Is Yahoo Undervalued?

Aug.13.13 | About: Yahoo! Inc. (YHOO)

One of the better turnaround stories happening on Wall Street these days is Yahoo! (YHOO), which has seen its share price drop to historical all time lows during a time period long-term shareholders want to forget. Shares of Yahoo! have increased over 80% in value in the past year, investors need to start asking the important questions; such as, is the run over or can the company continue driving up shareholder value?

Low expectations bode well for short term

The company is in the middle of a turnaround with what I believe to be low expectations for a material improvement in financial results in the near term. As such, so long as the company reports quarterly numbers that are within the range this will satisfy investors and the rally in share prices and company momentum will continue. Obviously, if the numbers are at the higher-end of guidance (or perhaps exceed it) this will be seen as a positive for enthusiasm for recovery but investors are evaluating the long-term recovery prospects one quarter at a time.

Tremendous value in Alibaba

The "potential next big" IPO chatter revolves around Alibaba, the Chinese E-commerce giant that does more in sales than eBay (EBAY) and (AMZN) combined. Most recently, Alibaba has seen net profits increase by 203% to $669 million on revenue of $1.38 billion (71% increase from same quarter last year). This is significant as Yahoo! owns about 24% of the Chinese company that has seen valuation figures as high as $120 billion being mentioned in anticipation of an IPO. As it stands today, at a $120 billion valuation, Yahoo!'s 24% stake translates to $28.8 billion and according to Yahoo! Finance the company's current market cap is $30.88 billion. This can suggest that Yahoo's share prices are undervalued relative to its Asian assets alone, which also include a stake in Yahoo! Japan whose shares are up about 65% year to date.

Yahoo! is committed to sell half of its 24% stake in Alibaba on a potential IPO that will net the company a good chunk of change depending on the final valuation. Alibaba is denying plans for an IPO, a move which Yahoo! shareholders can live with as Alibaba has already contributed $4.3 billion in after-tax cash since the initial investment in 2005.

Product overhaul is key to growth

There is certainly tremendous value-creation potential in Alibaba and Yahoo!'s other worldwide assets however a greater exposure to a turnaround at the company's core is better for investors than a gigantic balance sheet and value coming mostly from Alibaba.

Yahoo! is now releasing new products and product updates at an accelerated pace. There is more of a mobile skew as the company was severely lacking in this area of fast growth over the years. Yahoo! Weather has become a compelling mobile app, the Summly technology is rolling out across all the editorial sites, and Mail, Flickr and many other products have seen recent upgrades for both the iOS and Android.

Better products and a better user experience will drive a more engaged end user. A compelling user experience should lead to more time spent on Yahoo! Properties and a larger opportunity for display advertising and better pricing.

The Tumblr acquisition

Yahoo! closed the acquisition of Tumblr in late June with a $1.1 billion price tag. A lot of debate surrounded the massive price tag on an acquisition where there has been no monetization on the site to date so there will be no near-term financial impact. There exist many synergies between the two companies as Tumblr traffic adds 20% to global Yahoo!, which is a large number considering Yahoo! is already one of the top three global Internet properties.

Management is taking a hands-off approach in running the business except for adding a Yahoo! Search bar on Tumblr and that display ads will start slowly and ramp up over time. Any contribution in 2014 and beyond would be accretive to Yahoo!'s revenue growth as the property has essentially no revenue today.

Finally, it is important to note that Yahoo! will likely generate two-thirds of the Tumblr price tag in 2013 and likely not get much credit from investors.

Taking a page from Google

Infrastructure technology was a significant factor behind Google's (GOOG) rise to supremacy in the Internet space. Because of a standard platform, product iterations could be rolled out globally with very little effort. Yahoo! grew by creating a highly fragmented environment and at one time there were 37 different code platforms across the entire organization.

Former CEO Carol Bartz took a page out of Google's book and did a complete platform overhaul, standardizing and modernizing its technology infrastructure. A foundation rebuild does not lead to revenue growth (one of the reasons for Bartz's departure) but this action laid the groundwork for Yahoo!'s product-driven turnaround in today's environment. Today, while never directly mentioning Google, Marissa Mayer is continuing the "Google plan" to remodel the company in the image of her former employer.

Final words

Shares of Yahoo! I believe still have room to grow as they are undervalued today based on current assets and current trading valuation. Shares are currently trading at around 3.8X consensus EBITDA for 2014, and a successful turnaround could drive the valuation on par with other large-cap internet companies that are trading with a valuation ranging from 10-20x.

Everyone loves a turnaround story, and we are witnessing the early signs of one at Yahoo!. The signs are encouraging and could be a prelude to a long awaited turnaround.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.