Yahoo-AOL Merger In Focus

  • Starboard recently sent a letter to Yahoo’s management team and board of directors with a sum of the parts analysis, which is in-line with my previous estimates even though the method of analysis differs.
  • Starboard’s recommendation of acquiring AOL will come with some cost synergies which could only add incrementally to profits, rather than the $1 billion figure that Starboard has estimated.
  • If Yahoo does acquire AOL, a combination of efficiency gains, along with improving CPM/CPC trends need to occur for meaningful accretion.

yahoo AOL merger

Yahoo (NASDAQ:YHOO) received a sizeable boost to its valuation after Starboard Value sent a letter to Yahoo executives and board of directors. In the letter, Starboard believes that Yahoo’s intrinsic value when summing the parts is $48.47 billion. This is in-line with my earlier post on Amigobulls using a sum of the parts analysis.

Starboard aggressive on AOL synergies, but pessimistic on acquisitions

Quoted from Starboard Value:

We believe the combination of (i) unlocking the value of Yahoo's non-core minority equity stakes in a tax efficient manner, (ii) preserving shareholder capital by halting the current aggressive acquisition spree, and (iii) improving the profitability of Yahoo's core business on a stand-alone basis or, ideally, in a merger with AOL, would result in a significant appreciation of Yahoo's stock price.

There’s a lot of debate as to whether activist fund managers add or subtract value to a company over the long-term. However, the suggestions offered by Starboard Value addresses the concerns that other equity holders have had.

Starboard makes the case that many of the acquisitions that Yahoo has generated has demonstrated no material impact to top line revenue growth.

Yahoo acquisitions and financial metrics

Source: Starboard Value

Since Q2 2012, Yahoo has invested $1.275 billion, but has generated 0% sales growth in the period, the EBITDA figure worsened, which was driven by stock compensation expenses, higher SG&A and R&D expenses. Top line revenue growth has been muted due to falling CPMs, which came as a result of mobile application uptake. Mobile ads are priced cheaper, because cookies don’t track user behavior on mobile devices, and the lack of screen space reduces ad engagement.

Yahoo global display ad trends

Source: Yahoo

However, an interesting trend is starting to emerge; ad sales and price per ad figures have increased and decreased proportionately. The numberof ads that Yahoo has been able to sell has increased by 24%, whereas the price-per-ad has dropped by 24%. I think the acquisitions that Yahoo has made, have provided Yahoo the opportunity to sell more ad-space, even though the ad-space was sold at a lower price. Selling more ad units can only come as a result of being able to have more places to display ads, and a larger number of users are actually looking at them.

This moves onto the next point; Starboard thinks that an AOL (NASDAQ:AOL) merger will result in significant upside due to Yahoo having a larger network of properties to market and sell ads. I guess the impact from having a larger network is the ability to offer a broader inventory of ad space, and to lower back-end costs due to the overlap in some of the same exact functions. This assumes that Yahoo and AOL can generate efficiencies, which to an extent I agree with.

Starboard makes the case that the synergies from a combination of Yahoo and AOL will somehow add up to $1 billion. However, when looking at the financials of AOL I’m fairly certain that the estimated synergies are extremely aggressive.

AOL Income statement

Source: AOL

When looking at AOL’s financial statement, the company generated $2.31 billion in consolidated revenue. Cost of revenue was $1.7 billion, and to reduce costs by $1 billion, AOL would need to cut back expenses by 59%. That’s extremely aggressive, in fact, too aggressive to be even remotely realistic.

AOL cost of revenue

Source: AOL

When looking at the cost of revenue break down, the traffic acquisition costs, other costs of revenue, cannot be reduced by much even if Yahoo were to acquire AOL. Traffic acquisition cost in AOL’s case is a combination of advertising spends to acquire users, paired with the cost of buying ad-inventory from other websites. AOL engages in the process of buying ad space, and selling it for a higher premium (basically a marketplace platform). The line item “other costs of revenue” is the cost of creating content, which is an unavoidable cost, as users will not go to AOL’s portfolio of websites without content.

I think $800 million in costs are unavoidable; however, the remaining $900 million may be reduced significantly. Perhaps, personnel, facilities, and network related costs can undergo some significant reductions. Not up to $900 million, but perhaps up to 30% to 40% of that figure. If we work with a realistic reduction of those kinds of expenses, AOL may be able to boost its operating income by $270 million, totaling to $460.3 million. Tax rates vary significantly by year; however, for the sake of simplicity we will use the most recent effective tax rate reported by AOL, which was 48%. The high tax rate comes as a result of foreign losses that cannot be reported to the IRS (Internal Revenue Service), which inflates the income reported to the government, resulting in higher income tax expense. After factoring in the impact from taxes, the net income figure may improve to $239 million. Assuming those synergies, Yahoo will buy AOL for 14.6 times forward earnings. This assumes that AOL can potentially operate at a 10.3% net profit margin. To put things in comparison, Google has a 21.35% profit margin, and Facebook has a 23.4% profit margin over the trailing twelve month period. Admittedly, any incremental income will be taxed at a 35% rate, which should lower the effective tax rate inclusive of foreign operations. However, predicting the exact tax impact is extremely difficult; therefore we’re offering a conservative estimate using a much higher tax rate.


An incremental $239 million improvement in net income would boost Yahoo’s valuation, and give investors further confidence in how Yahoo manages its financial resources. Furthermore, if Yahoo is able to price ads higher, or at least stabilize CPC trends, the added synergies paired with revenue growth could drive meaningful gains beyond the $239 million in net income that I estimate.

However, on the downside, $270 million reduction in costs is a far cry from the $1 billion that Starboard estimated. Therefore, investors should lower their expectations with regards to the amount of accretion Yahoo could potentially generate by consolidating both organizations.

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