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Commentary

Yahoo Is Undervalued

Although we're lowering our fair value estimate after another disappointing quarter, Yahoo's massive reach and the value of its Alibaba stake hold appeal, writes Morningstar’s Rick Summer.

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Investors are playing a tiring waiting game, and another quarter of disappointing results from  Yahoo (YHOO) has caused us to reduce our fair value estimate to $38 from $41. Still, we believe the shares are undervalued at these levels, and we think the risk is to the upside. Additionally, although Yahoo's assets pale in comparison with companies with higher engagement and better data, such as  Facebook (FB) and  Google (GOOGL), the company's broad reach of 1 billion users has value, supporting our narrow moat rating.

In spite of the challenging financial results in the company's core business, unlocking the value of the investment in Alibaba remains the overwhelming factor in our investment thesis.  Alibaba Group (BABA) represents $20 of our $38 fair value estimate. Our valuation continues to assume a 33% likelihood of a favorable tax-free spin-off. Management provided very little color around the spin-off of Alibaba shares into a separately traded entity (called Aabaco Holdings); however, the expected timing for this is now January 2016. If the spin-off is fully taxed, our fair value estimate declines to $35.

Total revenues excluding traffic acquisition costs, or TAC, declined 8% relative to 2014, the worst top-line decline since Mayer took over as CEO. A 13% decline in search revenues was the primary cause of the weak results, which management blamed on increased TAC and investments in its new advertising platform, Gemini. We believe the company will be able to stabilize the results in the company's core business, but we remain skeptical that a turnaround will be successful or likely.

On the expense side, the company has shown reasonable discipline, with improved expense leverage in the product development, sales and marketing, and general and administrative line items. We expect the company to continue to focus on better cost discipline, an area where we believe there is ample room to improve. 

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Rick Summer does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.