Yahoo! Is Too Cheap – How to Profit Now and In The Long Term

October 16, 2006 at 9:07 pm  ·  Category: Options, Stocks

Since reporting 2nd quarter earnings 3 months ago, on Tuesday July 18, 2006 after the close, Yahoo’s stock (NASDAQ: YHOO) has been absolutely hammered.  When it announced 2nd quarter results, it also announced that it will delay the release of its new online advertising platform, I believe it is called Panama. 

It closed at $32.24 on Tuesday July 18.  The stock got hammered the following day, down $7.04 to close at $25.20 – 204 million of Yahoo’s 1,381 million shares outstanding, almost 15% of the company, traded hands that day. 

After that, the stock trended back upwards to to close at $29.00 on Monday September 18 – exactly 4 weeks ago.  The next day, however, at a New York investment conference CEO Terry Semel and CFO Susan Decker announced that slowing online ad growth from auto and financial companies would cause the company’s revenue to be at the lower end of the estimates it gave in July. 

As soon as they said this, the stock started to get hit.  Over the course of the day, it lost $3.25 to close at $25.75 – pretty much giving back all the gains it had made since the first announcement of Panama’s delay.  128 million shares, more than 9% of the company, traded hands.

Personally I’m wondering what all the fuss is about.  It seems to me like alot of people panicked for no really good reason.  So what if the online advertising platform is to be delayed?  So what if revenue is going to come in a little light?  This is the still one of the two premier internet properties in the world at a time when the internet is growing exponentially and is becoming increasingly important to everyday and business life.  This trend, which is what really matters, continues to be in place. 

What it’s done is given us a great opportuntity to own a great company.  With an enterprise value of around $33 billion Yahoo! had $1.3 billion in free cash flow in 2005 – for a trailing EV/FCF ratio of around 25.  Revenues grew about 26% in the 2nd quarter, operating cash flow by 35%, and free cash flow by 19% – on a tough compare because Yahoo! had about $1 billion in extra income in the 2nd quarter of 2005 due the sale of some Google stock it had acquired. 

This is cheaper than Google (NASDAQ: GOOG), which at today’s close of $421.75 has an enterprise value of around $121 billion.  With $1.6 billion in free cash in 2005, that’s a trailing EV/FCF ratio of just under 75.  Google is growing about three times as fast in terms of revenue and twice as fast in terms of operating cash flow and so it deserves higher multiple than Yahoo.  But if it deserves a multiple 2 times higher that would be 50.  So, relatively speaking, Yahoo is cheaper. 

So, even though we are entering what I see as a severe economic slowdown in which advertising is likely to get hard, I think Yahoo is too compelling to pass up at this price.  The strong growth of online advertising should cushion the blow to Yahoo. 

I also think we can profit in the short run.  Yahoo is reporting 3rd quarter earnings tomorrow (Tue Oct 17) after the close.  Because I think the bad news is priced into the stock I suggest selling Yahoo Oct06 $25 puts.  Selling them means that you agree to buy shares of Yahoo at $25 from anytime between now and Friday should the person you sell the puts to want to sell them.  He will want to do so if the stock is trading below $25. 

Now, we don’t need Yahoo to rally above $25 to make money on this trade.  Because the current price for Yahoo Oct06 $25 puts is $1.35 we will get that money when we sell the puts.  That means that as long as Yahoo doesn’t fall below $23.65 ($25 – $1.35) we will make money on this trade.  That represents about a 2.2% fall from the $24.18 at which Yahoo closed today.  Unless Yahoo reports some pretty bad news, I can’t see the stock falling that much given how much its fallen recently.  The bad news seems like its already priced into the stock.  If we can get a 3.4% bounce to $25 we won’t have to buy any stock at $25 and we’ll just pocket the entire price of the put.  Wouldn’t that be sweet!

Now, you can just stop there.  However, if you believe with me that the bad news is priced into the stock already and an in line quarter, without any unexpected bad news, will cause the stock to bounce you might want to buy some calls as well.  I suggest the Oct06 $22.50 calls which closed today at $2 each.  If the stock can rally just 1.3% from today’s close to $24.50 we’ll be at the break even point – everything above that will be profit.

Note: the above calculations on the options trade exclude transaction costs which can be significant when trading options due to higher commissions and smaller investment capital. 

Posted by Greg Feirman  ·  Trackback URL  ·  Link
 

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