Yahoo! is Finally on the Right Track, But the Stock is Near Fair Value

Nauman is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Yahoo!'s (NASDAQ: YHOO) fourth-quarter results have given investors a real reason to believe that Marissa Mayer is moving the company in a positive direction. Yahoo! reported Q4 EPS of $0.32, better than the analyst estimates of $0.28. Revenue, excluding traffic acquisition costs, was $1.22 billion, compared with $1.17 billion in the year-ago quarter. That's a sequential increase from its third-quarter 2012 revenue of $1.2 billion -- a higher EPS of $0.35 in 3Q was due to one time gain from the Alibaba sale.

Yahoo! signed several key partnerships during the fourth quarter, including with CBS and NBC Sports, and made several improvements in Yahoo! Mail and Flickr for a better mobile experience. I believe Yahoo! has now initiated its long-awaited return towards recapturing its former status as the king of the web portal.

Marrisa Mayer's role

Since taking over the helm at Yahoo!, Marissa Mayer has been active in putting Yahoo! on the right path. She persuaded co-founder of Paypal -- Max Levchin -- to join the company, as well as hiring famous recruiter Sandy Gould. She also stepped up on M&A through acquisitions of Stamped,, and videochat startup OnTheAir. By hiring better employees and acquiring promising new companies, Yahoo! is re-focusing on its talent-building strategy, which will lead to a better quality of people joining Yahoo! in the future.

Mayer, through her former experience at Google (NASDAQ: GOOG), is also aware that Yahoo!'s success in the future lies in implementing incremental improvements in existing users' experience -- through personalization of search, video and mobile. Mobile growth still remains a weak spot for Yahoo!, where it needs to make better quality products in order to sell more ad space to advertisers. Due to the shift from the desktop to mobile, it's a no-brainer that this is an area where Yahoo! needs to be investing in the near future.

Mobile is the future

Yahoo! already has an advantage in mobile because of its large existing users base -- the company already knows users' habits through products and applications available on its web portal such as finance, news, weather, email, sports, etc. Yahoo! can now capitalize on this and provide mobile contents with users' daily habits and potentially add more personalization around those habits in the future.

The mobile transition is now a global phenomenon, with smartphone adoption increasing worldwide. This move has shifted consumer behavior, with many people now using their smartphones to listen to music, watch tv, do online shopping, and consume other media. But Yahoo! will have to face immense competition in the mobile space, especially from Facebook (NASDAQ: FB) and Google.

Mobile Competition

Reports suggest that Facebook's revenue from its mobile platform will exceed those of any other platform next year. Facebook is now expected to reach a market share of almost 20% of the mobile advertising market in the US next year. Its mobile games and apps are showing no signs of slowing down, with popular games experiencing new record monthly active users. Together with its newly acquired Instagram, Facebook is sure to give Yahoo! a tough time as the latter tries to expand into mobile.

Yahoo! actually is in double jeopardy; not only it has to gain mobile market share but also defend its current desktop portal dominance. This compared to Google, whose mobile penetration has shown no signs of slowing down. Google ended 2012 with a mobile market share of 17%. But through its excellent service to advertisers on AdMob network and future expansion of YouTube mobile monetization, Google is all set to further extend its mobile advertising presence.

Revenue diversification

Moreover, while increasing usage Yahoo! needs to put more focus on growing international presence and appealing to a broader demographic of users. At present, Yahoo! derives 75% of its total revenue from the Americas region, something that needs to be worked on in the future. Organic user growth in the emerging markets, as more new members of the middle class start accessing the Internet, has the potential to deliver much needed revenue-diversification for Yahoo! in the future.

Search growth

Doubtlessly, search will continue to be a key area of investment for Yahoo!, and its partnership with Microsoft (NASDAQ: MSFT) will continue to have positive effects on its key search metrics. Consequently, Yahoo!'s revenue from search increased 9% to $1.61 billion in the fiscal year 2012, compared to $1.47 billion in 2011.

Microsoft partnered with Yahoo! to replace its search and ads engines under a 10-year deal in order to improve its Bing search platform. Under this partnership, Microsoft currently pays Yahoo! more than 85% connected with the Bing search ad sales. Bing currently holds less than 5% of the global market share, whereas Google search engine's more than four-fifth market share still makes the latter the leader by a wide margin. Microsoft wants to dominate in search, but so far has remained unsuccessful at doing so.

Yahoo! is also improving the advertising quality on its search engine, which will explain how it was able to translate lower traffic into higher clicks in the fourth-quarter. If Yahoo! can maintain this performance, revenue from search is likely to grow even further in the future.

That said, I still think Yahoo! needs to improve its search interface design to make it more user friendly on both desktop and mobile. I believe that in the future search will be more user personalized, where search engines know exactly in what context users are searching for something. So I wouldn't be surprised to see Yahoo! investing more into developing better personalization technology in the future.

Foolish bottom-line

After the bitter experiences with 5 CEOs in the last five years, it's my view now that Yahoo! is finally on the right track under the leadership of Marissa Mayer. Revenue and earnings are improving for the company, and it seems both employees and investors are equally optimistic about the future.

Yahoo!'s share count has already fallen sharply from 1.4 billion in fiscal 2010 to 1.18 billion at the end of 2012, and considering management's plan to spend a big chunk of the future cash flow on buybacks, this trend should continue. Yahoo! has historically managed mid-20's cash flow margins -- longer term, though, I believe the company can boost that margin into the high-20's.

Moreover, I'm comfortable with a long-term revenue growth outlook of 2% to 3% on Yahoo!, along with a steady improvement in free cash flow generation. All told, I think Yahoo! can grow its free cash flow at a 4%-6% rate for the long term -- discounting that back, it suggests a fair value of about $23.

Admittedly, that's not a huge upside to today's price, but Yahoo! is generally regarded as a top-notch company and its shares don't often give investors a chance to buy at a substantial discount to a fair value. While I'm indifferent about buying Yahoo! at these levels -- as the shares trade near all time high -- I'd certainly consider a purchase if a broader market sell-off or periodic tech-overbought panic sends the shares down to the high-teens, as the shares present an attractive risk/reward there. Sub-$19 is where I will start a long-term position.

MaaniValueGuru has no position in any stocks mentioned. The Motley Fool recommends Facebook and Google. The Motley Fool owns shares of Facebook, Google, and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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