Yahoo! Inc. : Starboard Value Demands Significant Changes

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Starboard Value, the activist hedge fund headed by Jeffrey Smith, expressed its frustration with the performance of Yahoo and demanded changes in the management, board composition, strategy and execution of the company.

In a letter to the Board of Directors of the tech giant, Smith said 2015 had been an “extremely frustrating” year for Yahoo shareholders because the proposed spinoff of the company’s stake in Alibaba Group Holding did not materialize due to concerns regarding the massive tax liability. The activist investor believes that the Board made the right decision in suspending the spinoff.

Yahoo core business continues to underperform

Aside from the spinoff, Smith said his firm was also frustrated with the continued underperformance of Yahoo’s core businesses (search and display advertising). He noted that the operating and financial performance of its core businesses continued a “downward spiral” despite its efforts and billions of dollars spent on acquisitions over the past three years.

The annual operating cost of the core business is increasing by approximately $500 million despite its declining revenue. The company spent $2.3 billion on acquisitions. Most of its investments have been misguided and poorly overseen, and ultimately shut down,” said Smith. He also noted the accelerating departures of the company executive leadership.

Smith is confident that there interested and credible buyers for the company’s core business. According to him, several parties reached out to the Board and management and expressed their interest in buying its core business.

“The management team that was hired to turn around the Core Business has failed to produce acceptable results, in turn, causing massive declines in profitability and cash flow. It appears that investors have lost all confidence in management and the Board,” said Smith.

Yahoo Stub trading near zero

He also pointed out that the Yahoo Stub (the company’s market value minus the value of its stake in Alibaba) collapsed as of Tuesday, and it is currently trading near zero.

Smith said the company derived the bulk of its current market value “almost entirely” from its extraordinary investment in Alibaba over the past ten years. Its investment in Alibaba is worth more than $30 billion today. Yahoo’s current market capitalization is around $30.5 billion.

“The current valuation of Yahoo implies either a massive tax liability on Yahoo’s minority equity interests in Alibaba and Yahoo Japan Corporation (“Yahoo Japan”) or that the remaining operating assets of Yahoo are worthless, or some combination of the two,” said Smith.

According to him, Yahoo could separate its assets in Alibaba and Yahoo Japan by selling and spinning off its core businesses. He believes that a sale or spinoff of the company’s core businesses should result in a more tax efficient separation.

On the tax issue, FBN opines that Yahoo should consider the following:

  1. Consider issuing a tracking stock for Aabaco Holdings that would contain the same assets initially planned for the asset backed security in the transaction the IRS refused to rule on. In this fashion, Yahoo could highlight the value of the BABA position as well as YHOO’s other assets without any tax impact. In the event the new tracking equity didn’t trade well, it could be structured so the Aabaco Holdings tracker could be rolled back into YHOO at any time in the future if doing so made sense, thus giving the Yahoo Board more flexibility than many other options. This structure would also give the Board all the time they needed to evaluate other options.
    2. Consider issuing a Convertible Exchangeable Debenture tied to all or much of the BABA position settleable in cash or BABA equity at Yahoo’s option with plans to use most of the cash raised from said issuance to tender for billions of YHOO equity. In this fashion, Yahoo could tax efficiently monetize some or all of the BABA position (likely at a very low interest rate for which they would get an interest deduction) while materially shrinking the equity base at YHOO, leading to leveraged equity returns for shareholders. We would think given the value of the BABA shares owned by YHOO and the current equity capitalization of YHOO, such an issuance would clearly create and highlight value for shareholders.
    3. Consider effecting an auction swap whereby YHOO shareholders could elect to swap YHOO shares for shares of BABA held by Yahoo. This could be structured such that Yahoo gets the maximum value for the BABA shares and also results in equity shrink at the parent company similar to a repurchase or share tender.

Shareholders have no confidence in the company’s leadership

Smith said it is unfortunate that shareholders have no confidence in the Board and management to execute the proposed separation of Yahoo’s assets or improve the performance of its core business. He said, “We are confident that both of these objectives are achievable, but will require a change in leadership and strategy.”

Furthermore, the activist investor said turning around Yahoo’s business is “extremely difficult” given the several failed attempts to return the company towards growth and profitability.

According to him, the company needs a new leadership with a different thinking to develop a plan to balance priorities between growth and profitability. He explained that the new leadership needs to prioritize and invest in certain parts of Yahoo’s business while deeply cutting unnecessary costs, selling or exiting unprofitable businesses and research projects as well as overhauling incentives and compensation programs.

“The Board must accept that significant changes are desperately needed,” said Smith.


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