Alibaba IPO Not Necessarily a Treasure Trove for Yahoo

We have erred on the side of caution in the past with respect to  Yahoo's ability to realize value from its holding in Alibaba Group (BABA), which came public Friday. We believe Yahoo has primarily been a vehicle for investors to participate in Alibaba's potential upside, but we have historically provided a margin of safety to account for valuation risk, the uncertainty of the timing of an initial public offering, and the potential for return of capital to Yahoo shareholders. On the basis of the now-completed IPO and our fair value estimate of $90 per share for Alibaba, we have revised our fair value estimate for Yahoo to $42 per share from $39. We still do not see a compelling reason to recommend the shares of narrow-moat Yahoo, particularly based on our belief that the firm is disadvantaged versus the richer advertising platforms of Facebook (FB) and Twitter .

Our largest concern with respect to the potential liquidity of Alibaba for Yahoo shareholders is the lack of opportunities for Yahoo to invest in high-return projects. Yahoo was to sell nearly 122 million shares in the offering and retain a 16.3% ownership interest in Alibaba Group. While we are giving Yahoo full credit for the Alibaba shares that are to be sold, we are taking a 20% haircut from our Alibaba fair value estimate of $90 to account for our concern that the shares are not reinvested wisely. If we did not take a haircut, our Yahoo fair value estimate would be $47. Still, we prefer to be cautious, since the turnaround in Yahoo's core business has been slow to materialize.

Too Much of Yahoo's Current Price Hinges on Alibaba
We believe Yahoo's current stock price is predicated on a robust valuation and successful exit of the firm's investment in Alibaba. Investors should be aware that a significant amount of Yahoo's enterprise value is tied up in its 35% interest of Yahoo Japan and resulting 16.3% interest in Alibaba holdings as well as cash from the IPO. Alibaba Group has ownership interests in privately held Taobao and Alipay, as well as publicly traded Alibaba.com. Given Yahoo's lack of control over these holdings as well as reinvestment risk, we do not believe its value can support a sound investment thesis.

Yahoo may be able to turn around its core business, but the divide between possible and probable is wide. Marissa Mayer has been at the helm for more than a year, but declaring a successful turnaround is premature, in our view. We believe the company can improve its near-term fortunes, but its longer-term positioning and durability of its advantages are unclear.

Yahoo's base of more than 800 million users is an important asset, but management must appropriately navigate several hurdles in order to effectively turn around its core business. First, although Yahoo's focus on display ads has been its strength, users and advertisers are spending more time and money on other websites like social networking giant Facebook. Second, while Yahoo's media properties--including its home page, Yahoo Sports, and Yahoo Finance--are well suited to a desktop world, the company has done very little to connect mobile applications to its more traditional Web experience.

Yahoo has continued to lose market share in online advertising to other destination sites such as Facebook and Twitter. Currently, Facebook is the most heavily trafficked website in the world. Furthermore, Facebook has been able to gather superior information about its users, which helps advertisers target their campaigns. Although this industry is still relatively nascent, we believe these efforts will shift offline dollars to social networking companies more rapidly than to more traditional firms dependent on display like Yahoo and AOL.

High-Traffic Properties Provide Advantage
We currently give Yahoo a narrow Morningstar Economic Moat Rating. Yahoo has one of the world's most visited collections of Internet properties. We believe some of its premier Web properties, including Yahoo Mail and Yahoo Finance, provide an experience with nontrivial switching costs, helping to create repeat Web traffic and sustainable revenue potential. Importantly, its collection of websites has provided comprehensive reach and distribution for advertising clients looking to run branded advertising campaigns.

Pure Web content companies cannot easily build or protect an economic moat, in our view. We expect that Yahoo will translate its audience into acceptable returns on capital for the next five years, but other content sites and social networking will slowly eat into its share of ad dollars.

Microsoft Agreement Another Big If
If the company's search partnership with Microsoft continues to underperform, advertisers may abandon placing ads in Yahoo's search property, leading to declines in revenue. Furthermore, if the relationship with Microsoft sours, it's not clear that Yahoo has any better options to support its search technology. Social networking sites like Facebook also represent a risk to Yahoo. If these sites are able to continue increasing users and building tools for advertisers to selectively target large and specific demographic groups, Yahoo may quickly become an inferior place for advertisements. Additionally, Yahoo's mobile strategy is less than clear, and the company risks investing in several low-return projects.

Lastly, financial interests in Yahoo Japan and Alibaba Group ultimately may be worth much less on an aftertax basis than the firm currently believes. As a private company until very recently, Alibaba Group is challenging to value. We have no information advantage relative to management of Yahoo or Alibaba in in pricing this holding. Although we recognize the ultimate value of Alibaba Group could prove quite lucrative, there is a wide range of values that this interest may hold for Yahoo shareholders. With respect to Yahoo Japan, it will be challenging to unload this large of an interest without taking a discount or encountering a potential tax liability.

Core Business Worth $11 per Share
Our fair value estimate considers approximately $11 per share for Yahoo's core business, with the balance represented by cash and its ownership interest in Yahoo Japan and Alibaba Group. It is important to note that we still believe we are at a distinct information disadvantage in valuing the interest in Alibaba Group, and we would be hard-pressed to encourage aggressive exposure to what is essentially a venture capital investment. Furthermore, corporate governance is a serious issue at Alibaba Group, and it's not apparent that Yahoo shareholders will ever receive a value that is close to Alibaba's current fair value. We expect revenue to grow in the single digits in 2014 and beyond. We also believe search revenue will grow at a rather pedestrian rate as well, because we remain concerned about Yahoo's ability to drive search query volume. We expect overall revenue growth to average 5% over the next five years. We are encouraged that the new management team will instill greater discipline in managing operating expenses, although we expect a reasonably heavy investment period over the next couple of years in mobile applications.