Yahoo! Inc. (YHOO) Operates Like a Well-Run Hedge Fund

Yahoo! Inc. (NASDAQ:YHOO)  has been on a hot conquest to buy out many small companies. While many technology columnists believe that Yahoo! Inc. (NASDAQ:YHOO) is attempting to turn its recent $1.1 billion buyout of Tumblr into a profitable business entity, I believe just the opposite. I believe that Yahoo! will benefit regardless of whether or not it turns a penny of profit from Tumblr.

Analysis of Tumblr

Upon close examination of the deal, many critics have pointed out that the user base of Tumblr is young and fickle, meaning that users may pack their bags and move on to the next social network (sort of like what happened to MySpace). That being the case, Yahoo! Inc. (NASDAQ:YHOO) can immediately start monetizing its Tumblr blogging platform through display-based advertising.

Now many of you are probably frowning because the web-advertising business model — while offering high gross margins — doesn’t provide nearly the revenue upside that alternative business models on the Internet have been able to. That is why some critics have advised investors not to invest into Yahoo! because the company’s recent acquisition could burn through shareholder capital that could have been used elsewhere.

Why is Yahoo! pursuing an acquisition-based business model?

The reasoning falls under Generally Accepted Accounting Principles. Now, I’ll try to explain the reasoning in layman’s terms (if you get lost, don’t worry because I’m going to summarize the results in the following paragraphs).

Basically, what Yahoo! Inc. (NASDAQ:YHOO) is currently doing is cutting back on its research-and-development-related expenses. This, therefore, increases the amount of net income the company is able to record on its income statement. However, it doesn’t end there.

The cash that’s recorded as net income is also recorded as assets on the balance sheet (earnings accrue on the balance sheet). What Yahoo! does after recording net income is use the cash on its balance sheet to buy out other companies. When Yahoo! Inc. (NASDAQ:YHOO) buys out another company, the buyout doesn’t show up as an expense (even though it shows up on the cash flow statement, a buyout affects Yahoo’s! balance sheet rather than its income statement).

So by diverting cash from research and development and putting it towards M&A, the company is able to accomplish two goals. First, it is able to report a higher amount of net income. Second, the company could potentially generate higher amounts of revenue and net income from the businesses it acquires, or Yahoo! sells-off its stake at a later point for an exceedingly enormous profit. Yahoo! has done this in the past with its $7.1 billion sell-off of its Alibaba stake; Yahoo! Inc. (NASDAQ:YHOO)’s original cost-basis was $500 million (entry-point).

Source: YCharts

The company has been able to cut sales, general, and administrative costs by 27.6% over the past five years; likewise, the company cut research and development costs by 27.5% in the same period. Following that, the company re-directed that cash into mergers and acquisitions, which resulted in a 28% increase in the amount of long-term assets. Buying long-term assets isn’t an expense based on GAAP accounting standards, which is why net income increased by 841.8% over the same period.