Yahoo’s profit margins are going to expand much more than Wall Street currently thinks, says Ross Sandler of RBC.
Ross attributes this as-yet-unforeseen improvement to cost savings from the Microsoft search deal and improved per-employee efficiencies.
We buy Ross’s logic on the search side. Unfortunately, companies like Yahoo can’t save their way to prosperity (see Time Warner). And we still have no clue where Yahoo’s future revenue growth is going to come from.
We have taken an extensive look at Yahoo’s cost base and believe that the company could expand EBITDA margins from current mid-30%’s to 49% over the next several years, well above the consensus margin assumption of 37.8% in 2011.
The key take-aways from our analysis are as follows:
1) the shift of search-related costs to MSFT per the partnership terms should allow the YHOO search EBITDA margin to drift to 85% (by 2011/2012); and
2) the non-search businesses at Yahoo could achieve peak EBITDA margin of 32% based on similar costs at niche-content peer companies;
3) most cost savings should come across the board as Yahoo’s current overall expense per employee is up 18% from its peak and current EBITDA per employee is 28% below its peak.
Top-line improvements in 2H09 and 2010 are likely to accentuate the operating leverage.
Search Margin improvements will be coming off of a smaller revenue base, blunting their impact. Yes, the Microsoft deal should allow Yahoo’s search margin to expand as it shifts hundreds of employees to Microsoft (and fires others). However, all else being equal, Yahoo will only be getting 88% of the search revenue it is currently getting, so the search revenue base will be smaller.
Search revenue will likely shrink. More importantly, given the rate at which Yahoo is currently losing share in the search market, it is hard to see how search revenue will grow in the future. (Remember, even if Bing is a success, Yahoo’s revenue is dependent on its OWN search share. It gets nothing from searches conducted directly on Bing). At best, Yahoo’s future search business is likely to be a stagnant cash gusher. Which means the company needs to find another way to grow.
Cost savings across the board will mostly be achieved through more cost cuts–and at least for now, Carol has said she doesn’t plan to cut more costs. Recovery of the display business will also help, but this will take time. There is also a risk that if Yahoo focuses too much on maximizing the short-term profit margin, it will underinvest in the business. Given that Yahoo’s search business is dying and the display business is stagnant, Yahoo desperately needs to continue to invest to develop another revenue engine. Cutting costs to the bone isn’t the best way to go about this.
Top line improvements may “accentuate the operating leverage”…but these improvements will largely be driven by economic recovery. Yahoo’s display ad revenue should grow as the economy comes back. Countering this, however, will be Carol’s plan to cut down on the number of ads on the site to make the ads less annoying to users. Unless/until Yahoo has a real breakthrough in display ad monetization, it’s hard to see how the company will drive steady 20% growth again.
We agree with Ross that a valuation of 5X EBITDA is too cheap, though!
Valuation: Excluding the combined value of cash+Asian assets, which we estimate amounts to roughly $9 p/share (discounted), YHOO is trading at 5.1x our 2009E EBITDA and 4.8x our 2010E EBITDA.
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