On July 25^th Verizon announced that it would acquire Yahoo’s core business in an all-cash deal, valuing it at around $4.83bn.

Companies Overview

Verizon

Verizon Communications Inc. (NYSE:VZ) is one of the world’s leading providers of communications, information and entertainment services and products to consumers, businesses and governmental agencies. With global presence, it offers voice, data and video services and solutions on its wireless and wireline networks which are projected to meet customers’ demand for mobility, reliable network connectivity, security and control. Verizon can be classified for providing three main products:

• Connectivity: Relates to data services provided by Verizon, such as 4G and 5G services

• Platform and Solutions: These are high growth markets. Platforms includes services such as AOL and the Internet of Things (IoT). Solutions provides clients with the tools they need to utilize platform services, such as Smart Cities

Another classification of the firm’s business could be done through its two reportable segments:

Wireless

The Wireless segment earns revenue primarily by providing access to and usage of its network as well as the sale of equipment. In general, access revenue is billed one month in advance and recognized when earned. In this business network, revenues grew 4.6% during 2015 driven by a 54.4% increase in equipment revenue as a result of an increase in device sales, primarily smartphones, under the Verizon device payment program (formerly known as Verizon Edge), partially offset by a decline in device sales under traditional fixed-term service plans.

Wireline

The Wireline segment earns revenue based upon usage of its network and facilities and contract fees. In this segment, revenues declined 1.8% during 2015 primarily due to revenue declines in Global Enterprise resulting from lower voice services and data networking revenues, as well as the negative impact of foreign exchange rates.

However, Verizon is also active in the advertising market. Advertising revenues are generated through display advertising and search advertising. Display advertising revenue is generated by the display of graphical advertisements and other performance-based advertising. In addition, Verizon acquired AOL to enhance their digital media and advertising capabilities, in an effort to enter on this business and build competitive services for its users.

The financial position of Verizon is very strong as the last years were characterized by considerable growth and increase in profitability and clients retail grew by 3.9% over the last year. Furthermore, asignificant increase in EBITDA (from 9.9 to 10.3 billion) can be noticed over the last year.

Yahoo

Yahoo Inc. (NASDAQ:YHOO.O) is an American multinational technology company headquartered in Sunnyvale, California founded in January 1994 by Jerry Yang and David Filo, which focuses on informing, connecting and entertaining its users with its search (Yahoo Search), communications (Yahoo Mail and Yahoo Messenger), and digital content products (Tumblr, Yahoo Finance, Yahoo Sports, and Yahoo Lifestyle).

Yahoo offers two main services segments:

• user offerings include Yahoo Search, communications such as Yahoo Mail, and digital content such as Yahoo Finance and Tumblr (acquired in 2013 for $1.1bn)
• advertiser offerings (Gemini and Brightroll) which include clicks on text-based links to advertisers’ websites that appear primarily on search results pages (“search advertising”), the display of graphical, non-graphical, and video advertisements (“display advertising”), and other sources. This is the segment from which Yahoo generates the majority of its revenue

The Company’s geographies and respective revenue split are: Americas – $4bn; Europe, Middle East and Africa (EMEA) – $343m; Asia Pacific – $650m.

Yahoo generates revenue principally from search and display advertising on Yahoo Properties and Affiliate sites, with the majority of the revenue coming from advertising on Yahoo Properties. Other sources of revenue include listings-based services, facilitating commercial transactions, royalties, patent licenses, and consumer and business fee-based services. In order to increase its revenues and withstand competition, Yahoo lately has been trying get access to the lucrative social media advertising but unfortunately without any result. Witness of this attempt is the purchase of Tumblr for $1.1bn in 2013 that turned out to be a total failure.

Graph 1: Source of revenue for Yahoo in 2015 and revenue split by region (Source: Annual report; 10K)

Yahoo was once the king of the Internet, a $125 billion giant as big in its time as Facebook or Google are today. In the last years, however, the poor leadership and increasing competition in has shrunk its market share in the TMT industry. As a result of poor decisions, Yahoo’s share price has fallen from $51.75 reaching a lowest of $27.04 in 2015. The all-cash acquisition by Verizon amounting roughly $4.8bn gives Yahoo the opportunity to end the long process to extricate itself from a mess of its own making. This explains why Yahoo is being sold to Verizon for comparative chump change. With the deal, Yahoo will be left with its stakes in Alibaba Group Holding Ltd. and Yahoo Japan Corp., with a combined market value of about $40 billion. The sale will unite Yahoo with another fallen star, AOL, the first web portal Verizon bought last year for $4.4 billion. The United States’ largest wireless provider is betting nearly $10 billion that combining the two formerly dominant websites will give it an edge in mobile content and advertising technology it can leverage across its more than 140 million subscribers.

Industry

The sector in which the deal is involved is the online advertising industry. In this area advertisers sell spaces on their platforms to companies to reach users and promote their products/businesses, hence users are crucial to the value proposition of an advertiser, since with that they attract companies that have precise targets.

We can sub-segment the industry on the various ad format and considering the fact that you can access internet through mobile (smartphone, tablet) or desktop:

• Search: every ads shown close to the results of a query in a search engine
• Display: banner ads in the form of video, text or images shown in sites
• Other: every other ads unrelated to the previous ones like retargeting ads or flash ads, this category is a minority in almost every advertiser.

Performances have been outstanding in past years. In 2015, revenues reached a record size of $59.6bn, 20.4% higher than 2014. Main driver of this growth was the diffusion of smartphones in both occidental and oriental cultures, massive daily usage of social media and decreasing tech age gap. Therefore, mobile played a key role in this growth, a sector that accounts for $20.7bn of revenues and was just born in 2010. In other words, a 100% CAGR in the past 5 years.

Online advertising continues to be very concentrated around 10 ad-selling companies. In 2015, these companies made almost 75% of the industry revenues as graph 3 shows, while during 2014 the same figure was 71%. As revenue consolidates, ad-selling companies that are seeking leadership positions will see their prospect gets more negative and they might be subject of acquisition, as they try to catch up with the competition. Lately this has been saw in the $26.2bn Microsoft-LinkedIn deal, and it seems to be driving rumors of Apple/Google buying Twitter.

Terms and Structure

The July 25, 2016 deal, where Verizon agreed to acquire Yahoo for approximately $4.83bn in cash was a simple but unusual one: it is effectively a carve-out of Yahoo’s main operating business (including the Yahoo name and IP address). This transaction only makes sense in the context of the dramatic change in profitability of the company’s different business units: the $1bn investment in Alibaba in 2005 has soared in value to over $30bn while the online business has failed to keep up with tech giants like Facebook and Google.

The carve-out does not include its 15% stake in Alibaba, its c.35% stake in Yahoo Japan, its convertible notes, minority investments, its non-core patents (the Excalibur portfolio) or any cash at the end of the period. These assets will continue to be held by Yahoo, under a new name, which will become a registered and public investment company.

As with most carve-outs, Yahoo shares will not be converted to Verizon shares but will instead become shares of the newly-named investment company, which will announce a capital return strategy after the deal closes. Verizon will, however, issue cash-settled Verizon RSUs for Yahoo RSUs that are outstanding at the close.

The deal, expected to close in early 2017, is subject to customary closing conditions and shareholder and regulatory approvals. Until then, Yahoo will continue to operate independently as it has done since 1995.

Rationale

The deal is mainly driven by Yahoo’s desire to sell itself and Verizon’s aim to create a “third force” in digital advertising.

Yahoo’s outlook has been bleak for quite some time, as Google’s, Microsoft’s and Facebook’s advertising revenues grew a lot faster than Yahoo’s. Moreover, the attempt to catch up by buying Tumblr for $1.13bn in 2013 contributed to a $4.4bn goodwill impairment charge in Q4 2015, which was reflected by a year-on-year share price fall from $44 to less than $30 in February 2016.

Hence, in the same month it decided to explore “strategic alternatives” and auction itself off to the highest bidder. In the end, Verizon won with a $4.83bn all-cash bid for Yahoo’s core business, which does not include any of its cash, the investment in AliBaba and its “excalibur” portfolio of patents.

Once the transaction has taken place, Yahoo plans to rename itself, become a publicly traded investment company and return most of its cash to its shareholders.

Verizon on the other hand plans to make a big entry into the digital advertising market and started last year by acquiring AOL. Since Yahoo traded at a discount, considering it had non-core assets of around $41.5bn ($8bn cash, $30bn investment in AliBaba, estimated $1bn “excalibur” patents and other equity investments of $2.5bn) compared to a market capitalization of around $40.7bn, buying its core assets seems like a cheap way of further expanding.

After the deal finishes, Verizon plans to merge AOL and Yahoo to create a competitor for Google and Facebook in the online advertising market. The combined company will control 6 per cent of the US digital advertising market and Verizon’s management believes it could expand this share by creating an unique platform. Due to Verizon being a mobile telecom company, the platform could target users based on location in contrast to the incumbents. Additionally, Verizon will add Yahoo’s 1bn customer base to its 100m subscribers. Hence, the executives believe that the combination will bring the edge needed to grow into a “third force” in digital advertising.

However, recent revelations of a hack affecting more than 500mn Yahoo-users has brought some uncertainty to the deal. Verizon’s management has sought a $1bn reduction of the price, but stated that it still values Yahoo highly. Despite this drawback, the deal is developing quickly and expected to close between December and February.

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Sources and References: Bloomberg, Wall Street Journal, Financial Times, Companies’ websites and annual reports

To contact the authors:

Michele Di Paola            michele.dipaola@studbocconi.it

Niklas Müller                  niklas.muller@studbocconi.it

Harry Blaxland               simon.blaxland@studbocconi.it

Johnathan Riad              johnathan.riad@studbocconi.it

Stefano Melchiori          stefano.melchiori@studbocconi.it