Yahoo! reported a Beat & Raised bottom-line quarter. It also started disclosing user engagement metrics that exhibited for the first time some encouraging signs of a possible trend reversal. However, even after adjusting for divestitures, change in accounting due to search alliance, and rev share with Microsoft, the revenue growth is somewhat tepid and Bing-infused RPS upside is still not meeting Yahoo!'s expectations. We believe that by 2H-11 Yahoo! can pick up some growth (driven by steady state of display, RPS/volume upside from search, and new products and enhancements) and margin can continue to improve. Yahoo! remains the cheapest large cap Internet stock we cover (5x to 6x EV/EBITDA depending upon assumed valuation for Taobao/Alipay) and we see upside to valuation driven by upside from Microsoft search deal, some encouraging improvement in user engagement, new products, a possible liquidity event for Yahoo! Japan, and a likely IPO for Taobao/Alipay. We reiterate our 1/Buy rating and $21 PT.

Key Points

â Earnings/growth trends vs. our/Street estimates. Yahoo! reported net revenue of $1.06bn (down 6% Y/Y), GAAP operating income of $189.7mm, adjusted EBITDA of $404.1mm, GAAP EPS of $0.17, and non-GAAP EPS of $0.22 vs. our/Street estimates of $1.05bn/$1.06bn, $151.9mm/$143.9mm, $437.3mm/$369.7mm, $0.16/$0.16, and $0.20/$0.19 and company guidance of $1.05bn, $145.0mm.

â Guidance vs. our/Street estimates. For Q2-11 YHOO guided for net revenue of $1.10bn and GAAP operating income of $175.0mm vs. our/Street estimates of $1.15bn/$1.10bn and $218.1mm/$168.5mm, respectively.

â Positives from the Quarter: 1) A Beat and Raised bottom line quarter; 2) Share repurchases reinstated; 3) Disclosure of additional metrics by the company; 4) Progress with Yahoo! Japan monetization.

â Negatives from the Quarter: 1) Somewhat tepid revenue growth; 2) Some noise in Microsoft search deal; 3) Social media impact.

â Our old vs. new estimates: For 2011 we are modeling net revenue of $4.60bn (prior $4.70bn), operating income of $852mm (prior $870mm), adjusted EBITDA of $1.73bn (prior $1.97bn), and non-GAAP EPS of $0.92 (prior $0.97).

A Beat and Raised Bottom Line March 2011 Quarter

Revenue and growth analysis. Yahoo! reported on Tuesday, after market close, net revenue of $1.06bn (down 6% Y/Y,

down 12% Q/Q), GAAP operating income of $189.7mm, adjusted EBITDA of $404.1mm, GAAP EPS of $0.17, and non-

GAAP EPS of $.22 vs. our estimates of $1.05bn, $151.9mm, $437.3mm, $0.16, and $0.20 and company guidance of

$1.05bn, $145.0mm, n/a, n/a, and n/a, respectively. Yahoo!'s Q2-11 guidance came in line with Street for top line but above Street for bottom line.

Overall Trends. As expected, GAAP revenue for the quarter was negatively impacted by the divestiture of several

businesses in 2010, the transition of paid and algorithmic search to Microsoft, and the loss of an affiliate partner in South

Korea. GAAP revenue declined 24% Y/Y (down 20% Q/Q) while net revenue was down 6% Y/Y (down 12% Q/Q).

Excluding the impact of all one-time items, net revenue would have been flat Y/Y. On the other hand, Traffic Acquisition

Costs (TAC) continue to decline and reached $150.0mm, down 68% Y/Y (down 53% Q/Q), representing 12.4% of gross

revenue materially below the average for the prior eight quarters.

Trends in display. Positive trends in display advertising continued throughout the quarter and Yahoo! saw healthy growth from all geographic regions. Both its premium and non-premium segments contributed with strong impressions growth on relatively flat yield. Gross display revenue increased 6% Y/Y (down 18% Q/Q) while net display revenue was up 10% Y/Y (down 17% Q/Q). Adjusted for 1x items, net revenue growth was 17% Y/Y but on reported basis both gross and net display revenue growth have decelerated in Q1-11 compared to last year's quarters.

Trends in search. As anticipated, search revenue declined during the quarter. Gross search revenue was down 46% Y/Y (down 29% Q/Q) while net search revenue declined 19% Y/Y (down 8% Q/Q). The negative impact came largely from affiliate search which was down 23% Y/Y (due to the loss of NHN in Korea) and from the search alliance transition in the US. In addition, the search alliance is also not on par with expectations about RPS and both companies are working actively to fix the situation.

Trends in other revenue. GAAP Other revenue (e.g. fees, listings, and leads) declined 11% Y/Y (down 5% Q/Q) as the company completes an overhaul of this category by divestitures and new partnerships. Net Other revenue declined 10% Y/Y (down 5% Q/Q).

Trends by geography. Net revenue from Americas was $780.8mm (down 11% Y/Y, down 12% Q/Q), net revenue from EMEA was $96.5mm (up 9% Y/Y, down 9% Q/Q), and net revenue from Asia-Pacific was $187.0mm (up 11% Y/Y, down 11% Q/Q).

Gross and EBITDA margin analysis. Given the full transition of Yahoo!'s paid search to Bing in North America, the company's TAC declined materially to $150.0mm (down 68% Y/Y, down 53% Q/Q). As a percent of gross revenue, TAC (at 12.4%) was materially below the average run rate for the past eight quarters (at 27.5%). The company's gross margin of 78.7% was down 20bps Y/Y (down 160bps Q/Q). Its adjusted EBITDA margin increased 100bps Y/Y (down 420bps Q/Q) to 38.0%, reflecting the ongoing restructuring efforts at Yahoo!.

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