The White Elephant in Marissa Mayer’s Yahoo Turnaround

Investors are still mostly interested in the company's Asian assets

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Noah Berger / Reuters

“I’m not gonna talk about Alibaba any further tonight,” Yahoo CFO Ken Goldman declared early in the question and answer portion of the company’s earnings call Tuesday, after barely mentioning at all the Chinese e-commerce giant in the previous 35 minutes.

Which, for investors, was too bad. Because the elephant in the mock television studio where Goldman and Marissa Mayer webcast the earnings call—the great white, $100 billion, soon-to-go-public elephant named Alibaba—was doubtless the main reason why most investors tuning into the call were there in the first place. Yahoo still holds a 24% stake in Alibaba, which has seen its revenue, profit and private valuation soar in recent quarters.

Instead, Mayer and Goldman wanted to talk about how Yahoo’s turnaround is progressing. How is it progressing? Grindingly slow. It’s never a good sign when the CEO has to remind everyone that, hey, she said this was going take years to turn around. Nor is it encouraging that such comments come in a quarter when revenue declined and operating expenses expanded.

On the upside, there were plenty of encouraging metrics for Mayer to share. The company released 15 new product updates last quarter, many of them on mobile. And mobile usage is growing: Daily active users on Yahoo Sports rose 50% year-over-year after Yahoo launched its sports app. Mobile users of Yahoo Mail grew 20% quarter over quarter. Mayer also said Yahoo has more than 380 monthly mobile users, an increase of 15% in the past quarter alone. That has helped push total monthly unique users above 800 million for the first time ever, a 20% increase in the past 15 months that erased many of the traffic declines Yahoo had seen in the previous couple of years.

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Here’s the thing: Yahoo has yet to monetize that new traffic, a task that Goldman vowed will become a priority through 2014. But it’s hired 1,000 engineers to improve its products, pushing up operating costs. As a result, GAAP operating income fell 39% to $93 million, pulling operating margins down to 9% of ex-TAC (excluding traffic acquisition costs) revenue from 14% a year earlier.

This is happening while Yahoo’s ad revenue is declining. A 3% rise in search revenue was more than offset by a 7% decline in ad revenue. Industry wide, according to the IAB, online-ad revenue is rising at a 18% clip this year. Price per click has been declining for most online-ads, but other companies have compensated with greater volume or a focus on targeted mobile ads.

Just as worrisome, cash flow from operating activities has eroded to $298 million from $496 million in that period. And payouts to investors through buybacks and dividends has eaten into the company’s cash. Yahoo had $9.4 million in cash a year ago after selling part of its stake in Alibaba. That figure has since dwindled to $3.2 billion.

Yahoo is likely to receive several billions of dollars more when Alibaba stages an IPO expected in the first half of 2014. And so the best hope for Yahoo until it can wring more money from users is—once again—Alibaba. Despite Yahoo’s middling performance this quarter, not to mention its guidance for the current quarter that is lower than expectations, Yahoo’s stock is up 68% this year, more than double the Nasdaq’s 26% rise. That is mostly because of Yahoo’s investments in Alibaba and Yahoo Japan.

Yahoo owns about 24% of Alibaba and about 35% of Yahoo Japan. Alibaba’s net income rose 145% in its most recent quarter and Yahoo Japan’s profit gained 15%. The earnings from equity interests in these companies totaled $233 million in Yahoo’s third quarter. Subtract that figure from the $296 million Yahoo reported in net profit and it leaves a net profit of $63 million for the quarter—or six cents a share versus the 28 cents the company posted.

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To be sure, Mayer has revived Yahoo’s brand, remade core products in a way that’s improving traffic and turned the company into a place many engineers want to work again. But she largely isn’t responsible for the rally in Yahoo’s shares. It’s too early in the turnaround to give her credit for that.

Instead, credit belongs to earlier Yahoo leaders, especially Jerry Yang. Yang was a director and co-founder of Yahoo in 1996, when the company invested a 40% stake in Yahoo Japan. He was even more instrumental in Yahoo’s 2005 investment in Alibaba. Both of them are driving the bulk of Yahoo’s earnings today, and will likely do so for the next several quarters.

So kudos to Mayer for managing the early stages a tough turnaround many consider impossible. But it’s Yang, improbably, who deserves the most credit for making Yahoo an attractive investment today. The company’s stock would be a lot cheaper today without those early investments.

The flip side, however, is that Yahoo’s success is hardly its own doing. It’s a vicarious victory by virtue of its ownership in better performing Asian assets. These days, Yahoo is finding better success as an investment fund than it is as an Internet company.