Jeffrey C. Smith of Starboard Value is running out of patience.
The highly successful activist fund that tends to take a constructive behind-the-scenes approach with its portfolio companies has sent a harsh letter to Yahoo!’s (YHOO, Financial) board. Starboard is specifically displeased with CEO Marissa Mayer and Chairman Maynard J. Webb.
The full text of the letter can be read here, but below I’ll summarize the key points (emphasis mine):
Despite over three years of effort and billions spent on acquisitions, 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.
The letter opens with a decidedly negative evaluation of the results booked by the current management team. This sets up the rest of the letter where the results and actions are discussed in more detail. The gist of it is that Valueact considers its efforts value destructive and wants the team out.
As of Tuesday's close, the value of the "Yahoo! Stub" (defined as Yahoo!'s market value less the value of its shares in Alibaba) has collapsed and is currently trading near zero. The bulk of Yahoo!'s current market value almost entirely derives from an extraordinary investment Yahoo! made over 10 years ago in Alibaba (BABA, Financial), and the good fortune that Alibaba's management team has executed well such that this investment today is worth over $30 billion. This compares to Yahoo!'s current market capitalization of approximately $30.5 billion.
The Yahoo! sum of the parts valuation story is what all the bulls hang on to, myself included. It basically comes down to Yahoo!'s equity interests in Alibaba and Yahoo! Japan exceeding the market cap of Yahoo! itself. Depending on how you look at the potential tax liability and Yahoo!'s ability to destroy value, there is a lot of upside to the story that does not require great performance by the company. In fact Yahoo!'s core business is so small that, even if its management team is fairly adept at value destruction as Starboard implies, that is not a huge problem.
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. While we agree that the failed separation has been frustrating, we are confident that a separation of these assets can be accomplished through either a sale of the core business or a spin of the core business. Either of these outcomes would result in a much more tax-efficient separation than the market currently implies. Unfortunately, it appears that shareholders have no confidence that management and the board will be able to execute on a separation of these assets or improve the performance of the core business. We are confident that both of these objectives are achievable but will require a change in leadership and strategy.
Starboard is now pushing for a sale of the core business or a spinoff of the core business. The firm is against the previous plan to spin off the Alibaba interest along with a minor Yahoo! business. It appears it is viewed as too risky from a tax standpoint. I may be reading too much into it, but the final sentence of the above paragraph has me believing Mayer is not on the same page with Starboard. That isn't particularly good news for shareholders because, whoever is right, it is probably not conducive to an expedient resolution.
We are highly confident that there are interested and credible buyers for Yahoo!'s core business. It is our understanding that, even after Yahoo! announced its plan to spin off, instead of sell, the core business, several interested parties subsequently reached out to Yahoo!'s management and board expressing interest in buying the core business. Yet, unfortunately, according to several credible media reports, Yahoo! has thus far ignored this inbound interest. This is highly concerning to us because, when recently asked specifically on CNBC, Maynard Webb, Yahoo!'s chairman, stated that, if Yahoo! received inbound interest from potential strategic or financial buyers, the board would engage with those parties:
"The board has fiduciary obligation to engage with any legitimate person that comes forward with a good offer. The board will always do its fiduciary obligations when something like that occurs." - Maynard Webb, Dec. 9, 2015
This is unacceptable.
The above paragraph is significant in that it specifically calls out Webb and the board for not engaging in talks with interested parties. It's a huge positive that Starboard is highly confident there are interested parties out there who want to plunk real money down for the core Yahoo! business. Remember, the market is valuing that business at zero or near zero. A sale would be a significant positive catalyst for the share price. This letter puts pressure on the board to start taking these interested parties more seriously even if executives don't like it.
We told you that, aside from separating the minority equity interests, the performance and lack of turnaround execution on the core business was our primary concern and focus. You assured us for over a year that you had a plan for execution and that you were confident that 2014 would be a low point for EBITDA. We explained over and over again that we did not believe your actions, or lack thereof, would achieve the desired result of stabilizing the business. Unfortunately, it appears we have been right, and each quarter is worse than the last. Your solution to just announce a change in direction of the spin and that it will require another year for shareholders to wait while the existing leadership continues to destroy value is not acceptable.
After evaluating executive decisions in more detail, Smith's ruthless conclusion is that current management strategy is simply not acceptable. That doesn't mean it can get slightly amended or the ship can be steered in a slightly different course. This is clearly Starboard out for war.
The board must accept that significant changes are desperately needed. This would include changes in management, changes in board composition and changes in strategy and execution. If the board is willing to embrace the need for significant change and pursue a strategy along the lines of what we have proposed above, we are hopeful we can work constructively together and make changes to the board through a mutually agreeable resolution. This is clearly the preferable route. If the board is unwilling to accept the need for significant change, then an election contest may very well be needed so that shareholders can replace a majority of the board with directors who will represent their best interests and approach the situation with an open mind and a fresh perspective.
Finally, threats are not left to the imagination of the board. If the board doesn't cooperate to realize changes in management, changes in the board itself go along with changes in strategy and execution Starboard is likely to start.
I have held a position in Yahoo! since the summer of 2015 and consider this letter to be both a positive and a negative. A fight between management and an important shareholder is seldom going to result in a short-term positive result. I still had hopes Yahoo! could positively resolve the tax overhang issue of the Alibaba equity stake. This letter quashes my hope of reaping a quick profit here. On the other hand, it is a huge positive there are likely interested buyers for the core business. I also consider it a huge positive Starboard is taking such a hands-on approach with Yahoo!. This is a firm with an excellent track record that knows something about tech. It just isn't usually so vocal.
Disclosure: Long Yahoo!
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