Yahoo (YHOO) reported terrible third-quarter results Tuesday. Revenue, excluding traffic acquisition costs, fell 5%, while GAAP revenue dropped 25%. The primary driver for the decline had to do with weaker revenue associated with its agreement with Microsoft (MSFT). We believe that softness in display revenue, which was roughly flat in the period, and turnover at the sales level also impacted results to some extent. The attractiveness of competing sites like Facebook and Google (GOOG) is becoming increasingly more difficult for Yahoo to overcome, in our opinion. Google's third-quarter revenue, in contrast, advanced 33%! We are maintaining our $10 fair value estimate for Yahoo. Our report supporting our fair value estimate can be found here.
Income from operations fell 6%, while net earnings per share dropped 26% from the prior-year period (diluted earnings per share fell 23%). Cash flow from operations nudged 3% higher from the same period a year ago, while free cash flow shrunk modestly to $247 million during the quarter. We don’t expect a material about-face in Yahoo’s core U.S. operations, with the likes of Facebook and Google growing stronger, but we do think Yahoo could still unlock potential in its Asian assets (it owns 35% of Yahoo Japan and 25% of Alibaba.com). Management commented on the value of these respective stakes on its third-quarter conference call:
"With that review of our core business dynamics, I'll now turn to the value of each of our Asian assets. First, on Japan, based on public market data as of September 30, the pretax value of our 35% stake in Yahoo! Japan was $6.4 billion. Our efforts to unlock shareholder value on a tax efficient basis are ongoing, but potential transactions are complex and generally involve extended timeframes to complete.
And with respect to Alibaba group, using the pending third-party tender offer from employee-owned shares as a value guide based on the number of shares Yahoo! owns and the proposed offering price, we believe our investment in Alibaba Group will be valued at just over $14 billion on a pretax basis."
The pretax value of these assets appear to be greater than Yahoo's market capitalization at this time, but we note their illiquid nature and the tax ramifications of monetizing them represent huge haircuts to management's optimistic value expectations. Though we don’t think Yahoo represents a compelling value play at this time, especially given its troubled top line, we can’t rule out its candidacy as a takeover target (particularly as it is currently lacking a permanent CEO; former chief executive Carol Bartz was fired in early September). CEO Jack Ma of Alibaba.com, which is partially owned by Yahoo, has indicated interest in the company, and so has Silver Lake Partners. Microsoft, which pulled its $47.5 billion offer a few years ago, seems content to not have done a deal with Yahoo, and such inaction by the software giant at these levels leads us to believe that any takeover of Yahoo is far from a given.
We're not excited about Yahoo's declining business prospects at all, and instead are considering opening a put option in our Best Ideas Newsletter.