By Alex Gavrish, CEO of Etalon Investment Research and author of “Wall Street: Back To Basics”

The following is a chapter from Alex Gavrish’s book “Wall Street: Back to Basics”*. Two of the three case studies in this chapter on Activist Investors have been included.

Chapter 4:

Activist Investors

Activist shareholder activity has risen significantly in recent years. Activist investors and hedge funds typically buy large stakes in companies and then actively work (or fight) with management, boards, and other shareholders to enact different changes and reforms in an effort to extract value from their investments.

Activist investors engage different types of companies, across different industries, and of various capitalization sizes from small-cap to large- and even mega-cap businesses. During 2011 and 2012, for example, these investors initiated campaigns at such companies as Yahoo (internet), Hartford Financial Services (insurance), BMC Software (software products), Murphy Oil (energy), and many others. These investment firms have significant assets under management, invest a lot of resources into research, and allocate considerable amounts of capital to these portfolio positions. They are not afraid to engage in proxy fights, gain board seats, etc in order to influence outcome of their investments as opposed to waiting passively for the stock price to rise.

Tracking the performance of activist investors is difficult, but many academic studies point to outperformance. For example, IRRC Institute’s 2009 study of 120 companies – in which activist investors gained board seats during 2005 to 2008 – found that total shareholder returns were 19.1% to 16.6% higher than peers during a one-year period beginning from the proxy contest period. Morgan Joseph & Co. tracked 94 campaigns over an 18-month period during 2005 to 2006, and found that excess returns for these stocks were ~16% in the year following the first announcement of an activist shareholder’s involvement. Other studies also report similarly positive results.

Does it make sense to follow activist investors and perhaps invest alongside them? By sticking to companies and opportunities that investors can understand on their own and having an adequate decision making framework, this area can be a constant source of opportunities to earn attractive returns.

4.1 ACTIVIST INVESTOR STRATEGIES

Activist investors are required to submit a 13D filing to the SEC within 10 days of owning 5% or more of a company’s shares and state “purpose of the transaction,” in which they describe their intentions at the company. “Hedge Fund Activism,” a 2006 academic study by April Klein and Emanuel Zur, researched activist investments made by hedge funds. The study identified the major reasons stated by investors and the success rates of their efforts.

Most common stated reasons and intentions were:

– Change the compensation of board of directors

– Demand to pursue strategic alternatives

– Oppose a merger

– Sell the firm or pursue a merger

– Buy more stock with intention of buying the firm

The study reported the success rate of this sample (155 activist campaigns) as ~60%. Overall, these broad categories can help investors better understand and formulate an opinion regarding the specific activist case. Of course, more general statements and intentions such as “undervaluation of company’s stock” and intention to “engage management” are also common.

Another study, “Hedge Fund Activism, Corporate Governance, and Firm Performance” by Alon Brav, Wei Jiang, Frank Portnoy, and Randall Thomas, analyzed a larger sample of activist campaigns between 2001 and 2006. The study found that activist hedge funds propose strategic, operational, and financial changes and attain success or partial success in two thirds of the cases. About 48% of cases in their sample state general undervaluation/maximize shareholder value as the investment objective/purpose of transaction.

“Hedge Fund Investor Activism and Takeovers,” an academic study by Robin Greenwood and Michael Schor in 2007, determined that firms targeted by activists are more likely to be acquired than other similar firms. Also, an additional interesting observation the study makes is that although overall activist investors have rather long investment horizons, activist hedge funds’ objectives are to earn returns in as short a period as possible. Therefore, they are especially interested in finding merger and acquisition opportunities for the target company.

4.2 MARKET INEFFICIENCY

By following activist investors and looking for opportunities in this area you can obtain a few “competitive advantages.”

Excellent research

Activist investors are often large hedge funds and have significant assets under management. The stakes of 5% (or more) that they acquire represent both large amounts of money and often are large portfolio positions. Investors’ funds and their own reputation are at stake here, and the level of responsibility they assume when making such investments is much higher than, for example, a mutual fund manager who manages a very diversified portfolio. Activist investors would not be able to do this if they did not conduct comprehensive research and analysis of the target company. Obviously, the resources they invest into this task are significant and are not typically available to an individual investor or even an institution.

Disclosures in proxy fights, presentations

U.S. securities regulation is robust, and requires many disclosures. Activist investors report how much they invested in a target company and the size of their ownership stake. They also declare their intentions; file other documents such as letters to the company’s management; create presentations in which they outline their investment thesis and analysis of the company, as well as all the required disclosures and documentation related to proxy fights. All this is beneficial to an individual investor who may be also interested in investing in this company. However, you should not be too naïve, because activists may begin to purchase shares, and only some time later, when they achieve a 5% holding threshold they report with the SEC. During this time, the stock price often rises significantly. Once the requisite SEC documents are filed, the publicity in the market and media that activists receive help move the stock price even higher. In order to achieve good results by following activist investors, you must first estimate if the investment is still attractive even after stock price rises.

Alignment of interest

Overall, the interests of activists and the rest of the firm’s shareholders are aligned. First, the majority of companies that become targets of activists are considered value stocks. For example, it is rare to see activists initiate investments in high-growth companies. So, such starting point is really suitable for more conservative, value-oriented investors. Second, activists often raise corporate governance issues and may even expose management problems at the company. As a result, their interests are completely aligned with other shareholders, who ultimately seek attractive returns. Third, as previously discussed, activist investors conduct thorough research and analysis, and they often identify and value non-core assets which can be sold, or they look for other M&A opportunities. The sales of non-core assets can only improve the efficiency of a company’s operations and extract more value from the investment in a proactive way – instead of depending solely on the market to “correct” itself.

4.3 DECISION FRAMEWORK

Many investors follow and copy activist investors. The media provides lively coverage of these developments. There are even dedicated websites that allow you to track activist investors’ holdings, other famous funds or investors, and even insiders. However, achieving good returns might not be as easy as just mimicking these investors. Activist investors have different strategies and time horizons, the price might not be so attractive – after all, there is a delay until 13D filings are made public (meaning that an activist investor may have already changed his or her strategy). Overall, activist investors have a long-term investment horizon of at least three years, and the demands they present to a company and its management might take a long time to negotiate and achieve. What are the main principles that investors should use when analyzing a company that is subject to activist investor campaign? Here are some main guidelines.

Valuation

In addition to the main thesis undervaluation, there are few aspects that are especially important in activist investments: cash, balance sheet, and non-core assets. Companies with large cash holdings and strong, unleveraged balance sheets are more likely to become targets of activists. The activists will usually press management to return such excess capital to shareholders in the form of dividends or share buybacks. In addition, the company might own some non-core assets, which can be sold – such as real estate – but may not be properly valued, and, as a result, their value is not properly reflected in the stock price.

Activists also often become involved in situations where companies operate several separate businesses, often in different industries. It is difficult for investors to accurately value these companies, and activists may conclude that if the divisions were valued separately, the company would be worth more, and so it makes sense to sell or spin-off some units. The Yahoo and Office Depot cases discussed below provide excellent examples of such situations.

Type of an activist campaign

The academic study, “Hedge Fund Activism, Corporate Governance and Firm Performance” mentioned above reports that there is significant positive return, 7% on average, during the month an activist files a 13D form. The stock price increases even more when activists engage in campaigns with reported objectives to force the company to sell itself; sell some assets; or spin-off noncore business. In contrast, campaigns that are oriented at making changes in corporate governance do not produce such price movement. The one-month, short-term price movement of 7% is not significant for a value investor who plans to hold the stock for the medium- to long-term and has a return objective of 30% at least, but this finding can provide a guiding principle for investors. One possible theory explaining the differences in market reaction between the two types of activist campaigns is that campaigns which are more corporate-governance oriented may be an indication that the company is not well managed and that management might be corrupt and non-cooperative. In these types of cases, it might take a long time to fight management, gain board seats, and eventually to enact the necessary reforms. On the other hand, campaigns that call on companies to sell some non-core assets, distribute extra cash, or spin-off part of the business and focus on the performance of the main division, do not necessarily imply that management is corrupt. It is more likely that management will cooperate, and the campaign will unlock value for shareholders.

CASE STUDY #1: Yahoo Inc (NASDAQ: YHOO)

SEPTEMBER 2011

Company Profile

Yahoo is a premier digital media company that delivers personalized digital content and experiences, across devices and around the globe, to vast audiences. The company provides engaging and innovative canvases for advertisers to connect with their target audiences using its unique blend of science + art + scale. Yahoo generates revenue from several services including the display of graphical advertisements (“display advertising”), the display of text-based links to advertisers’ websites (“search advertising”), and other sources.

Chart

Investment Rationale

On Sept. 8, 2011, Third Point Funds disclosed that it acquired a 5.15% stake in Yahoo. 45 million shares were acquired at an average price of $12.73 per share and option contracts to acquire an additional 20 million shares were purchased, with average stock acquisition price of $14.65 per share if exercised. In total, $866 million dollars was committed to this position, which is extremely large even for a $9 billion dollar fund such as Third Point. The average price for the combined stake was $13.32 per Yahoo share. Together with the disclosure of share ownership, Third Point disclosed a letter to the company’s board of directors that outlined its demands and investment thesis for the company, which we will discuss in the next section. Below are Yahoo’s main financials and valuation numbers:

Share Summary Sept. 8, 2011
Market Price 14.44
Shares Out (mil) 1,300
Market Cap (mil) 18,771
EV (adjusted)* 16,890

Enterprise Value (EV) is calculated as Market Cap – (Current Assets – Total Liabilities).

Balance Sheet	Q2 2011	2010	2009	2008	2007	2006
Current assets	3,890	4,346	4,595	4,745	3,238	3,750
Current liabilities	1,242	1,626	1,718	1,705	2,300	1,474
LT Assets	10,918	10,583	10,341	8,944	8,992	7,763
LT Liabilities	767	706	700	734	396	879
Equity	12,799	12,596	12,519	11,251	9,533	9,161

Main Financials	6m 2011	2010	2009	2008	2007	2006
Sales	2,443	6,325	6,460	7,209	6,969	6,426
Oper Income	381	773	387	13	695	941
Net Income	460	1,232	598	419	660	751
EBITDA	716	1,455	1,126	803	1,355	1,481
FCF	200	526	877	1,205	1,317	682
Dividend	–	–	–	–	–	–
Share buyback	609	1,749	113	79	1,584	1,782

EBITDA is calculated as Operating Income + Depreciation and Amortization.

Valuation	Current	2010	2009	2008	2007	2006
P/S	3.84	2.97	2.91	2.60	2.69	2.92
P/E	20.41	15.24	31.39	44.81	28.44	24.98
P/B	1.47	1.49	1.50	1.67	1.97	2.05
EV/EBITDA	11.80	11.61	15.01	21.03	12.47	11.40
ROE	7.2%	9.8%	4.8%	3.7%	6.9%	8.2%
FCF Yield	2.1%	2.8%	4.7%	6.4%	7.0%	3.6%

Current market price and EV is used in P/S, P/E, P/B, EV/EBITDA and FCF Yield calculations to emphasize the price investor is paying now for company’s historical profitability. Current financial results (2011) are annualized based on first six months of 2011.

Valuation thesis

In addition to its own operations, Yahoo had two valuable investments in subsidiaries: 43% of Alibaba Group and 35% of Yahoo Japan.

Yahoo Japan

Yahoo Japan is a publicly traded company and engages in internet advertising, e-commerce and other internet businesses in Japan. Its main financials (in USD million) are summarized below:

Share Summary	Sept. 9, 2011
Market Price	24,500
Shares Out (mil)	58
Market Cap (mil)	18,342
EV (adjusted)*	16,155

Enterprise Value (EV) is calculated as Market Cap – (Current Assets – Total Liabilities).

Balance Sheet	Q1 2011	2010	2009	2008	2007	2006
Current assets	3,066	3,260	2,625	1,180	2,121	1,489
Current liabilities	844	1,084	1,363	835	1,149	981
LT Assets	2,847	2,829	2,774	2,842	2,651	2,622
LT Liabilities	35	34	5	134	387	646
Equity	5,034	4,971	4,031	3,052	3,236	2,483

Main Financials	3m 2011	2010	2009	2008	2007	2006
Sales	928	3,775	3,612	3,430	3,382	2,744
Oper Income	501	2,060	1,857	1,738	1,611	1,371
Net Income	301	1,190	1,078	964	808	748
EBITDA	532	2,187	1,988	1,886	1,742	1,482
FCF	71	770	1,748	1,046	955	807
Dividend	238	215	–	–	75	61
Share buyback	–	33	40	1,058	–	–

EBITDA is calculated as Operating Income + Depreciation and Amortization.

Valuation	Current	2010	2009	2008	2007	2006
P/S	4.94	4.86	5.08	5.35	5.42	6.69
P/E	15.24	15.42	17.01	19.02	22.69	24.51
P/B	3.64	3.69	4.55	6.01	5.67	7.39
EV/EBITDA	7.59	7.39	8.12	8.56	9.27	10.90
ROE	23.9%	23.9%	26.7%	31.6%	25.0%	30.1%
FCF Yield	1.5%	4.2%	9.5%	5.7%	5.2%	4.4%

Yahoo Japan valuation is reasonable (EV/EBITDA multiple of 7.6). At September 2011 market prices Yahoo’s stake in Yahoo Japan was valued at $6.4 billion or about $3.85 billion after tax, assuming a 40% tax rate.

Alibaba Group

Yahoo owned 40% of Alibaba Group, a leading group of e-commerce companies in China. Alibaba Group holds dominant market positions in difference ecommerce segments, has tremendous revenue growth potential and is a candidate for IPO. The media reported during 2011 that Alibaba Group’s founder and an investment group he led approached Yahoo with the offer to buy back part (15%) of Yahoo’s 40% stake for about $3.5 billion. This offer valued Alibaba Group at about $23 billion. On Sept. 22, 2011, an investment group led a tender offer for a stake in Alibaba Group in order to provide liquidity to Alibaba employees (according to a news report). The deal valued Alibaba at $32 billion. In a regulatory filing with SEC, Third Point Funds estimated that the value of Alibaba is $25 billion. Based on this valuation, Yahoo’s 40% stake was worth $10 billion or about $6 billion after-tax, assuming a 40% tax rate.

Yahoo’s valuation adjusted for holdings in Yahoo Japan and Alibaba Group

After making adjustments to enterprise value to account for Yahoo Japan and Alibaba holdings as well as $702 million in marketable long-term debt securities (which are reported in the long-term assets part of the balance sheet), enterprise value was an estimated $6.4 billion:

Adjusted Valuation
Market Cap	18,771
EV (mil)	16,890
Yahoo Japan (35%)	3,852
Alibaba Group (40%)	6,000
Marketable long term debt	702
*– Adjusted Market Cap*	*8,217*
*– Adjusted EV*	*6,336*

Valuation	Current	2010	2009	2008	2007	2006
P/S	1.68	1.30	1.27	1.14	1.18	1.28
P/E	8.93	6.67	13.74	19.62	12.45	10.94
P/B	0.64	0.65	0.66	0.73	0.86	0.90
EV/EBITDA	4.43	4.35	5.63	7.89	4.68	4.28
ROE	7.2%	9.8%	4.8%	3.7%	6.9%	8.2%
FCF Yield	4.9%	6.4%	10.7%	14.7%	16.0%	8.3%

Yahoo’s own business was valued only at an x4.4 EV/EBITDA and x8.9 P/E multiple. In addition to this, we can reasonable to assume that upside potential from the growth of Alibaba Group over the next 2 to 3 years could be significant. A 50% increase in the value of this holding to $9 billion, for example, would bring valuation multiples to x2.3 EV/EBITDA and x5.7 P/E. One could easily recognize significant possible upside in the shares. Yahoo could sell its Asian holdings, return capital to shareholders, optimize its capital structure, and stabilize its own business and operations

In addition to its valuation thesis and demands to take active steps to restructure the company and realize inherent value of its assets and business, the activist shareholder made demands to improve different aspects of corporate governance such as the replacement of the CEO and replacement and nomination of new candidates to the board of directors.

Position and Return

The stock did not move higher straight away and remained almost flat during the first 12 months. More active developments started to take place in May 2012 when the activist investor threatened the company with proxy fight. Since then, the CEO was replaced, new board members were nominated, Yahoo sold half of its stake in Alibaba (20%), and began to actively return capital to shareholders. Investment in Yahoo alongside the activist investor would return +59% in a 18-month period (September 2011 to March 2013)

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