Yahoo! Still Needs To Generate Better Intrinsic Value

By Stephen D. Simpson, CFA | July 17, 2013 AAA

A year into her tenure as Yahoo!'s (Nasdaq:YHOO) CEO, Marissa Mayer may have ruffled a few feathers, but Yahoo!'s feathers were badly in need of ruffling as it was well on the AOL (NYSE:AOL)/MySpace path to irrelevance and doom. While there's still quite a lot of work to be done in turning the business around, the better-than-70% rise in the shares over the past year has to be encouraging to shareholders. The biggest question now is whether or not Yahoo! can take the cash coming from the Alibaba IPO and reinvest it into sustainable cash-generating growth opportunities.

Second Quarter Results Disappoint
Yahoo!'s second quarter results are a good reminder that while the tone around the stock may have changed, the business is still struggling. It is still profitable and free cash flow positive, though, which ought to buy more time for Mayer's strategies to bear fruit.

Revenue (ex-TAC) declined 1% this quarter. Search came in more or less as expected (with revenue up 5%) on a 21% improved in paid clicks, but Display disappointed. Display revenue declined 11% as overall display ads declined 2% and a shift away from premium ads send pricing down about 12%. The company's relatively large “Other” category saw revenue rise 10%.

Although revenue was disappointing, profits weren't so bad. Gross margin more or less held steady, while operating income more than doubled from the year-ago period (while declining 25% on a sequential basis). All told, Yahoo!'s EBITDA came in about 4% to 5% better than many analysts expected.

All Eyes On Asia
There is no real sign that Yahoo! is making major progress in gaining ground on Google (Nasdaq: GOOG) or Facebook (Nasdaq:FB) in ads, and while an extension of the minimum payments agreement with Microsoft (Nasdaq: MSFT) in search is a plus, it doesn't change that Yahoo!'s core operations are still in need of serious improvement.

With that, a lot of the attention around Yahoo! focuses on the company's investments in Alibaba and Yahoo! Japan. Even with the weakness in China, Alibaba's results have been quite strong recently and speculation is running that Alibaba's post-IPO valuation will run in the $90 billion to $100 billion range. As a reminder, Yahoo!'s agreement with Alibaba requires it to sell half of its stake (roughly 12%) through the IPO, while the other half can be sold at management's discretion.

There's not much that Yahoo! can do to improve the value of this stake at this point, other than to explore various tax-efficient methods of selling that second half of the stake after the IPO. Speaking of which, the timing of an Alibaba IPO is still a big unknown, as the weakness in China has many analysts speculating that the deal will be delayed into 2014 pending better market conditions.

SEE: Strategies For Quarterly Earnings Season

It Will Take Time For Seeds To Sprout
Outside of the large and much-discussed Tumblr acquisition, Yahoo! has been busy on the M&A front, with well over a dozen deals in the past few quarters. Many of these deals look like “hire by acquisition” situations, though, and it could take time for their impact to show in Yahoo!'s traffic, revenue, and profits.

Even so, I think Mayer has a cogent plan for getting this business turned around. Refocusing around mobile makes sense (and many of the deals have been targeted at mobile apps) and there are signs that traffic is on the way back. Even so, the trick will be to keep those visitors coming back and encouraging others to join them.

The Bottom Line
It's interesting to compare Yahoo! and Facebook side-to-side, and notice the relative lack of overlap. I'm not saying or suggesting that Facebook will or should buy Yahoo!, but it's nevertheless interesting to note how their strengths and weaknesses complement each other.

As is, I think Yahoo! is pretty close to fair value today. I value the Alibaba and Yahoo! Japan stakes at around $15.50 per share combined, with almost another $4.50 from cash on the balance sheet. I see the core Yahoo! business as being worth about $10 today, but that is on the basis of extremely low assumptions for future revenue and cash flow growth. Should Mayer's traffic- and value-generation strategies pay off, there could certainly be meaningful upside to the core value of Yahoo!.

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