Yahoo Still Faces Many Challenges

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by Larry Gellar

Internet information provider Yahoo! (YHOO) has been one of the most tumultuous tech companies in recent months, and yet, Wall Street has reacted favorably to what appears to be a rather insignificant development. With this in mind, I recommend holding back on a Yahoo! purchase, especially considering the higher price that the shares have been trading for.

Indeed, the move I am referring to is news that the company will shed 2,000 jobs. Don't get me wrong - this is probably the right move for a company that has 14,100 employees but only $4.98 billion of revenue. On the other hand, investors shouldn't see the headline as a buying opportunity but instead a grave reminder that Yahoo! still has a variety of challenges ahead. While some of Yahoo!'s portals (finance, movies, news, sports) are certainly very strong, people are visiting Yahoo! much less than they used to. That can be attributed to Facebook and strong competition from a number of other web sites, and for the time being, I don't think these shares are worth more than $15.

Famous hedge fund Third Point isn't thrilled either. Like me, the fund agrees that the layoffs were necessary, although Third Point makes a good point in its press release. These layoffs are coming prior to CEO Scott Thompson's announcement of his strategy going forward, and this should be taken as a warning of how misguided the company is. Any management team can reduce costs by reducing headcount - but a good management team has other ideas that will lead to increased revenue.

As one of Yahoo!'s largest shareholders, Third Point will try to put four new directors on the Yahoo! board, and this could be a step in the right direction. The idea here is that these new directors will influence CEO Scott Thompson, or if all else fails elect a new CEO at some point. Assuming Third Point is successful with its boardroom shakeup, I would definitely recommend investors take another look at Yahoo! at that point in time.

Furthermore, compared to other Internet information providers like Google (GOOG), Yahoo!'s price ratios are not particularly attractive. Yahoo!'s price to earnings ratio is 18.71, while Google's price to earnings ratio is 21.34, and I think Google's stronger growth prospects make that slightly higher price to earnings ratio easier to justify. Additionally, price/earnings to growth ratio for Yahoo! is 1.69, compared to only 0.84 for Google. Gross margin for Yahoo! is actually pretty strong (69.85%), but the operating margin of only 16.55% outweighs that pro.

Yahoo! has also struggled with its legal battles. The company recently accused Facebook of violating patents regarding advertising, social networking, and privacy controls, and I wouldn't be surprised if that lawsuit ends up not being very successful. Meanwhile, Facebook is now firing back with lawsuits surrounding features like advertising, photo tagging, and online recommendations. The move appears to be an eye-for-an-eye of sorts because Facebook is choosing to match Yahoo!'s ten lawsuits with ten of its own. In fact, Facebook lawyer Ted Ullyot had this to say: "While we are asserting patent claims of our own, we do so in response to Yahoo!'s short-sighted decision to attack one of its partners and prioritize litigation over innovation." On the other hand, Yahoo! shot back with this statement: "Other leading companies license these technologies, and Facebook must do the same or change the way it operates." In my opinion, neither company will benefit from these lawsuits because they will simply reach a settlement that neutralizes the situation.

Another interesting aspect of Yahoo! is its Yahoo! Japan. Yahoo! owns just under 35% of this enterprise, and it's mind-boggling that Yahoo! has been unable to dump it completely considering how long shareholders have been asking for such a move. Goldman Sachs actually just reiterated its Sell rating on Yahoo! Japan, and the main issue is that the company has been slow to shift its focus on the mobile market. Considering Softbank owns 42% of Yahoo! Japan and is one of the country's largest mobile operators, one would expect Yahoo! Japan to be better prepared for a world dominated by smartphones. The only good sign on this front is that CEO Manabu Miyasaka just started on April 1st and recently said this in an interview: "The one thing I've decided is to make smartphones our priority. That market will grow much faster than the personal-computer market."

There are actually a couple of other recent headlines that have been good for Yahoo!, so it's important that investors realize this stock isn't bad enough for a short - it's just not a buy either. One positive story has been Yahoo!'s decision to create a Do Not Track option for its web site. Indeed, users who choose the Do Not Track option will not receive ads based on their viewing history. This is an important step because many Internet companies (such as Yahoo!) are slowly losing their image as a 'good guy' because of privacy concerns.

The other piece of good news is more important though - Jordan Rohan from Stifel Nicolaus believes that Yahoo! is improving its ability to monetize its search partnership with Microsoft (MSFT). This analyst is more optimistic than I am (he currently has a price target of $18), but I still think his research is worth taking a look at. For example, Mr. Rohan's communications with those involved in search engine marketing suggest that AdCenter (Microsoft and Yahoo!'s project) may finally be gaining market share as measured by advertising budgets. This is pretty impressive considering Google's dominance and the fact that other statistics also went in the favor of Microsoft/Yahoo! as well.

In my opinion, Yahoo! has a few things working in its favor, but the big story here is that management still does not seem to have a strategy for growing revenue. This is obviously a big problem, but not worth a short sale for now. I recommend investors take no action on this stock, at least until the influence of Third Point is felt.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.