Merger rumors and acquisition proposal for Yahoo Inc

Yahoo!

The market capitalization of Yahoo as of April 29, 2011 is approximately $23.18 billion. The purchase price for a company often includes a premium to entice stockholders to sell their shares to the bidder. Alexandridis (2010) notes that the mean acquisition premium for large acquisitions is around 38%. This would give Yahoo! An implied acquisition price of $32 billion.

From a financial perspective, Yahoo is a healthy company. It is very liquid, with high current and quick ratios of 3.06 and 3.0 respectively. Yahoo's interest coverage ratio is 1.7, which is a little bit lower than might be preferred, but the company has a very low level of long-term debt ($138 million) that would likely be retired as a result of this transaction. Yahoo has strong earnings as well, recording a record $1.231 billion in net income last year. However, there is cause for concern, in that Yahoo's cash flow from operations has declined in each of the past three years, from $1.918 billion in 2007 to $1.24 billion today. This indicates that there may be long-term issues with the company's business model.

Indeed, Yahoo is experienced negative growth in sales, down 24% last year compared with an increase of 37% for the industry. The company also experienced a quarter-over-quarter decline in net income, and has a five-year sales growth average of just 3.76%, compared with an industry average of 42%. This indicates that while the Internet information business is growing, Yahoo is not. Its five-year average ROE is 6.9%, compared with 21.9% for the industry average; the five-year average ROA is 3.3%, compared with 18.2% industry average and its five-year average ROI is 3.8%, compared with a 21.3% industry average. Yahoo is simply underperforming in the industry (MSN Moneycentral, 2011).

This chronic underperformance, and more importantly the declines in Yahoo's business, would seem to call into question the logic of paying even the modest acquisition premium proposed for Yahoo. The current multiple is 20.82, which implies that the market still expects strong profit growth from Yahoo going forward. Yet there is little reason from a qualitative perspective to believe this. Yahoo's increase in net income in 2010 is impressive (over 100%), but it does not correspond with the decrease in the company's cash flow from operations. Thus, it is advisable to break down the increase in net income. Net income rose $633 million in 2010. Of this, $252 million came from a gain on the sale of assets. A further $145 million came from equity in affiliates, therefore not from Yahoo's own business. The company also saw a $68 million reduction in "unusual expense" and a reduction in R&D expense of $73 million. This totals $538 million. The company did improve its gross margin as well, but ultimately much of the profit improvement comes from one-off items.