Gene Marcial's Stock Picks August 3, 2009, 9:02PM EST

Marcial: 'An Excellent Deal' for Yahoo

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BW's Gene Marcial

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Concerns About Yahoo

The Yahoo-Microsoft marriage "doesn't look as exciting after three years of volatile courtship," says Christa Quarles, Internet services analyst at investment firm Thomas Weisel Partners (TWPG) (which has done business with Yahoo). The stock's recent drop, she argues, might make it appear attractive based on 2010 earnings estimates, but it doesn't mean that investors should rush back into the stock.

Quarles gives two reasons why investors may hesitate before wading back in. First, "there appears to be heightened distrust of management," she explains. After a honeymoon period that included comments by CEO Bartz that it would require "boatloads of cash" for Yahoo to agree to a search deal with Microsoft, she says "investors are feeling slighted at what appears to be a lower deal than that offered by Microsoft in July 2008."

The second reason is "fear of what Yahoo management is seeing in its search business trends," says Quarles. The deal doesn't include an up-front payment to Yahoo, an element of prior proposals, and the lack of such a provision prompted investors to sell the stock, says Quarles.

There is also concern that Yahoo's search business may be weakening. "To switch from a power position in the spring to the defensive deal struck could suggest that Yahoo management believes search is a deteriorating asset," asserts the analyst. In particular, Quarles adds, management posted weak search results in the second quarter. And on its conference call with analysts covering the company's second-quarter performance, Yahoo spent little time discussing its investment in the search business, she recalls.

A Lackluster Stock?

In turn, many analysts believe Yahoo will be a lackluster stock over the next six to 12 months. "We think Yahoo's stock will be range-bound," given investor disappointment about the search deal, warns analyst Justin Post of Bank of America (BAC)/Merrill Lynch in a report titled Dead Money on Deal Fallout. (Bank of America has done banking for Yahoo.) The concern, he says, mainly involves Yahoo's financial performance during the interim period before the deal is fully implemented in early 2010.

Says FBR Capital's Terry: "The current valuation premium relative to its growth rate remains difficult to justify" given the competitive environment among consumer portals. His price target is where the stock is right now: 14.

Analyst Mark May of investment firm Needham says "the negatives outweigh the positives for Yahoo" in its deal with Microsoft. Aside from the lack of an up-front payment to Yahoo, one other negative is that management doesn't expect to see the full benefits of the deal until two years from the time it gets government regulatory approval, he says.

Bank of America's Post, who rates the stock neutral, figures Yahoo is more of a longer-term play, as management is building toward revenue acceleration and margin improvement in 2011 and 2012. He says "Yahoo is currently under-monetizing its user traffic," but that its traffic leadership in several categories "could provide significant value to potential acquirers."

The debate about the Yahoo-Microsoft agreement may linger for some time. In the meantime, investors will have to decide whether Icahn is right, and if Bartz made the best move for Yahoo.

Marcial writes the Inside Wall Street column for BusinessWeek. In 2008, FT Press published the book Gene Marcial's 7 Commandments of Stock Investing.