Yahoo's Turnaround Trudges On

Although second-quarter GAAP revenue grew 15% versus the prior-year period, revenue excluding traffic acquisition costs was essentially flat in the quarter as Yahoo continues to invest heavily in its partnership with Mozilla for preferred search placement. Management expects search and display traffic acquisition costs to remain elevated over the next several quarters as it focuses on GAAP revenue growth and improving engagement metrics for its advertisers. We have some concern that Yahoo is walking a fine line with this strategy, as it is investing in an advertising platform that has ceded substantial market share over the past several years. Still, there were some encouraging developments in the quarter, as Yahoo generated its best price-per-ad growth in over two years, driven by greater uptake in its native video ads and generally higher pricing for video ads overall.

Yahoo is seeing positive trends in mobile, which now drives 22% of traffic revenue, but we still question how well its mobile platform can compete for advertising revenue with the likes of Facebook FB, Twitter TWTR, and others over the long term. Management touted Yahoo's new daily fantasy sports offering, and while the early engagement metrics are promising, this space remains hotly contested, and Yahoo will have a difficult time differentiating its product.

Hurdles Remain to Fixing Core Business 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 three years, but declaring a successful turnaround is premature, in our view. We believe the company can improve its near-term fortunes, but Yahoo's longer-term positioning and durability of its advantages are unclear.

Yahoo's large 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 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, and it 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.

Narrow Moat Could Be Narrowing Further We currently rate Yahoo's moat as narrow. Yahoo is one of the world's most visited collection of Internet properties. We believe some of its premiere 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 this 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.

The massive adoption of mobile data has rendered products such as Yahoo Finance, Yahoo Sports, and Yahoo Mail less relevant over the short term. Additionally, we believe users are finding it easier to aggregate their own content using other companies' Internet tools and will depend less on diversified Web properties like Yahoo to get their information. Furthermore, we believe Google GOOG/GOOGL and Microsoft's MSFT Bing will be able to spend more to innovate their search businesses, further eroding Yahoo's share in Internet search. Finally, as users continue to access more Web content with smartphones and tablets, we expect audiences to become even more fragmented. In the mobile world, companies providing smartphone operating systems, including Apple AAPL, Google, and Microsoft, will marginalize Yahoo, in our opinion.

As Yahoo's relative prominence subsides, the company may be forced to rely more heavily on third-party content through higher sharing of economics.

Spin-Off Specifics Still Slightly Uncertain If the search partnership with Microsoft continues to underperform, advertisers may abandon placing ads in Yahoo's search property, leading to revenue declines. 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 growing 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.

We note the risk that the Internal Revenue Service may not issue a favorable ruling for the structure of the spin-off, so we strongly encourage investors to consider a margin of safety to account for this risk. Currently, Yahoo holds 384 million shares of Alibaba Group, which represents approximately $34.5 billion at our fair value estimate for Alibaba Group. Yahoo is planning a tax-free spin-off of these shares into a separately traded registered investment company. Although the IRS probably will not issue a final ruling until the end of 2015, Yahoo has received the blessing of its advisors for the structure. By avoiding the tax, the company will save roughly $12 billion. Perhaps most important, the entire value of the shares is being returned to shareholders. Our $55 fair value estimate for Yahoo assumes that the value of the Alibaba spin-off is $31 per share. Yahoo Japan and net cash on the balance sheet contribute $16 per share. Yahoo's core business contributes only $8 per share.