Yahoo! Inc. (YHOO) 4Q Earnings Report Breakdown

Yahoo!’s 4Q13 highlights

This report discusses our initial reaction to Yahoo! Inc. (NASDAQ:YHOO)’s 4Q13 results. Alibaba’s results were on balance better than our expectations (a hair lower on revenue growth but much better on margin), and we believe it is well under way to beat our previous 2013 net income estimate of $2.76 billion, which we now expect to be to $3.02 billion. The core’s results were in line and 1Q14 margin guidance was weak. The hope for returning to revenue growth continues to be centered on improving engagement one day leading to better monetization. We remain skeptical of the core, but believe Tumblr is an underappreciated asset with fast growing user base, now larger and growing faster than Twitter’s, and engagement levels. We think Tumblr may actually be capable of creating as much value as the traditional Yahoo! core business. We are maintaining our Alibaba valuation at about $190 billion ($24 per Yahoo! share) and increasing our valuation of the core to 8 times EV/EBITDA to account for the Tumblr monetization potential. As a result, we get $45 as our new 12-month target price.

Yahoo! Inc. (NASDAQ:YHOO) reported roughly in line results (Exhibit 1). Yahoo! reported revenue ex-TAC[1] of $1,200 million (in line with consensus), and light adj. EBITDA, excluding the one-time gain on sale of patents, of $408.8 million (vs. consensus’ $413 million). Reported adj. EPS for the quarter was $0.46 per share, but excluding patent sale gain of close to 5 cents EPS would have been $0.41, slightly above consensus. EPS was also impacted by a penny from a lower than expected tax rate.

Weak 1Q14 margin guidance for Yahoo’s core business

Next quarter’s revenue ex-TAC guidance was in line with expectations but EBITDA and EBITDA margin were significantly below expectations (Exhibit 2). Management guided to a 1Q14 revenue ex-TAC midpoint of $1.08B, or flat revenue growth YoY, largely in line with pre-quarter consensus. However, adjusted 1Q14 EBITDA guidance midpoint of $310M, was significantly below consensus of $365M. In addition, the implied ex-TAC EBITDA margin of 29% corresponds to a 700 bps YoY decline, again much worse than what was implied by consensus.

In Yahoo! Inc. (NASDAQ:YHOO)’s earnings call, CFO Ken Goldman suggested that the level of expenses in 4Q will continue roughly constant into the next year (on a dollar basis) implying that revenues will lever into the second half due to seasonality, leading to EBITDA expansion and a flat to slightly declining EBITDA YoY. Given the material YoY decline in the guidance in the first quarter, to get flat to slightly declining EBITDA one would indeed need material second half acceleration.

At least the guidance is consistent with the view that expenses will not increase significantly sequentially. The midpoint of guidance implies a sequential decline in revenue ex-TAC of $120 million, and a sequential decline in EBITDA of $100 million.

Expectations for Yahoo’s expenses and revenue

We think expecting flat or slow growing expenses and stable to growing revenue for Yahoo! Inc. (NASDAQ:YHOO) is quite risky. Count us as sceptics: we suspect expenses will increase and we will see at best a small acceleration in revenues in 2H14, jeopardizing the informal EBITDA guidance (“small decrease”). Our updated 2014 adjusted EBITDA is $1.39B, 11% below 2014. We think the results and guidance have not shown a fundamental improvement in performance, justifying our near-term negative outlook for the core.

• Display revenue has shrunk by 3%.
• Tailwind behind search revenue growth from Google Inc (NASDAQ:GOOG)’s change in policy, which likely drove a material increase in the number of publishers and clicks to the Yahoo! Inc. (NASDAQ:YHOO)Network, will start decelerating in 1Q14.
• Other Revenues, which correspond to 20% of revenues, are shrinking by 9%, despite benefiting from growing 100%-margin Alibaba royalty payments.
• Margins have deteriorated throughout the year and guidance is weak, with second half inflection.
• Yahoo! Inc. (NASDAQ:YHOO) continues to be outcompeted in programmatic by Google Inc (NASDAQ:GOOG), Facebook Inc (NASDAQ:FB), Microsoft Corporation (NASDAQ:MSFT) (all much larger and better funded) as well as myriad publisher-driven exchanges such as Pubmatic and Rubicon.
• The company does not have a good answer for its dependency on Microsoft for search, a business Microsoft could conceivably decide to stop investing in if or when a new CEO comes on board.

Alibaba results roughly in-line with expectations

Alibaba results were roughly in line with our expectations, suggesting TaoBao and TMall growth continues to be well above 65% YoY, as Alibaba.com is likely a substantial portion of revenues (maybe ~20%), but, we think, growing much slower. We continue to value Alibaba Group conservatively at about $190 billion, and assume Yahoo! Inc. (NASDAQ:YHOO)’s 24% stake is worth at least $24/share for Yahoo! shareholders.

• We now expect Alibaba Group to come very close and likely meet or exceed our 2013 revenue, and exceed our operating and net income expectations pre-report (Exhibit 3), as YTD margin results are ahead of our expectations (see again Exhibit 3). What’s more, based on anecdotal evidence from China on merchant participation in promotional activity on Single’s Day (11/11) and Double 12 Day (yes, that is 12/12) on TMall and Taobao, we think we could see material sequential acceleration in YoY revenue growth, which would put 2013 revenue well ahead of our pre-quarter and revised expectations. To be conservative, however, we are reducing our revenue estimates slightly.

• Alibaba Group margins came much ahead of our expectations. We are increasing our margin forecasts and as a result our 2015 net income estimate is now $6.2 billion (vs. $6 billion before).

• Exhibit 4 shows our pro-forma estimates for Alibaba Group for the next several years. We now believe these estimates could be quite conservative, and Alibaba could beat our $6.2 billion 2015 net income. Despite that, we will retain our valuation at about $190 billion until we see 4Q13 results and get another data point on the revenue growth trajectory.

• We believe this $190 billion valuation for Alibaba implies at least $24/share for Yahoo! Inc. (NASDAQ:YHOO) shareholders (Exhibit 5). This assumes that (1) Alibaba IPOs at a roughly 40% discount to our Alibaba fair value. Importantly, given the agreement between Yahoo! and Alibaba, Yahoo! is compelled to sell 40% of its stake at the IPO price. We then assume (2) the transaction is fully taxed at 38% (potentially a very conservative transaction), and (3) that Yahoo! will keep 30% of the roughly $7B of IPO cash proceeds, distributing the rest. Finally, (4) we apply a 50% discount to the cash proceeds Yahoo! keeps for the risk that it will not be fully returned to shareholders (Exhibit 6).

• We see our Alibaba valuation as highly conservative and think the asset could be worth materially more than $190 billion or $24/share for Yahoo! Inc. (NASDAQ:YHOO) shareholders.

Challenges for Yahoo’s core business

We think the core remains challenged and believe a steep reacceleration of revenue and EBITDA growth on an apples-to-apples basis remains unlikely. The one big exception is Tumblr, which we believe could be worth at the very least $5/share, if we use a back-of-the-envelope (but extremely conservative) valuation approach.

• In addition to the positive engagement-related data points associated with the core business shared by management in the call, there are other glimmers of hope. For example, search ex-TAC has shown (relatively to the rest of Yahoo!) healthy growth, growing at 8% YoY, but still losing market share to Google and probably with an artificial boost due to Google’s change in policies for its Network partners. What’s more display advertising pricing was still weak (at -7%), Yahoo! Inc. (NASDAQ:YHOO) disclosed that exnative, in-stream ads, display pricing change was positive YoY. In addition, Yahoo! may benefit from increased advertising budgets in 2H14.
• In addition to increasingly easy comps, in 2H14 Yahoo! may benefit from an ad spend uplift due to the World Cup in July and the US midterm election.

• These are indeed positive signs, and the investment in content and technology probably has potential too, but we find it hard to be optimistic that we will see a material turn-around. There is no question that the core is under-monetized, but it is not obvious that the legacy issues (culture, technology, margin structure, processes, etc) will not frustrate an effective turnaround.
• All else equal, however, we would continue to value the core at about 4 times 2015 EBITDA, an admittedly low multiple that reflects our skepticism about a turn-around, the lacklustre performance in 2013, the weak guidance in 1Q14, and the more than trivial chance that we could actually see EBITDA decline YoY in 2014, as we currently forecast.

Tumblr’s valuation

Yet, not all else is equal. We now believe that Tumblr is a valuable asset that may contribute materially to Yahoo! Inc. (NASDAQ:YHOO)’s revenue growth rate in 2015. Our 4 times EV/EBITDA multiple on the core does not account for it appropriately, and we are now confident enough on Tumblr’s trajectory to incorporate some upside into Yahoo!’s valuation.

How much is Tumblr worth and why are we attributing value to it now? We don’t know enough about Tumblr’s economics to develop a detailed valuation with high confidence. However, we are very comfortable ascribing to Tumblr a valuation in the order of 1/4th to 1/8th Twitter’s. Here is why:

• We estimate that Twitter Inc (NYSE:TWTR) has roughly 250 million monthly unique visitors, while Tumblr is probably 50% larger with around 375 million monthly unique visitors, and likely growing the user base faster.
• Comscore data on monthly PC usage per user, which we recognize is inadequate given that Twitter isprimarily a mobile property but think it is roughly indicative, suggest Twitter and Tumblr have similar usage intensity.
• Tumblr has a large and fast increasing mobile user base, just like Twitter, and there are some striking commonalities between the two platforms1. First, followership relations are asymmetric, as an individual can follow a Twitter feed or someone’s Tumblr blog without reciprocity, unlike, e.g., Facebook or LinkedIn. Second, both platforms are default public making sharing easier and often facilitating “virality,” which is highly attractive to a cohort of advertisers.
• Of course, Tumblr is much earlier in its path to monetization (revenues are likely 1/10th, or so, Twitter revenues), and it does not (at least to our knowledge) have real-time usage at the same level as Twitter, a consequence of the choices both made about constraints on content (Twitter’s original choice to favor 140 character, short messages vs. Tumblr much more flexible environment, which seems tobe converging on pictures and richer content).

• That said, we think that based on Twitter’s valuation (or our own much lower $40 price target if one prefers), one can easily justify a valuation of $5 to $10 billion for Tumblr, which would correspond to 1/8th to 1/4th of Twitter’s current valuation (a range that already takes into account the possibility that Twitter is richly overvalued).
• We do not think we will see investors valuing Yahoo! Inc. (NASDAQ:YHOO)’s core on a sum-of-the-parts basis any time soon. However, we believe Tumblr will become a material contributor to core revenue growth in 2015, and perhaps in 2H14 thus justifying a higher multiple for the core’s EBITDA.
• We had not included the Tumblr upside in our price target before because of concerns with the evolution of the user base (Yahoo! disclosed in the earnings call that Tumblr users grew 30% since March 13), and engagement (Yahoo! disclosed that time spent per user was up around 50% in the same period).

Despite the weak guidance for 1Q14, we are raising our price target to $45/share as we increase the core’s EV/EBITDA multiple from 4 to 8 to account for Tumblr and maintain our roughly $190 billion valuation for Alibaba. We are lowering our 2014 EBITDA estimates for the core, keeping the 2015 estimate as we think Tumblr will be a small but material contributor to incremental revenues then, and increasing our multiple on the core to 8 times EBITDA, yielding a valuation for the core of $11/share.