The Future of This Internet Company

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

In just a year, Yahoo! (NASDAQ: YHOO) has gone from a company nobody cared about to one of the most followed publicly traded companies around. Yahoo! hired former Google (NASDAQ: GOOG) executive Marissa Mayer as CEO about a year ago, following six different CEOs in the preceding six years. Mayer wasted no time revamping the company, including redesigning Yahoo!'s home page, email service, and Flickr photo service. She has also bought 17 companies, including the $1 billion acquisition of micro-blogging site Tumblr.

The results, however, are so far mixed. When Yahoo! reported Q2 earnings on Tuesday, revenue declined by 7% year-over-year, or 1% if traffic acquisition costs are excluded. EBITDA also fell by 7% while non-GAAP operating income decreased by 13%. Net income, however, rose by 46% as results from equity interests in a couple of companies drove Yahoo!'s earnings higher.

Backing out cash and investments

Yahoo is currently valued at about $29 billion, and the stock has increased by about 85% from its 52-week low.

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YHOO data by YCharts

But this performance was driven mainly by the performance of the company's investments, namely Alibaba. Yahoo! owns about 24% of the private company after selling part of its stake last year. It also owns 35% of Yahoo! Japan, a stake worth about $10 billion based on current market prices. Based on the price Yahoo! got on its sale of part of its stake in Alibaba last year, the company's current stake is worth about $8 billion. Backing these investments out, along with the $4.8 billion in cash, brings Yahoo!'s enterprise value down to just about $6 billion.

The core businesses

Yahoo!'s net income includes contributions from these stakes, but since I've accounted for them directly those contributions need to be backed out as well. In 2012 the company had operating income of $566 million, which based on a 35% tax rate would leave about $370 million in net income. This puts Yahoo!'s enterprise value at about 15 times core earnings. It's not cheap, but it's not all that expensive either.

The problem is that Yahoo!'s core businesses aren't doing that well. The company is guiding for between $630 - $720 million in operating income for the full year, up from last year but still lower than both 2010 and 2011's results. The guidance for full year revenue is between $4.69 and $4.82 billion, down from last year.

Yahoo's display ad business had a rough quarter. The number of ads sold dropped by 2% year-over-year while the price-per-ad plummeted 12%. Marissa Mayer has only been on the job for a year, but its clear that Yahoo!'s core businesses needs a to turn a corner.

The future has potential

It's hard to tell what Yahoo! will look like five or 10 years from now, but the company is trying to increase the number of users of its various websites and services. After the redesigns ordered under Mayer the number of daily active users of the Flickr photo app rose 50% while use of mobile e-mail climbed by 70%. And the acquisition of Tumblr is expected expand Yahoo!'s audience by 50%.

But users don't equal profits, as many Internet start-ups are realizing. Yahoo! has bought a lot of companies, including Tumblr, which generate very little revenue and are currently unprofitable. Especially with Tumblr, there's a balance between monetization and user experience, and if Yahoo! is too quick or too aggressive with advertising the platform could fall apart in its hands.

All of the moves Mayer is making are long-term, meaning that there likely won't be any payoff in terms of profit for at least a few years. In the short term, Yahoo!'s ad business is in decline, which needs to be reversed. Yahoo!'s share of the online ad market is expected to slip to just 3.1% this year, down from 3.4% in 2012. Google's share is expected to rise to 33% from 31%, and Facebook's (NASDAQ: FB) share is expected to hit 5% from 4.1% last year.

Yahoo! is trying to follow a similar strategy to Google, not a surprise given Mayer's ties. Google built a bunch of very popular web services, like Gmail and Google Docs, in order to drive users to rely on the company's products. With the most popular search engine, the leading mobile phone operating system, YouTube, and many other products it's difficult for someone to not use a Google product.

Yahoo!, with its acquisitions under Mayer and new product launches, is attempting a similar feat. Monetization, it seems, is the not the immediate goal. Instead, getting users to depend on Yahoo! products and services is step one.

One recent win for Yahoo! in this department is the Yahoo! Weather native app for iOS 7, Apple's upcoming mobile operating system. The app has built-in support for Flickr, another Yahoo! product. The app pulls photos for the appropriate city from Flickr instead of just showing a canned animation, an innovating feature which led to Apple awarding the app an Apple Design Award. Apple had this to say:

Yahoo! Weather stands apart with its simple, uncluttered, and beautiful visual design. This highly-rated app displays weather details with stunning photography based on time of day, location, and current conditions. Yahoo! Weather has great layout and typography, compelling animations, fast image processing, and clear iconography. This attention to detail means that in a saturated category, an app can rise above the crowd. Yahoo! Weather is available in 30 languages and optimized for all current iOS devices.

A few years ago Yahoo! winning accolades for a mobile app would have been unheard of. Now, under Mayer, the company is producing quality products again. If Yahoo! can build on this and offer a stable of popular products the company could start taking advertising dollars away from Google.

Yahoo!'s purchase of Tumblr puts the company in competition with Facebook, especially considering that young people are increasingly ignoring the leading social media site. Young people are being driven to Twitter as well as Tumblr, and if Yahoo! can successfully monetize the platform and continue to grow the user base then the company could start taking advertising dollars away from Facebook as well.

The revamp of Flickr will also introduce real competition for Facebook's Instagram app, which the company bought for about $1 billion. Facebook has been trying to monetize its enormous user base, but investors have not been happy with the results, sending the shares well below the IPO price. Whether advertising on a social network can be effective enough for Facebook to justify its valuation remains to be seen, and given Facebook's problems monetizing Tumblr will be no easy task for Yahoo!.

The bottom line

Yahoo! is planting the seeds for growth, but don't expect to see any real results for at least a few years. Given the state of the ad business we may see things get worse before they get better, but if Mayer can execute and drive users to Yahoo! products there's a real chance that the company can turn things around. The word innovation and Yahoo! haven't appeared in the same sentence in a long time, and the new Yahoo! is trying to change that.

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Timothy Green has no position in any stocks mentioned. The Motley Fool recommends Facebook and Google. The Motley Fool owns shares of Facebook and Google. 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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