Yahoo: Why The Core Business Should Be Valued Higher

Sep. 4.14 | About: Yahoo! Inc. (YHOO)

Summary

Yahoo’s core business has significant upside from current levels based on how undervalued it has become in relation to other web properties.

The Alibaba IPO will give significant proceeds to Yahoo, which will be put to good use through share buybacks, acquisitions and investment into content.

Yahoo’s core mobile properties have generated significant user growth, and based on M&A activity, the core Yahoo business should be worth significantly more.

Yahoo (NASDAQ:YHOO) may be undervalued going into the Alibaba IPO. While the core business has been struggling, the intrinsic value of the business most certainly isn't worthless.

Quoted from CNBC:

While Yahoo does face significant challenges even after it gets the Alibaba windfall, all hope is not lost - at least not yet, said Kinshuk Jerath, a Columbia Business School marketing professor. "Yahoo is in trouble, there is no question about that," Jerath said. "A simple analysis of its financials shows it's valued nearly at zero, everything is basically Alibaba."

Yahoo's core business should be worth significantly more

It's likely that as Yahoo adjusts its cost structure and attracts new users to its mobile application ecosystem, the business will improve its profit margin significantly. Furthermore, ad pricing will eventually stabilize and grow. Despite the limitations of the mobile form factor, consumption of media content via mobile devices is expected to increase significantly, and pricing levels will become more attractive over time.

The approach to mobile devices has been to create a programmatic ad-buying experience, paired with native advertisement placement. Because native ads look like the content that the ad is placed next to, the content is much more user friendly, allowing it to take up further screen real estate. The strategy has worked fairly well for Facebook and Instagram, while alternative monetization models may be inclusive of selling a premium package of the free product, or in selling in-app products and services.

Because there are various revenue models that Yahoo can explore, it's likely that at some point, the mobile ad business will stabilize. Also, Yahoo still has the financial resources to become a major competitor in the online video streaming space. While it's unlikely that the service that Yahoo is developing will look anything like YouTube, it's likely that various web streaming apps will work alongside each other to become a television-like experience without the hassle of using a remote control in front of a TV.

Currently the leaders in the video streaming space are YouTube, Amazon Prime video, Netflix (NASDAQ:NFLX) and Hulu. The $10 billion in proceeds will go toward acquisitions, share buybacks and content investment. Half will go toward share buybacks. Therefore a $5 billion shareholder return program will at least put a floor underneath the price of the stock as it will induce a shortage in supply. Furthermore, an increase in content investment will allow Yahoo to revamp its video streaming service and its Finance application.

Yahoo has recently made further inroads into content through the launch of Yahoo Finance Contributors, and while the move may make Yahoo Finance a stickier application, it's unclear as to whether or not Yahoo will put larger financial resources behind the project. It's still in its infancy, which is why it will take many years to scale the business. Investors will need a wait and see approach for Yahoo's content investment.

Yahoo core business isn't worthless as Yahoo search still has respectable market share in the United States. Yahoo also owns a couple major web properties outside of the Yahoo family like Flickr, and Tumblr, and while those businesses may not grow into dominant mobile applications, they can still generate meaningful contribution to sales and earnings going forward.

According to Marissa Mayer:

In Q2 2012 our mobile user base was hovering just above the 200 million monthly active users. Today I am happy to report that Yahoo saw 450 million monthly active users for the very first time in Q2 2014 representing more than 100% growth in just two years. In addition to driving user growth, mobile has also delivered step changes in engagement with the time spent on mobile growing 79% in the last year alone.

At 450 million monthly active mobile users, WhatsApp was valued at $19 billion, so based on the eyeballs that Yahoo has been able to attract, it's hard to imagine the valuation of the company being built purely upon the equity interest in Alibaba going forward. Yahoo's 23% equity interest in Alibaba (when assuming a $200 billion market capitalization) is worth $46 billion. Yahoo's proceeds from the sale will be taxed at a really high corporate income tax rate, which is why a sum of parts analysis implies that after factoring a 35% tax rate, the Alibaba equity interest is worth approximately $30 billion post-tax at Yahoo's current market cap of $38.3 billion, the core business is only valued at approximately $8.3 billion. However, if Alibaba were to appreciate further, it would imply that Yahoo itself has no intrinsic value.

Conclusion

Based on recent M&A history, paired with the potential to monetize those 450 million monthly active users, the recent trend in valuation hardly makes sense. Yahoo has grown its net income when excluding the impact from selling its equity investment interest to Alibaba in the prior year period. Therefore, the financial performance is there, and the intrinsic value of owning Alibaba is there. What's holding the price of Yahoo back is the lack of institutional demand.

By the end of 2014, investors should anticipate Yahoo to appreciate further. The added certainty from Alibaba becoming a publicly-traded security will help put a floor underneath Yahoo's valuation going forward.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.