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Why Yahoo! Shares Could Test Highs Ahead of the Alibaba IPO

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Yahoo! (NASDAQ: YHOO  ) solved two key problems that had been constraining the stock price before it reported numbers on Tuesday night. The revenue line is growing internally for the first time since 2012. More important, it's doing so as Alibaba's growth rate reaccelerated. It is difficult to compare Yahoo!'s growth rate and valuation to Internet advertising companies like Google (NASDAQ: GOOG  ) and Facebook (NASDAQ: GOOG  ) , but the share price could retest its highs as the Alibaba IPO occurs and Yahoo! discloses how it will use the IPO proceeds.

Buy vs. build
Google has built the most popular search engine and used the profits from the related AdWords business to fund the purchase of YouTube, another growth home run. Facebook offers a unique way to keep in touch with friends and family while offering advertisers insights into their target audiences. Each of these companies started out with a unique property that people use as a destination. Being the first with the best makes each of these companies difficult to compete against. 

Yahoo!, on the other hand, had been unable to differentiate itself enough as a portal and email service to create the customer lock-in that both Facebook and Google enjoy. Rather than develop its rapidly growing, high-margin business in house, the company bought into the right one at the right time, Alibaba. Looking forward, if Yahoo! can deploy the cash it will receive from the IPO to reduce its share count and accelerate growth, the share price could see rapid growth again.

Alibaba kicked it up a notch
Alibaba's growth had slowed to 51% in the September quarter. But the more recently reported 66% revenue growth is likely to alleviate concerns that the company is selling shares into a dramatic revenue slowdown. Yahoo! owns 24% of Alibaba and is required to sell 40% of its position heading into the IPO. If the shares are priced for a $150 billion valuation, that would mean a pre-tax cash inflow of $14.4 billion. But that $150 billion was the number being discussed when revenue growth was expected to be near 50%.

Yahoo!'s internal growth engine seems to be building steam
Yahoo!'s core business is advertising, and as the company provides high-quality unique content, we are starting to see results. Search revenue, ex-traffic acquisition costs, grew at 9% over the prior year, an acceleration from 8% growth last quarter. But the bigger change was in display revenue, which saw a decline in September and grew by 2% in December.

Don't underestimate the benefits from low expectations
Pundits may take issue with Yahoo!'s growth when compared to competition, but the bottom line is that the company is growing again internally. It may be only single digits today, but this clearly is a big step in the right direction. Guidance met but didn't exceed expectations, so in a stable tape, this quarter would be a base hit. But considering the volatility of the last five weeks and the low expectations, it's at least a double.

Quick look at results
Yahoo! announced revenue and earnings of $1.1 billion and $0.38 per share that edged above expectations of $1.1 billion and $0.37 by $8 million and a penny. This accounted for only 1.2% of year-over-year revenue growth, but the company is still streamlining its operating businesses, and its two core areas are growing faster than the overall top line. This is key -- more changes need to be made, but the top line is growing and driven by strategic lines of business.

So why could shares of Yahoo! retest recent highs?
Alibaba's profit growth was considerably higher than the 66% top-line growth. For the quarter, Alibaba generated net income of $1.364 billion. This is impressive enough for a private company, but the unbelievable part of this story is that the profit growth rate was 110%. When the expectations were for Alibaba to have a revenue growth rate closer to 50%, the sell side was discussing a valuation of $150 billion for the IPO. Considering the much faster profit growth, it could go up from here, bringing the share price along with it.

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David Eller

I started contributing to the Motley Fool in 2013. I have held research positions at two investment banks and two hedge funds before trying more entrepreneurial ventures. I'm passionate about helping people find freedom in financial independence. Feel free to add comments and start a discussion. I hope to use these articles as forums to learn from you as well as share my opinion.

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