Description

Yahoo Japan is the listed internet media joint venture between Softbank and Yahoo Inc, established in 1996.  Its business spans internet search and display advertisements on both PC and mobile, e-commerce via marketplace and auction platforms, online travel agencies, and other internet services.  It is one of the largest internet companies in Japan at $23bn equity market cap.  On a trailing basis this internet company is trading at a reasonable 22x LTM P/E, 6.3% FCF/EV, 13.3x EV/EBIT and averaging 19% ROE over past 4 quarters, at a time when we expect an upward inflection in earnings.  Yahoo Japan is also trading at a meaningful discount to peers.

We expect operating profits to rise at a mid-teens CAGR over the next 3 years vs. 2% over the previous 3 years.  We expect this because we are beginning to see the results of a corporate strategy shift, which began in FY2013, aimed at aggressively investing in their e-commerce and non-paid search advertising businesses.  The company is seeing material traction in vendor participation, GMV transaction growth, and take rate improvement.  Overall, total e-commerce related sales were only 10% of consolidated revenues at the end of FY3/14 but now account for 40% of consolidated revenues.  At the same time, a decline in non e-commerce related advertising revenue growth has bottomed and revenue growth has started to reaccelerate.  The reacceleration is  driven by mobile advertisement penetration and increased adoption of in-feed advertisements and display advertising network sales, which are used to maximize value of unsold inventory.  

We also believe that the pending acquisition of strategic shareholder Yahoo! Inc. by Verizon could potentially open the door for a positive balance sheet catalyst for Yahoo Japan.

Background / Description

For purposes of clarification, we have re-segmented Yahoo Japan’s P&L into three pillars: e-commerce, advertising, and other business/personal services.  The company’s existing revenue segmentation may not be entirely intuitive for the newly initiated, as it consists of three broadly defined categories of Marketing Solutions, Consumer Business, and Other Business. All three of these categories include some elements of advertising and e-commerce.  For further clarification, we have provided a chart of our re-classification:

E-commerce related revenues includes advertising revenues of Yahoo Shopping marketplace vendors, Yahoo Auction commissions, Yahoo Travel and hotel booking site Ikyu.com commissions, and the consolidated GMV of e-commerce listed subsidiary Askul.  This segment in the most recent quarter represents 40% of revenues vs. 10% of revenues 2 years ago.  The next segment is Advertising, which includes traditional Paid Search advertising on both PC and mobile phones, Display Advertising in the form of banners and targeted “in-feed” ads on Yahoo’s various online properties via both PC and mobile phones, and revenues from Yahoo’s own display advertisement network which allows the company to sell unused inventory to resellers and direct buyers.  Advertising represents approximately 30% of revenues in the most recent quarter vs. 59% of revenues 2 years ago.  Lastly, “other business/personal services” includes monthly membership fees of Yahoo’s  17m subscribers to services ranging from Yahoo Premium service, CRM software, broadband service resales, corporate data centers, and consumer credit card services. 

Ecommerce is now the largest driver of growth

We estimate that by the end of FY3/17 total e-commerce related revenues will have increased 8x over the past 3 years.  This increase includes the consolidation of GMV of listed Askul, an office supply and daily household items e-commerce company that was added to the consolidated P&L in Q2 of FY 3/16.  Stripping out Askul’s GMV, revenues in e-commerce would  have doubled over the past 3 years, realizing an annual growth rate above 25%.  The company was able to achieve this growth due to a combination of changing business models in their core Yahoo Shopping e-commerce business and increasing sales promotion expenses over the past 3 years.  Developing Yahoo Japan’s e-commerce business is a core initiative for the new CEO, Miyasaka-san, who took the helm in April 2012 but who has been with Yahoo Japan since its inception.  While Yahoo had a large presence in the Japanese online auction market during the period before his appointment as CEO, Yahoo Shopping was almost non-existent, with 20,000 vendors and GMV share of less than 1% of the domestic e-commerce market.  It was at that time the founder of Softbank, Son-san, as 43% owner of Yahoo Japan and major influencer on the board, pushed for a strategic change and encouraged the company to aggressively pursue a business model more akin to his other prized company – Alibaba.  Our understanding is that Son-san inserted his lieutenants into Yahoo Japan to oversee this transformation.  A few key individuals continue to be there today.

Prior to this period of change, the Yahoo Shopping marketplace generated revenues consisting of a fixed listing fee and commission for each transaction.  Starting in October of 2013, the company eliminated all fixed fees and commissions, but offered vendors the ability to purchase advertisements to differentiate their products.  The idea was to increase the number of vendors and products listed to attract more shoppers, which Son-san and team hoped would increase competition amongst vendors and cause them to spend more on marketing on the Yahoo Japan platform.  The result is that vendors increased from 20 thousand before the new strategy to currently over 470 thousand, with shopping-related GMV more than doubling over that same period.  For this fiscal year, we expect this trend to continue with the number of stores to increase 24% YoY, per store transactions to increase almost 2% despite this rapid increase in stores, and Yahoo Shopping GMV to increase almost 30% to JPY 490bn.

The total gross market value (GMV) of Yahoo Japan includes the transactions generated on Yahoo Shopping marketplace described above and other e-commerce businesses such as Yahoo Auction (#1 in Japan with 45% marketshare), Askul (consolidated office products e-commerce), Lohaco (subsidiary of Askul that specializes in household and pantry items), Yahoo Travel, and Ikyu.com (hotels booking). We estimate this total Yahoo Japan GMV to be JPY 1.8 trillion for FY3/17 with 25% YoY growth.  For clarification, we have provided a breakdown of YJ’s e-commerce GMV:

The overall e-commerce market in Japan is estimated to have 10% annual growth with approximately JPY 15 trillion in sales, 12% of which is digital content-related, 35% service related, and 53% product related. The core Yahoo Shopping GMV of  JPY 490bn, growing at 30% per year, compares to Rakuten’s roughly JPY 3 trillion in GMV with 10-13% growth and Amazon’s 1.6 trillion, which is growing slightly faster than Rakuten.  So from a market share perspective, Yahoo Shopping has a lot of head room for growth with only 6% of the e-Commerce products related market currently vs. 37% at Rakuten and 20% at Amazon.  Indeed based on relative growth rates since the debut of the new e-commerce strategy, Yahoo Shopping has been taking share.

In the past few quarters, revenue generated from e-commerce, and in particular Yahoo Shopping, grew faster than GMV .  We expect this trend to continue driven by continued positive leverage in take rates.  The effective take rate for Yahoo Shopping (total shopping advertising revenue divided by shopping GMV) was only 1.4% at the end of FY 3/14.  This increased to 1.5% in FY3/15, and 2.2% in FY3/16, and most recently 3.4% in Q2 FY3/17.  Management has indicated that they expect take rates for Yahoo Shopping to approach 5% by the end of FY 3/18.  The increase in take rates is a function of more effective ad products such as “in feed” display ads, and vendors’ overall propensity to spend advertising dollars as their marketplace transactions increase.

Similarly, in 2016 we have seen Yahoo Auctions take rates increase from 5% to 8% for individuals and from 5% to 7% for businesses.  Q4 of last year saw the acquisition of Ikyu.com – a hotel booking site that has a take rate of 10%; currently Yahoo Travel does not charge a commission for their users.  Management has disclosed that by FY 3/18, they plan on merging the Yahoo Travel and Ikyu platforms and taking a commission on Yahoo Travel with the higher Ikyu.com economics. Yahoo Travel is approximately 9% of total consolidated group GMV, and while there will be some attrition in transactions given the merger, we expect the business combination to be accretive to overall topline and profits.  Ultimately, a sensible question would be to consider what the take rate limit is for Yahoo Japan.  We believe there is plenty of room for increasing take rates.  Currently Rakuten has almost 40% market share of product e-commerce and they have a 6-7% listing fee and a 3-4% advertisement fee.  This effective 10% fee is much higher than the 3.4% effective take rate of Yahoo Japan.  We believe the continued positive leverage in pricing combined with a base case 20% GMV growth is quite compelling.

Advertising is re-acclerating

Yahoo Japan runs the dominant search engine with over 60% search market share on PC and 40% on smartphones.  Google is number two with 40% PC share and 60% mobile share.  Since 2010, Google has provided its search engine for Yahoo Japan in return for a royalty fee that is estimated to be approximately 3% of search revenues.  Out of an estimated 115 million internet users in Japan, Yahoo Japan has 36 million monthly active user ID’s and 17.4m monthly paid-membership IDs across all its online services – probably the largest share of users on the internet in Japan.  For clarification, we have provided a breakdown of Yahoo Japan’s advertising business below.  To allow for easier comparison with company disclosures and analyst reports we have included shopping related advertisements in the chart.  For purposes of our discussion however, we have excluded shopping related revenues in our calculations as we have already accounted for that in our e-commerce discussion.

We believe that non-shopping related advertising revenue growth has bottomed, and similar to e-commerce, it has reached an inflection point. Total non-shopping related advertising revenue compounded at a low rate of 5.7% over the past three years.  The two drivers of non-shopping related advertising at Yahoo Japan are Paid Search Advertising and Display Advertising. For the past three years, Paid Search represented 66%, 62%, and 54% of total non-shopping advertising revenue, respectively, as Paid Search revenues declined 10% cumulatively over those 3 years. Offsetting the decline in Paid Search is the growth in Display Advertising, for which revenues have increased 72% over the same three-year period.

We expect that by the end of FY 3/17, Display Advertising (ex-shopping) will be greater in revenue contribution than Paid Search and will continue to compound at least mid–teens growth rate.  As Display Advertising eclipses Paid Search advertising in scale in FY3/18 and beyond, we expect overall advertising revenue growth to re-accelerate from low- to mid-single digits to percentages in the teens over the next few years.

What is driving this dynamic?  Within Paid Search, which used to be 80% PC-based 3 years ago and declining by mid-teens annual rates, smart phone generated revenues have been increasing at a rapid pace, such that we expect mobile generated paid search sales to be equal in size to PC based sales by the end of this FY. As a result, overall Paid Search revenue declines have bottomed.  Concurrently, Display Advertising has been growing at 20%+ annual rates because of the rapid adoption and growth of precise, user targeted premium display advertisements and Yahoo Display Network (YDN) sales.  YDN sales have tripled in the past 3 years, now representing over 80% of Display Advertising (ex-shopping) sales.

In the most recent quarter, non-shopping advertising represented 32% of total consolidated revenues.  While we don’t expect this segment to see the same kind of growth as in e-commerce, we believe that growth has bottomed and we expect a minimum 10% annual revenue growth over the next 3 years.  The company has finally hit a critical juncture in product mix: Display Advertisements will be larger than Paid Search in FY 3/18, and Smart Phone based advertisements will be larger than PC based advertisements.

Cost increases have peaked

In addition to the positive trends we are seeing in the top line driven by e-commerce and advertising, we expect marketing costs have largely bottomed.

As management was ramping up the e-commerce business over the past few years, Yahoo’s sales promotion costs as a percentage of revenue increased from 3.5% in FY3/15 to 8% in Q4 of 3/16.  Concurrent with that 8% promotional spend, Yahoo Shopping GMV growth that quarter peaked at +62% YoY.  Subsequent to that, management eased off the promotion throttle, with 1H 3/17 sales promotion costs coming in at 2.9% of sales, but surprisingly Yahoo Shopping GMV maintained a 30% YoY growth rate, off a comp of +27%.  We were impressed that, despite easing off the expense throttle, GMV momentum maintained above a 20% YoY rate.  We don’t expect management to maintain promotional costs at 2.9% of sales indefinitely, but we also think that the large chunky promotional expenses are largely over.  Similarly, starting in 2015, the company embarked on an aggressive strategy last fiscal year to court buyers, offering Premium members a rewards-point rate of 9% for purchases made on Yahoo Shopping, with 1% of that subsidized by the vendors and the rest by Yahoo Japan.  Starting this FY, the company lowered that reward rate to 5%, with 2.5% of that subsidized by venors.  Subsequent to this change, we continue to see at least 25% annual increases in number of vendors as well as strong GMV momentum described above, while overall costs for Yahoo Japan have declined.  This kind of organic growth momentum, despite the curtailing of subsidies to both buyers and sellers on the platform, is a positive surprise. Yahoo Shopping on its own is currently not yet profitable, but we expect it to reach profitability by the end of FY3/18 as this organic growth we highlighted accelerates.  We also expect operating leverage for Yahoo’s overall P&L to kick in as Shopping reaches the breakeven mark.

Looking at consolidated group expenses as a whole, we believe that even with promotional expenses normalizing, there are potential improvements that could be additive to the P&L.  The company’s consolidated operating margin in FY3/15 prior to consolidation of major acquisitions was 46% vs. a much lower 24% in the most recent quarter.  For the casual observer, such a decline in profitability would be alarming, but looking through the acquisitions reveals a different story.  Askul is the largest recent acquisition, with LTM sales of 330bn vs. 813bn at Yahoo Japan (including consolidation).  Because Askul’s revenue is reported on a GMV basis, reported operating margins are quite low, at around 2.5%-3.0%, vs. Yahoo Japan’s FY 3/15 operating margin of 46%.  If we deconsolidate ASKUL, we see that Yahoo Japan’s latest Q2 OPM is roughly 39%.  While some expenses are fixed such as increased deprecation from its growing tech infrastructure, we expect a large portion of this difference can be recaptured as the company begins to experience organic growth and break even in its e-commerce business, and as the advertising business reaccelerates.

From a strategic perspective, the trend for global e-commerce players has been to create a rich ecosystem of personal and business services that will keep vendors and buyers on the platform.  Amazon in the US is a good example, with their focus on Amazon Prime services that includes preferred distribution, media and financial service tie-ups as well as corporate and SME services like Amazon Web Services (AWS).  All of these initiatives have depressed Amazon’s recent operating results from a pure cash earnings perspective.  If we look at Japan, Rakuten is also doing the same, making investments in credit card and other financial consumer services for its members.  Yahoo Japan on the other hand, has spent the past 20 years building this ecosystem, and only recently made a concerted effort in e-commerce.  While we expect management to continue spending money to round out their ancillary services like credit cards, data centers, travel rewards, and media – the bulk of the investments have already been made.

The importance of creating a full service e-commerce ecosystem cannot be understated because  entrenched members are the best customers.  We estimate there to be more than 14m Yahoo Premium members, and Yahoo discloses that less than 20% of the entire membership base use Yahoo Shopping, but those members account for 60% of total transaction value.   At the same time, the total transaction value of Yahoo Wallet, Yahoo’s proprietary payment platform, is now 50% of total group GMV, and now boasts over 30m members.   Yahoo Japan has plenty of sticky users already, so it should be easy for them to further penetrate the existing membership base.

With the bulk of their eco-system already built, we expect Yahoo Japan to take much faster share of the market than peers with much lower incremental cost per customer.  We are already seeing that happening, evidenced by their competitors’ slower GMV growth rates.

Optionality of large share buyback is a bonus

While we view Yahoo as a high quality, stand-alone investment, the current situation surrounding strategic holder Yahoo! Inc. adds another potential positive catalyst.

As one of the original JV investors in Yahoo Japan, Yahoo! Inc. still owns 35.5% of Yahoo Japan, a stake that is worth more than JPY 900bn.  As the press has reported, Verizon is in the final stages of completing the acquisition of Yahoo Inc.’s core operating assets for approximately USD$5bn.  Upon completion of this, the financial holdings of Yahoo! Inc., which includes the 15% stake in Alibaba and 34.5% stake in Yahoo Japan, will remain in the listco – to be renamed Altaba.  We don’t expect Altaba to indefinitely remain a listed holdco with no operating assets.  We expect some corporate resolution upon a) closing of the Verizon deal, and b) a clearer picture of the tax regime upon inauguration of the 45th President of the US.

In addition, considering that Softbank has 43% of Yahoo Japan shares and Son-san has always placed great emphasis on maintaining his control over the company – we don’t expect them to sit idly if Altaba decides to divest its holdings.  Son-san has always viewed Yahoo Japan as the cash cow within his group as it consistently generates high amounts of free cash flow, and we don’t think he will want to lose control.  His ability to continue to make outside investments with  Softbank’s balance sheet requires that he maintain control of Yahoo Japan.  In our view two possible likley outcomes are: 1) a full acquisition of Altaba by BABA, or 2) Yahoo Japan conducts a large buyback of its stock from Altaba and BABA acquires the remaining BABA holdings from Altaba.  The latter is a preferred outcome, but BABA acquiring the whole listed entity might also be taken positively by Japanese retail investors given the dominance of BABA in China e-commerce and the cross border e-commerce cooperation potential.  We believe that Yahoo Japan has plenty of balance sheet capacity to be able to buy back a large portion, if not all of the outstanding shares held by Altaba.  Yahoo Japan currently has JPY 453bn of net cash and EV of JPY 2,252bn, with LTM FCF Yield/EV at over 6%. We think Yahoo Japan could easily raise bank debt to acquire the full 35.5% stake, if management (and Son-san) so desired.  Assuming this 35.5% stake is repurchased with half of Yahoo Japan’s cash on hand and the remainder with debt at market rates, the transaction is estimated to be 48% EPS accretive to our FY3/18 earnings estimate.  The implied FY3/18 P/E is 10.6x.

Valuation is attractive

We believe the stock is very reasonably priced for a leading internet company at only 19x P/E and 11x EV/EBIT for FY3/17e, with earnings just starting to hit a positive inflection.

We believe that Yahoo Japan is cheap on its own and also relative to both domestic and international peers across the search, online advertising, and e-commerce landscape.

Risks:

We could be underestimating the company’s expenses both in promotions as well as ancillary services.

Within Yahoo Shopping, 70% of the business is concentrated with the top 20%-30% of their largest vendors.  The recent growth in vendor participation has been impressive, but not surprisingly the concentration of high quality power vendors has declined in the new group.  While we expect the business to continue to diversify over time, we need to make sure that the marketplace does not grow too fast at the expense of quality.  This has been an issue at Rakuten.

The company could face resistence in raising its take rate either through increased pricing or resistance in adopting new advertising products.

Within Advertising, the growth of Yahoo Display Network could stall and/or mobile uptake of in-feed advertisements could stall.

Instead of a strategic share placement, Altaba could decide to do a public offering of its holdings at a large discount.

Instead of share buybacks, the company could lever the balance sheet for acquisitions in e-commerce.  While not necessarily negative, the potential positive effects will take longer to realize than a share buyback.  In addition, there could be a risk that Yahoo Japan uses their balance sheet for non-strategic investments at the behest of Softbank.  This has been speculated by the market to have happened in the past, with the funding of Yahoo Mobile as a result of pressures from Softbank Mobile as an example.

Catalyst

Earnings Inflection

Resolution of Yahoo! Inc's stake in Yahoo Japan