[Author was long YHOO at time of writing]
How has
In our core operating business we feel we have built a strong foundation and we are in an excellent position to execute and return the company to growth.... In late 2012 this management team changed course from a confused web-based mobile strategy which preceded us to a beautiful Native app-based strategy, the fruits from our mobile strategy are obvious just two years later, as we’ve fundamentally changed our trajectory in user growth, in industry response and most importantly in mobile revenue.... In 2015 we expect the MaVeNS [Yahoo's acronym for their mobile, video, native and social assets] will contribute over a $1.5 billion to our business. If broken out on their own, as a company they would undoubtedly be one of the fastest growing start-ups in the world.
And Ken Goldman:
Looking back in our Q4 full year 2014 performance I am pleased by significant steps we have made delivering share value by improving our operations, executing our transformative investments and prudently allocating our capital. Q4 GAAP revenue was $1.253 billion and revenue ex-TAC was $1.179 billion at or above the high end of our guidance range.... Adjusted EBITDA also exceeded our expectations at $409 million in the quarter as we continue to actively manage our cost base.
Under pressure from activist shareholder Starboard Value LP since September, Mayer has been on a shareholder charm offensive. She has been making the rounds with shareholders, giving interviews with the Wall Street Journal and other outlets to get her view across and repeating certain "talking points" in her earnings calls and other public appearances to drive home the message that Yahoo was a basket-case of a company when she arrived and she's turned it around.
She wants to paint a picture that she has been a good steward of shareholders' capital since she arrived and finally turned around the struggling core business. Yet anyone diving into Yahoo's reported numbers and their filings with the SEC might draw a different conclusion.
In fact, it appears that Yahoo is actively taking steps to make its adjusted EBITDA - or its operating profits - look substantially better than it actually is. There's nothing illegal about what Yahoo is doing. Companies are always allowed wiggle room to present both GAAP and non-GAAP results.
The problem is that, in our hyper-fast
Before Marissa Mayer arrived as CEO of Yahoo, Yahoo's annual EBITDA reported was $1.5 billion in 2011 (per Bloomberg). For this year, Bloomberg estimates Yahoo will do $1.1 billion in EBITDA. That's not great. A 30% drop in profitability since Mayer took over. This is while the company's revenues have dropped 12% from $5 billion to an expected $4.4 billion. Oh, and over that time, Google increased its top line 61%, Facebook saw its revenues go up more than 3x, and even little old AOL saw its top line grow 14%. Their operating profits also increased at a strong clip.
Yahoo has to really be doing badly if all its operating metrics have been dropping at a time in the American economy when free money is fueling an ad bonaza in the Internet space.
Mayer has pointed out - and there's some truth to it - that she took over a company in disarray. Yet, there have been a number of highly puzzling choices she has made to push the throttle forward when the crashing plane she's been piloting has already been in a tailspin.
Most of Yahoo's sell-side analysts accept the current consensus $1.1 billion EBITDA number and assign a multiple to it to get to what they believe Yahoo's core business is worth. A common metric you hear is, "well, AOL is valued at 6x Enterprise Value to EBITDA, so Yahoo must - at least - be worth 6 x $1.1 billion which is $6.6 billion." Then, when you add up the value of Yahoo's cash, its now tax-free holdings in Alibaba and its holdings in Yahoo Japan, you frequently hear: "How come the core business is valued at zero or negative $2 billion?"
Yet, Yahoo's actual EBITDA which it's getting from search and advertising related to their core properties is actually far below this estimated $1.1 billion. Over the years - and this started before Mayer arrived on the scene but has accelerated under her watch in the last 2 years especially - Yahoo has struck deals with partners to help get temporary high-margin revenue which it has been including in its adjusted EBITDA numbers even these are coming from effectively one-time or at least temporary gains.
Most people, when judging the health of a business and its future profitability potential, try to strip out any temporary gains or revenue streams which are not going to around for the long-haul. Then, they can really see how profitable the core business is and judge it on those merits.
In the case of Yahoo, over the years, it has struck a number of IP-related sales with Alibaba and Yahoo Japan which it has been recognizing as high margin adjusted EBITDA over time to supplement the EBITDA it's getting from its core business. If you actually removed these gains away from that adjusted EBITDA, the profitability of the core business is far less. And if you took out the stock-based compensation expenses on top of that, there's virtually no EBITDA left.
Let's walk through some of these agreements Yahoo has in place and when they'll be ending.
When Yahoo agreed to cut its holdings in Alibaba in 2012 from 44% (fully-diluted) to something like 22% -- valuing Alibaba then at somewhere around $35 billion -- they also included something called a TIPLA agreement worth $550 million. Even though they got that cash up front from Alibaba, they recognize that high-margin revenue over time.
In the Yahoo 10-K released this past week, Yahoo mentions that this TIPLA agreement will end on September 18, 2015. Between then and now, Yahoo will recognize the remaining $199 million of the original $550 million. That means 18% of Yahoo's adjusted EBITDA this year will come from this Alibaba TIPLA.
What did Yahoo license to Alibaba as part of this TIPLA? We don't know.
Why would they want to negotiate this, instead of just asking for more cash from Alibaba for the 20% of Alibaba they sold for around $7 billion in 2012 (which - had they waited until today to sell it - would be worth $42 billion or more than the current market cap of Yahoo)? It seems likely that Yahoo's Tim Morse and then CEO Scott Thompson who orchestrated that deal knew that Yahoo's core business would continue to decline in coming years and this type of deal would help it to appear stronger from an adjusted EBITDA perspective.
Mayer didn't negotiate this TIPLA deal, but in 2016 there will be $200 million less in adjusted EBITDA, meaning the likely consensus will be $900 million (all else equal).
While Mayer didn't negotiate the original TIPLA deal in 2012 - and while she has been quick to criticize her predecessors as incompetent - she replicated a similarly sized IP asset sale last year. Again per the recent 10-K, in the 2nd quarter of last year, Yahoo entered a patent sales and license agreement for $460 million:
The total consideration was allocated based on the estimated relative fair value of each of the elements of the agreement: $61 million was allocated to the sale of patents (“Sold Patents”), $135 million to the license to existing patents (“Existing Patents”) and $264 million to the license of patents developed or acquired in the next five years (“Capture Period Patents”). We recorded $61 million as a gain on the Sold Patents during the year ended December 31, 2014. We recognized $43 million in revenue related to the Existing Patents and Capture Period Patents during the year ended December 31, 2014. The amounts allocated to the license of the Existing Patents will be recorded as revenue over the four year payment period when payments are due. The amounts allocated to the Capture Period Patents will be recorded as revenue over the five year capture period.
Later in the 10-K, they say that some of their sold patents in 2014 went to Alibaba and some went to Yahoo Japan. So Mayer and Goldman are recreating the same thing we saw in the TIPLA agreement with Alibaba in 2012. It should lead to another $80 - 90 million of adjusted EBITDA in 2015.
Most companies would not include these one-time patent sale gains as part of its adjusted EBITDA, but Ken Goldman specifically says that Yahoo is including him. Here's an excerpt from the 2nd quarter 2014 earnings call:
<Q - Justin Post>: Thanks. Again, a lot of questions on EBITDA. Should we back out the patent sale when we think about the run rate for 2Q? And then 3Q, the guidance is 23% margins at the midpoint and that's down quite a bit from last year. Can you talk about the forces driving that and where that could bottom?
<A - Kenneth A. Goldman>: [...] if you back out the patents and around $800 million short-term expenses, and if you look at long-term, which is primarily depreciation and amortization, that's about $150 million.
And so to get to EBITDA is very straightforward relative from the revenue numbers I gave.
What's also interesting here is that during this Q2 earnings call from last year - when they were announcing this additional $460 million patent sale to Alibaba - Yahoo also announced that it was going to keep hold of more of its Alibaba shares through the upcoming Alibaba IPO.
Yahoo has been eager to point out to its investors that it successfully negotiated with Alibaba to retain more Alibaba shares than what the original 2012 agreement required them to sell. This point fortifies their "we're good stewards of your capital" narrative. Yahoo has never said it gave up anything in order to get Alibaba to agree to this. Maybe the timing is purely coincidental with this patent sale also occurring in the same quarter as their announcement that they are keeping hold of more Alibaba shares. But I doubt it.
We have no idea what the patents were which Yahoo sold to Alibaba (and Yahoo Japan). They say that they sold them for "fair value." Is it possible they could be worth a lot more to Alibaba than the $460 million, enough so that Alibaba was willing for Yahoo to keep hold of more Alibaba shares for longer? We may never know.
One thing that is clear is that Yahoo makes its adjusted EBITDA look a lot better with the aid of these IP asset sales. I have to believe Alibaba and Yahoo Japan are benefiting from these agreements too -- otherwise, why enter into them?
Now, we get to the relationship between Yahoo and Yahoo Japan. Most know that Yahoo still owns 35% of Yahoo Japan. What's less known is that Yahoo Japan pays royalties to Yahoo of about $90 - 100 million a year. This is pure margin and drops almost 100% to adjusted EBITDA. They are mentioned as part of exhibit 10.7, 10.8, and 10.9 of the recent 10-K.
The most important one is 10.9, which provides an example of how this royalty is calculated (about 3% of the Yahoo Japan revenue)
Here is the link to the file (the Yahoo Japan Agreement is at the end of the document).
And what's even less known is that, in August 2007, Yahoo sold an entity called Overture K.K. to Yahoo Japan in exchange for a 10 year search agreement from which Yahoo derives another $150 - 160 million a year in revenue/adjusted EBITDA. I recall when the deal was first struck and I had a number of questions about the arrangement which I blogged about here.
This extra $160 million a year in search revenue from Yahoo Japan will stop in 2017.
"Prior to August 1, 2008, Overture K.K., a consolidated subsidiary of the Company, had paid service fees to Overture Search Services (Ireland) Limited (“OSSIL”), a consolidated subsidiary of Yahoo! Inc. The contract term in the service agreement was 10 years beginning August 31, 2007. For the year ended March 31, 2008, Overture K.K. paid ¥12,990 million of service fees to OSSIL for the seven months from August 31, 2007 to March 31, 2008. Effective August 1, 2008, the contractual rights and obligations of OSSIL were assumed by another Yahoo! Inc consolidated subsidiary, Yahoo! Sàrl. The total service fees paid by Overture K.K. were ¥20,350 million ($207,165 thousand) for the year ended March 31, 2009."
Note that the amount paid in 2009, about $207 million, has decreased since then because of the currency. Today, it is difficult to ascertain its exact figure directly but, we can estimate very closely by subtracting from the total revenue received from Yahoo Japan (found in the 10-K, in the section about Yahoo Japan) and the Yahoo Japan Royalty:
$253 million (from page 123 of the 2014 K) - $90/100 million (Yahoo Japan Royalty) = $150-160 for Yahoo Japan Search Services agreement
On the royalty amount, here is an extract from the YJ 2014 Annual report – “Royalty charge rose ¥1,281 million, or 12.9%, to ¥11,227 million, owing mainly to higher net sales.” This arrives at a $90 -100 million figure depending on the exchange rate.
So, taking a step back, if we minus out the "temporary" IP asset sale gains from Alibaba and Yahoo Japan and the additional search revenue gains and royalties from Yahoo Japan, Yahoo's core business will do about $590 million in 2015 (not $1.1 billion) in terms of adjusted EBITDA. The math is as follows:
| 1122 | Bloomberg Consensus Adjusted EBITDA 2015 | |||||||||
| -253 | Revenue from Yahoo Japan assumed at 100% margin | |||||||||
| -199 | TIPLA Amortization for 2015 (from 10k, page 121) | |||||||||
| -80 | Amortization of other Patent sales (400 million divided by 5 years. From page 48) | |||||||||
| 590 | ||||||||||
Coincidentally, that's about exactly what AOL will do in EBITDA this year.
So, perhaps Starboard isn't so crazy for wanting to "merge" Yahoo's core business and AOL. The two companies are exactly the same size in terms of their "real" EBITDA -- despite the fact that Yahoo's top line revenue is double the size of AOL's.
And if you subtracted out Yahoo's stock-based compensation costs from its adjusted EBITDA (another $400 million), Yahoo's core business will only churn out about $190 million in operating profits this year. (However, all tech companies love to omit stock-based compensation costs out of adjusted EBITDA.)
Of course, I have long argued that Yahoo's core business is obscenely over-staffed. Not just a little, but a lot. I agree with
Yet, Mayer has never done a headcount reduction since she arrived. In fact, total headcount (including variable term contractors) has likely increased under her watch.
According to Bloomberg, Yahoo's SG&A costs have gone up $500 million since Mayer took over. Business Insider is reporting that Yahoo is paying sales people "mind-boggling salaries" in order to stay at the company. I have heard rumors recently from industry sources that Katie Couric has been re-signed by Yahoo to continue being its host on Snapchat Discover and a Global News Ambassador of some kind for $5 million a year despite disappointing traffic numbers. And in the latest 10-K, Yahoo discloses that it signed a 10 year lease in December in LA (Playa Vista) for $61 million in obligations despite having adequate office space in Santa Monica and Burbank (where they have 2 buildings in fact). That 10-K also points out that Mayer signed off on a 12 year lease in May 2013 for 4 floors in the New York Times building in New York City. Total obligations for those 4 floors are $125 million over the term. Yahoo already has adequate office space in New York and sales, after moving in to the Times building, has returned to Yahoo's more than copious space on West 45th street.
The bottom line here is that Yahoo's core business may actually only be doing $190 million a year in operating profits from its recurring business once you strip out the costs of paying its executive team and its IP asset deals and search deals which will end in the near future.
Marissa Mayer has chosen to dramatically increase the company's cost structure, even in the face of declining revenues. Yet the non-recurring aspects of their adjusted EBITDA which they're presenting to Wall Street give the impression that profitability in the core business is about 6 times bigger than it appears to be on a recurring basis ($1.1 billion vs. $190 million). This is all allowed under GAAP and non-GAAP accounting, but the truth of Yahoo's incredible shrinking profitability needs to have a light put on it.
