Yahoo! Still Has Upside

 | Oct 16, 2013 | 5:34 PM EDT
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I've been an unreserved bull on Yahoo! (YHOO) since December 2010, when I had the chance to meet Alibaba's then-CFO, Joe Tsai, in Hong Kong.

Even though Alibaba was a much smaller company than than it is now, you could see all the potential in front of it. In the three years since then, it has lived up to my heady expectations, and then some.

When I first bought Yahoo! back then, I thought it was the best way to play the coming explosion in the value of its stake in Alibaba. Until Alibaba's IPO, it probably still is (Softbank trading in Japan is another way, although it is even more diversified than Yahoo!).

After Tuesday's night's earnings call for Yahoo!, I remain optimistic that there's still good money to be made in holding on to Yahoo!'s stock in the near term, even though it has doubled since last year.

Here's why.

A lot of U.S. analysts over-focus on the performance of Yahoo!'s core business. They complain that Marissa Mayer hasn't really delivered. And that's true. Display, once the engine, or the core, is now in a steady decline that has yet to bottom. There's been exactly no turnaround under Marissa's sales guy Henrique De Castro since he came aboard. All investors can hope for is that Ned Brody and Marissa's new stream ads start to make a difference soon.

Search clicks keep growing, but the cost per click on search continues to drop. And, of course, Yahoo! signed away its destiny in search four years ago to Microsoft (MSFT) when it agreed to use Bing instead of its own.

So, that's the bad news. But the good news is that, in 2005, Jerry Yang and Dan Rosensweig decided to invest $1 billion to buy a 40% stake in Alibaba. Yahoo! still owns 24%, and it's the gift that keeps on giving.

In the most recent quarter, which was the second quarter, Alibaba did $1.7 billion in revenue and $700 million in net income. The operating margins were 49%.

Given that Alibaba did $1.3 billion in revenue in first quarter, that means it's at $3 billion in revenue from January to June. It seems very likely that it will do $7 billion in revenue for the year, and it will probably be more, given that the fourth quarter is its biggest quarter of the year.

That means Alibaba -- if you use today's price-to-trailing-sales multiple of 20x, which is what Facebook (FB) gets – is worth $140 billion today. That is much higher than what most sell-side analysts are saying Alibaba is worth today (they put it at $100 billion to $120 billion).

If you take an after-tax number for Yahoo!'s 24% stake using $140 billion, plus the after-tax value for Yahoo!'s 35% stake in Yahoo! Japan, plus its $3 billion in cash, and if you value Yahoo!'s core business at $7.5 billion (which is only 5x its $1.5 billion in EBITDA this year), you get "fair value" for Yahoo! at $41 a share. That's another 24% higher from today's levels.

What's more, we also got good news yesterday that Yahoo! and Alibaba agreed that Yahoo! could sell less of its stake when Alibaba IPOs. Yahoo! will keep an extra 2% stake in Alibaba after the IPO than it was previously planning.

Why did Alibaba agree that Yahoo! could do this? Jack Ma usually doesn't give something for nothing.

Is it possible that Alibaba and Yahoo! might be close to a cash-rich split for the 10% stake which Yahoo! was planning to sell to Alibaba at the time of the IPO? We will have to see.

The two parties might agree to do such a deal before an IPO at a valuation below $140 billion. Both sides would save on taxes and therefore have an incentive to do so.

The extra tax savings to Yahoo! would be an incremental positive to Yahoo!'s stock price, over and above the $41-a-share "fair value" level I mentioned earlier.

So there are still many good reasons to stay bullish on Yahoo!



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