake is a good first step.  However, we also want to ensure that you and the Board understand that we, and many other shareholders, expect much more.  We believe that Yahoo has the potential to create an additional $11.1 billion or approximately $11.70 per Yahoo share in shareholder value by implementing the steps described in this letter.  As demonstrated throughout this letter, and summarized in the table below, we believe these steps could result in a 27% increase in the current stock price, or equivalently, approximately a 100% increase in the value of the Yahoo Stub. 

It is time to adapt and change to the realities of the current industry environment.  Yahoo needs a plan that includes improved focus on businesses where Yahoo has a competitive advantage, substantial cost reductions, a tax efficient separation of Yahoo! Japan, and aggressive share repurchases funded with excess cash on the balance sheet and capital tied up in intellectual property and real estate assets.  We look forward to continuing our discussions.

Best Regards,

Jeffrey C. Smith
Managing Member
Starboard Value LP

About Starboard Value LP
Starboard Value LP is a New York-based investment adviser with a focused and fundamental approach to investing in publicly traded U.S. companies. Starboard invests in deeply undervalued companies and actively engages with management teams and boards of directors to identify and execute on opportunities to unlock value for the benefit of all shareholders.

Investor contacts: 
Peter Feld, (212) 201-4878
Gavin Molinelli, (212) 201-4828
Cristiano Amoruso, (212) 845-7947
www.starboardvalue.com

SOURCE Starboard Value LP

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http://www.starboardvalue.com

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