YHOO Still a Work in Progress

After reviewing Yahoo’s YHOO second-quarter results, ┬áthe firm’s turnaround has yet to materialize and surprising weakness in Yahoo’s display market is cause for concern. Still, given our expectations and the fact that Yahoo’s balance sheet assets and investments in Yahoo Japan and Alibaba Group represent the bulk of the company’s enterprise value, we are sticking with the fair value estimate.

The company’s fortunes remain cloudy even as CEO Marissa Mayer completes one year at the helm. Overall revenue excluding payments to partners declined 1% versus the year-ago-period, to $1.07 billion. Although the search business (38% of revenue) grew 5% versus 2012, the display business (39% of revenue) declined 11% versus 2012, highlighting a weak pricing environment for generic Yahoo traffic. In fact, price per display ad fell 12% across Yahoo’s total display business. We believe some competitors, including Google GOOG and Facebook FB , are capturing high-priced ads based on their ability to execute with a more targeted delivery platform.

While Yahoo’s core content assets help drive repeatable traffic, we aren’t convinced the company is deepening its understanding of its Web customers to better serve its advertising clients. The company continues to lose market share to the competition, and we remain skeptical that investment in assets like Yahoo Weather and Tumblr will alter the competitive landscape. Quarterly adjusted EBITDA (which excludes stock-based compensation and restructuring costs) declined 7% versus 2012, to $369 million.

Based on Yahoo’s focused effort to improve user experience, alter ad presentation, and develop new products, this profitability decline is not altogether alarming. Still, the company needs to eventually translate increased operating expenses into meaningful revenue growth, as the digital advertising market continues to grow at a double-digit pace, effectively leaving Yahoo behind, at least for now.

We remind investors that Yahoo’s investments in Alibaba Group (private) and Yahoo Japan (public) represent approximately $9 of our fair value estimate. But given Yahoo’s lack of control of these assets as well as the inherent liquidity and valuation risk related to Alibaba Group, we do not see a compelling investment thesis for Yahoo’s shares.

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