Yahoo's 2Q Is Long on Promise, Short on Evidence for a Turnaround

For our purposes,  Yahoo's second-quarter results revealed two recurring themes: 1) the company is an underperformer in its ability to translate traffic and users into meaningful revenue growth, and 2) the predominant value in Yahoo shares is the pending IPO and aftermarket performance of Alibaba Group. We are leaving our narrow moat rating and $39 fair value estimate unchanged, since we have recently revised our valuation based on preliminary work for the Alibaba IPO. Also, we are reiterating our negative moat trend.

The core business continues to be in the beginning of a turnaround, although we see few reasons for optimism and remain concerned that Yahoo’s ability to provide target advertising pales in comparison to leading companies such as Google and Facebook. Although digital advertising is not a winner-take-all market, it is certainly a winner-takes-most market, at least for now. We are troubled that display advertising excluding traffic-acquisition costs (ex-TAC) declined 7% from 2013. In our view, strong growth in this segment (which represents 38% of revenue) is necessary to demonstrate the beginning of a turnaround, particularly as peers are growing on both a top-line basis and an advertising-revenue-per-user basis. 

Our concern remains that competitors have consumer platforms that are more engaging, based either on time spent or on interactions. This engagement with the user and uniqueness in advertising targeting capabilities is necessary to protect Yahoo’s economic moat, in our opinion.

Regarding Alibaba Group, we consider our recent fair value increase to $39 from $35 to appropriately incorporate the value of this Chinese Internet giant. Although Yahoo’s management trumpeted that the company will be required to sell fewer shares in the pending IPO than previously mandated (reduced from 208 million shares to 140 million shares), this change has no impact on our fair value estimate, in spite of our optimistic view of Alibaba’s valuation. 

We are curious why Yahoo management believes it benefits Yahoo shareholders to participate (indirectly) in the IPO in a greater way (as opposed to viewing the IPO as the penultimate liquidation event). Given the magnitude of Alibaba’s contribution to the stock price, which we estimate at greater than $20 per share, investors must bet on Yahoo’s capabilities as a passive investment manager controlling the investment and liquidation of Alibaba Group rather than its ability to affect a turnaround. Although we recognize the upside based on our valuation methodology, if management doesn't effectively manage both the liquidation and the reallocation of capital appropriately, shareholder returns may suffer.

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