Yahoo’s shareholders and many pundits were happy with Yahoo until Monday when the company announced that it is buying back 40 million of its shares from one of its largest shareholders and current board member, Dan Loeb of hedge fund Third Point LLC at last Friday’s closing price of $29.11. In addition, Loeb announced that he and two of his associates will step down from the company’s board. Since then Henry Blodget of Business Insider absurdly suggested insider trading, while Steven Davidoff of DealBook questioned the timing of the deal and its impact on other shareholders.

I will not address the insider trading charge since it was brilliantly refuted in this Bloomberg piece by Jonathan Weil. However, I will address the other charges, mainly that the timing is suspect given that Loeb got a sweetheart deal by selling at Friday’s closing price and not paying a discount as is ‘supposedly’ customary in all large share sale transactions. The main gripe here is borne out of the fact that the stock dropped by 4% on Monday when the transaction was announced. I do not know Dan Loeb nor do I have any position in Yahoo right now.

What most investors fail to realize is that the stock dropped not because Yahoo was the buyer but because Loeb announced the sale of two thirds of his stake irrespective of who the buyer was. Loeb, as the main catalyst for change at Yahoo, and later as board member and an insider, was followed into the stock by many investors and other hedge funds after he first purchased his stake claiming that the shares were deeply undervalued at the time. So when he announces an exit by dumping a majority of his holdings, rest assured that all the other investors who followed him will take notice and many will do the same as this will be taken as a signal that Yahoo’s shares are at, or near, fair value. Moreover, there is a precedent of this. Earlier this year, on Friday February 1 after the markets closed, Loeb announced that he has sold 11million of his roughly 74 million shares at the time or 15% in the open market. Not surprisingly, Yahoo’s stock dropped by 2% in heavy volume on Monday. So a 4% drop when that same big, and well informed, investor announces that he sold 65% of his shares is not surprising and has nothing to do with who the buyer is. This is what can be called a “signaling discount”. Arguing that Yahoo should have negotiated a discount to the Friday closing price would have only made the drop on Monday even worse as it would signal to the market that the company believed its shares were overvalued at Friday’s close. A 4% drop because of Loeb’s signaling that shares are nearing fair value would have been exacerbated by an acknowledgement from the company that this was not only true but that Friday’s close actually exceeds fair value. A large share sale between two private parties is a lot different than a buyback by the issuer.

Another criticism is that Yahoo’s buyback program was used to buy Dan Loeb’s shares while other shareholders “went to the back of the line”as Robert Cyran from Breakingviews put it. The problem with this reasoning is that it fails to acknowledge that when a company buys back its shares, all shareholders benefit irrespective of whom those shares were bought from since it decreases the supply of shares, or float, and boosts earnings per share. In hindsight and as of now, it looks like Loeb may have indeed made a good trade but that does not mean that other shareholders lost because Yahoo bought his shares. Had he not sold his shares to Yahoo he would have been selling them on the open market at a slower pace and putting downward pressure on the shares (let’s call that a liquidity discount) in the process to the detriment of all other shareholders. Furthermore, as I explained above, this liquidity discount is in addition to the signaling discount that will occur when Loeb publicly announces that he sold his shares. What Yahoo did is remove this liquidity discount from its shares to the benefit of all shareholders including Loeb.

The third most frequent condemnation of Loeb is that there was some dereliction of duty when he announced that he will be stepping down from Yahoo’s board before the company’s turnaround was complete and that he has “issued an enormously damaging vote of no confidence in the company”. This view is utopian to say the least and fails to take into consideration the initial motive for Loeb’s involvement with Yahoo in the first place. Loeb, just like any other hedge fund manager, got involved with Yahoo to realize value for his fund investors first and foremost. When he was elected to Yahoo’s board he had a fiduciary duty towards all Yahoo shareholders. When his respective fiduciary duties to his fund investors and Yahoo shareholders conflict, make no mistake about it, Loeb’s allegiance and commitment is to his fund investors first and foremost. It is only natural that he steps down if he sees that his fund investors are better served if his time and energy are invested elsewhere.

“Yahoo! is moving aggressively to increase shareholder value. We have appointed a capable and dynamic CEO who is driving the business towards its next era of success. And we have reconstituted the Board of Directors with the right mix of experience and expertise to help Yahoo! build upon its very strong assets and brand base to take advantage of the opportunities ahead.”

So what does this mean to Yahoo’s share price?

Clearly this move by Yahoo is meant to appease shareholders who may be sympathetic to Dan Loeb who is waging a proxy battle against the company in a bid to install 4 of his nominees – including himself. It is clear that Yahoo today is not the same Yahoo of three months ago and the message to shareholders is that the current Board has implemented drastic changes and it should be given the benefit of the doubt in the upcoming proxy vote given that 1) both Jerry Yang and Roy Bostock have already stepped down – or will be shortly – and 2) Yahoo has a new CEO in Scott Thompson, and 3) the addition of the 3 new independent directors with impressive resumes. Given those three reasons I stated, it is hard for Loeb to make an argument that Yahoo has not reacted to shareholders’ grievances. (whether you think the moves are good or not). It is also foolhardy not to believe that many institutional investors will be swayed by these moves and will agree to give Yahoo the benefit of the doubt.
So, if your investment thesis in Yahoo is based on that Dan Loeb will win the proxy battle, implement a new strategy, and drive the share price up then that thesis has been dealt a severe blow. The chances of Loeb winning the proxy vote have decreased markedly today. If this logic is true then Yahoo’s share price will likely decline between now and Yahoo’s annual meeting.

Since former CEO Carol Bartz’s departure, Yahoo’s share price has been steadily increasing on the prospects of a sale of all or part of the company. The prospects of such a sale have cooled off since the appointment of new CEO Scott Thompson. If Yahoo’s slate wins the proxy vote, Thomson will have an accommodating Board that will be supportive of his vision and strategy. This vision and strategy is yet to be clearly communicated to shareholders and thus it is not a reason why Yahoo’s shares have been increasing or holding the $14-$16 level. The support we have seen in Yahoo’s shares has been based on more upcoming change if Loeb wins. Take that last part out and the only thing supporting Yahoo’s share price is the ever diminishing near term prospects of the Asian assets divestment. As I have mentioned before, Yahoo’s share price will increase when shareholders are excited about Scott Thomson and his strategy for Yahoo. Until then Yahoo is dead money.

Disclosures: No Positions in Yahoo

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Given the small amount of shares being offered and given the popularity and name recognition that the site enjoys, I expect the shares to do very well on their first day of trading and a nice IPO-day pop is expected. However, the main question is will the shares maintain their altitude post IPO and what will drive them higher in the future?

After looking at the latest Yelp S-1 filing, I can only say that the financial future of the company is not that promising in terms of future profitability in the next couple of years. If you believe that a company’s stock price is a function of its future profitability then you won’t find many profits in Yelp for the next couple of years. The company has never been profitable and lost nearly $17 million in 2011. However, Yelp has built an impressive website that saw 66 million monthly visitors last year – but how much is that worth?

Yelp generates revenue from local advertising (70% of total in 2011) by local merchants as well as branded display advertising (21%) and deals (9%). It operates in 46 markets (cities) in the US and 25 internationally for a total of 71 as of the end of 2011. What is noteworthy is that 44 markets (62% of total) are two years old or less (22 each in 2010 and 2011) which means that there was a huge investment in rolling out coverage of these markets with revenues still trickling in slowly. What is also noteworthy is that, at least in the US, each new market being opened is smaller, on average, than pre-existing markets. Logic says that you start operating in the biggest markets first then expand to smaller ones. So a market like San Francisco or New York City opened in 2005 and 2006 respectively are bigger than Providence (2010) and Buffalo (2011). It is “probable” that smaller markets are likely less expensive to set up and maintain but it is certain that they will likely generate less total revenue. This is significant in that future revenue growth will slow down as the company expands to new (smaller) markets – everything else being equal. So what else are you getting at a $780 million market cap:

- 24,000 paying local customers who shelled out $58.5 million in 2011 or $2440 per client per year. At $780 million market cap, you are paying $32,500 per client or 13.3x annual revenue for each local customer.
- 606,000 claimed businesses or in other words potential clients or leads. If you back out those 24,000 who are existing clients then you are paying $1340 per lead.
- 71 local markets that have been set up, local businesses catalogued, and sales and support staff hired to sell into and maintain. Per market, you are paying nearly $11 million.
- 66 million monthly visitors. This translates to $11.8 per monthly unique visitor

Now the purpose of this exercise is to show you what exactly you are paying for the set of digital assets that Yelp has. They are certainly valuable; they generate revenue and cost time and money to reproduce. However, are they worth the price you are paying or will pay post IPO? At $13 or higher my answer is a definite no. Having said that, I do expect a nice exuberant pop at the open and in the days immediately after the IPO. Yelp is a takeover play and not an earnings growth play. It is a speculative stock that will go up and down based on market sentiment for tech and social media stocks as well as the market overall. It is an ideal takeover for a big consolidator in the tech/social media space. Perhaps Google (NASDAQ:GOOG), Yahoo (NASDAQ:YHOO), AOL (NYSE:AOL), IAC (NASDAQ:IACI) may be interested at some point but most of these players already have a local/city product among their offerings. Still, if a consolidator picks it up, it won’t be at those multiple levels. My back of the envelope calculations puts the takeover value of Yelp today at $375 to $500 million ($6.25-$8.33 per share) based on a generous 50% revenue growth in 2012 to $125 million and based on the assumption that a consolidator can squeeze half of that in EBITDA ($62.25) and then slapping a 6 to 8 multiple on that. Incidentally, that comes out to the 4-5x sales multiple that I have always considered advertising based internet stocks are valued in a takeover by a strategic acquirer.

Perhaps with a new currency, its stock, Yelp can be the consolidator by rolling up other small local players such as Angies’ List (NASDAQ:ANGI) or Open Table (NASDAQ:OPEN). Either way, this stock is only for those with an extremely high tolerance for risk. Keep in mind that the longer Yelp remains public under its existing business plan the more likely it is to run out of cash and come back to the market to sell more shares diluting existing shareholders. So if you are lucky enough to get shares in the IPO from one of the Underwriters then you will be well served if you sell soon after the IPO. If you do not get any shares before it starts trading then you should look away and fight the temptation to jump in if you see the stock making huge advances.

The combination of Yahoo’s now cheaper stock price and Loeb’s move has tempted many to jump in the stock on the premise that Loeb will prevail and bring much needed change to Yahoo’s Board. That maybe true but until that happens, Yahoo in my opinion is dead money and likely to go lower than higher.

Investors need to know that if the proxy fight is settled by a vote, that eventual vote for Board nominees will not be settled before June 2012. Last year’s annual meeting was held on June 23 and if it takes place around that same time this year then we are basically 4 months away. During this 4 months period Yahoo’s share price will be impacted by overall market conditions as well as its first quarter earnings. Yahoo is likely to announce Q1 earnings around mid April and they are likely to disappoint rather than beat. Any beat will probably be based on drastically lower expectations. Yahoo has been in an indeterminate state since the Board abruptly dismissed then CEO Carol Bartz last September. Yahoo’s stock hit its 52 week low at $11.09 a few weeks before Bartz’s departure. I think we are at that point today. If the prospects of a sale of its Asian assets are off the table for now then there is little catalyst to justify a price that is only a mere 10% below that when the sale of those assets was a near certainty. As for the earnings I mentioned earlier, one has to assume that they will not come in too rosy. Yahoo has been in a state of confusion ever since Bartz left, and now that it hired a new CEO – Scott Thompson – it is in a state of transition. Employees are probably more worried, and panicked, about keeping their jobs than attending to their jobs as the new CEO tries to figure out what is the best strategy to pursue and which managers and employees are the most equipped to implement this strategy. And let’s not forget that Yahoo has been losing a steady stream of senior managers over the last 12 months which does not make for the smoothest running earnings machine.

Now I think there is tremendous value in Yahoo shares but with the shares trading north of $15 this leaves more downside risk in the near term if a divestiture does not take place. We need to remember that Yahoo was trading at more than $18 less than a year ago last May when the sale of Asian assets was not really overtly being discussed at all. The stock quickly declined when the Alipay fiasco was made public which caused investors to question Bartz’s (and Jerry Yang’s) leadership and competency as well as the business practices of Yahoo’s Chinese partners. With Bartz and Yang gone and the issue with Alipay rectified, I think we can get back to $18 a share when: 1) investors have the same confidence in the new CEO as they did in Bartz when she was first hired and 2) Yahoo has regained its earnings momentum. In the meantime I will avoid the stock and only go back in at much lower levels.

Disclosure: I owned Yahoo shares up until January 4, 2012. I no longer maintain any position.