Yahoo Set to Deliver an Alibaba Tax Shield -- Barron's

Yahoo! ( YHOO: Nasdaq)

By FBR & Co. ($40.18, Oct. 22, 2014)

We are upgrading Yahoo! to Outperform from Market Perform and raising our price target to $50 from $40.

Our upgrade of Yahoo (ticker: YHOO) is based on four factors: 1) Management appears to be going into motion on delivering a tax shield on Asian assets, a significant potential value driver that we think could be worth $13 a share; 2) The time frame for sharing plans has been pulled forward, to be revealed next quarter; 3) Progress on new initiatives (e.g., social, mobile, video, and native) are showing traction and starting to overcome core business pressure; and 4) We see attractive asymmetrical risk/reward with an upside/downside ratio of three to one (a 24% potential upside case of $50, and an 8% potential downside case of $37).

Management's comments were incrementally more positive on Yahoo's ability to shield taxes on future Alibaba ( BABA) stock sales. Yahoo is looking at all options and is optimistic that it can affect a structure that makes sense from a tax and economic perspective. We believe that such structures could include a spin-split, a cash-rich split, and/or raising debt against Asian assets. Under the terms of Yahoo's Alibaba agreement, Yahoo can take action in advance of the lockup expiration to create a structure that can minimize taxes. Yahoo intends to disclose its plans on or before its next earnings release versus our original expectation of next summer.

Yahoo's fourth-quarter net revenue guidance range (excluding traffic acquisition costs (TAC)) of $1.14 billion to $1.18 billion is in line with consensus of $1.17 billion. Adjusted earnings before interest, taxes, depreciation and amortization (Ebitda) guidance of $340 million to $380 million is above Wall Street's $348 million estimate at the midpoint of $360 million. Constructively, the implied fourth-quarter Ebitda margin of 31.0% is better than the consensus outlook of 29.9% as the company emphasized the efficiency measures it has recently implemented including reducing contractor head count, consolidating or closing offices, and reallocating personnel.

Yahoo's third-quarter revenue grew 1% (excluding TAC). In order to grow, new initiatives must more than offset roughly a $60 million quarterly slide in Yahoo's display ad business. For example, native is expected to contribute $80 million of revenue in the fourth quarter. Yahoo revealed that GAAP mobile revenues surpassed $200 million in the third quarter and will likely exceed $1.2 billion for the full year (these figures are pre-TAC and mobile TAC was not disclosed). Also notable, Yahoo's comments on its search partnership with Microsoft ( MSFT) did not indicate any intention to opt-out when the option becomes available in 2015.

Yahoo made its case that it is a good steward of capital, returning $7.7 billion through buybacks versus $1.6 billion in acquisitions during [President and Chief Executive] Marissa Mayer's tenure. Yahoo reduced its share count by 24% at an average repurchase price of $26.37 a share. However, the company did not increase the floor of 50% of the proceeds from Alibaba's initial public offering it plans to direct to stock buybacks.

Management made an effort to show that it has a cohesive and value-enhancing merger and acquisition (M&A) strategy segmented into talent acquisitions, building block technology acquisitions, and larger strategic acquisitions, which to date have consumed 80% of M&A dollars. Tumblr is now on track to deliver $100 million in revenue and positive Ebitda in 2015.

-- William Bird

-- Marvin Fong

The companies mentioned in Hot Research are subjects of research reports issued recently by investment firms. Their opinions in no way represent those of Barrons.com or Dow Jones & Company, Inc. Share prices at the time the report was issued and the date of the report are in parentheses.

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