Yahoo (YHOO): Q3 Stronger Than Expected

SAI analysis of Yahoo!’s earnings brought to you by Gridley & Company LLC, a boutique investment bank providing financial advisory services to companies in the Internet/eMarketing Services industry.

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Overall: Yahoo is finally headed in the right direction again.  Management has stabilised, revenue is re-accelerating, and most importantly, search-monetization is improving (Revenue per Search increased 20%).  Traffic growth was also solid.  Operating margin declined, which is a concern, but costs are easier to control than revenue, and we expect management will focus on efficiency later in Q4 or in early 2008.

Revenue ex-TAC at high end of guidance.  In light of display-ad weakness through quarter and chaos at Yahoo, this is good news.  Overall revenue up 12% year over year, an acceleration from Q1 (7%) and Q2 (8%).

U.S. revenue growth accelerating, as a result of search monetization and, surprisingly, display growth.
  The search news is especially encouraging.  Search revenue on US “owned and operated” sites accelerated to better than 30% year over year, driven by improved click-through rates (due to the new search algorithm).  Even display accelerated, with U.S. up 20% (from low teens in Q2).  Overall, US revenue up 13% Y/Y vs. 5% in Q2.  On the negative side, International revenue decelerated to 9% from 15%.  This is puzzling, especially in light of favourable currency trends.  Management blamed the cleansing of crappy affiliates and says international search algorithm improvements should kick in in Q4.

Owned and Operated (Yahoo sites) revenue continued to accelerate, which is also good news:  Up 24% in Q3, vs. 18% in Q2 and 14% in Q1.  This segment contributes far more profit than the “Affiliates” segment, so growth here important.  The Affliate network will contribute less than 10% of the company’s revenue ex-TAC in Q4.

Guidance for Q4 essentially unchanged.  Range has been reduced on both ends.  Given slight top-line out-performance this quarter, combined with the acquisitions of Blue Lithium and Right Media, Q4 guidance seems light, which will trouble people.  CFO Jorgenson also suggested some Q3 revenue gains were one-time (but then later reversed self and said “seasonal strength.”)  We suspect the company issued intentionally conservative guidance, which is wise in light of Yahoo!’s struggles and the macro economic environment.

Operating margin declined again (bad), especially in the U.S.  U.S. op margin declined from 35% last year to 28% this year.  Management is “not happy” about the margins, but blamed some of it on accelerated hiring in Q3.  It’s time for some strategic cost cutting. International operating margin rose a point Y/Y to 22%.

Free cash flow up modestly year over year (9%), but was goosed by decline in CAPEX to $150 million vs. about $250 million last year.  This growth is weak, especially in light of the revenue growth.  On positive side, company is well-positioned for strong FCF growth in 2008.

Off-Balance Sheet assets (Alibaba, Yahoo Japan, Gmarket) valued at $9.2 billion end of quarter, or $6.50 a share.

Conference call notes (uncorrected)…


SAI’s analysis of Yahoo!’s earnings brought to you by Gridley & Company LLC, a boutique investment bank providing financial advisory services to companies in the Internet/eMarketing Services industry.



Yang (CEO), Decker (Pres), Jorgenson (CFO).

Yang: Initially content free: Yahoo “powers and delights” all of its communities.  Etc. Buzzword city.

New strategy: Three objectives:

1) Become starting point for most consumers [not new]
2) Become must-buy for adverts [not new idea, now new challenge]
3) Develop leading platforms for developers [new].

1) Will invest all resources in “starting points.”  Not just front page, but Finance, etc.
Eliminating non-core services (music subscriptions, podcasts).

2) Become Must-buy for advertisers: Lines blurring between perf and brand (display).
Poised to lead by end-to-end services…ad platform company.

3) Platforms: third-party developers.  This is new.  In past, we sucked at this.  Now looking many ways to open up.  All kinds of apps: on Yahoo, on other sites, using Yahoo data, etc.

So, we have a plan.  [Thank goodness]
Have established internal milestones.  [Good]
Transforming from selling own inventory to on-and-off Yahoo.  [OK]
Will continue to work through.  But did better than we thought in Q3.  [Yes!]

Jerry: Overall, well done. 


477 million users, up 14% y/y  pageviews up 20%
[This traffic growth GOOD NEWS.  If traffic growth stalls, Yahoo dead.]

New search update.  “Assist” technology.  YAWN.
SERPs now have movie trailers, etc.  YAWN
Goal: change game, gain query share.  [KEEP DREAMING.  Well, OK–maybe can gain from someone other than Google.  But first have to stop LOSS of query share.]

Yahoo’s front page…
Opening front page to third party content (interesting strategy change, mimics News shift)
Deemphasizing original “programming” [THANK GOD]

Almost all on Panama now.
In next few weeks, ranking algorithm rolled out worldwide.
Financial gains have continued
RPS up over 20% y/y
US O and O search +30%


Display expected to grow 20%-25%, but most growth on ad networks (10%-15% on properties)
We saw deceleration in display for 5 quarters.  This quarter, accelerated to nearly 20%
US CPMs increased y/y across board


Why trends reversed in Q3:
better direct marketing tools
Lots of deals: Bebo, etc.
Building out capabilities and tools…
Blue Lithium acquisition, Right Media.
Migrating non-premium inventory to Right Media
Newspaper partners will benefit from these capabilities.

We’re MORE EFFICIENT, LESS BLOATED now  [Thank goodness]
Minor re-orgs, etc.

NEXT: Ability to combine “attention” with search relevancy.
Example: Show American Idol in Today module to Idol fans, World Series to baseball fans.
1% click improvement = 2 billion pageviews

Working to transform Yahoo on multiple fronts:
More efficient decision-making
Inventory undervalued…

Decker: Awesome, as usual.


Free cash flow: $310mm, 66% of op cash flow.

Cash balance $2.8 billion, spent $320 on acqus, bought $350 of stock at $24/share.
Repurchased 1.6B in 2007.

Balance sheet:
Yahoo Japan, Alibaba, Gmarket
Total $9.2 billion value = $6.50/share

Solid growth in both marketing services/fees
Pleased w/ o and  o: to 22%…
US O and O search +30%+…[excellent]
O and O display also accelerated
internal PVs 20% y/y

Headwinds: rising TAC rates
Revenue ex TAC down y/y basis
Only about 10% of revenue ex-TAC at end of year
Quality efforts part of deliberate strategy.

$224mm, up 7%
ex one-time gain last year, was up 12%
primary driver: premium offerings
Exited Q with 18.7 paid relationships, up 1.2mm from Q2
Access relationships, fantasy sports (football), subs from acquisition.

+13%, 8% ex currency
intl O and O up 25% (so network awful).
we think search will accelerate.

460 mm Op cash flow
margins ahead of plan  ?
$5mm reduction in costs Q to Q.
US OCF down…

Added 1200 employees Q3
transition Overture Japan
Mostly product development
Also pulled forward Q4 hiring.

Revised outlook:
includes Zimbra, Blue Lithium.
Overture Japan:
Enables Yahoo Japan team to present unified
Will reduce reported revenue and TAC…
Yahoo Japan will pay us a service fee.
Slightly positive to OCF.

Free Cash outlook:
$1.2-$1.3 billion 2007


20% global display growth, up from low teens in Q2
20% pageviews

Think display benefitted from some unusual strength in movies, etc.
Incremental scale in display is crucial.
We are the largest in 8%-9% of pageviews…higher in revenue
Value creation accrues to our O and O.
Display deals…we expect benefits to accrue to Yahoo.

new ranking algo sensitive to relevancy
so clickthrough rates moving in a positive direction.

Margins…not happy.  Still focused on balancing w/ investment.
Continuing to add employees, but continue to focus on improving.

One-time benefits…seasonal
Conscious of economic slowdown…haven’t seen in any one sector, but conscious of the issue.

Guidance…no margin improvement in Q4.
Hired 1200 people in Q3…will continue to impact in coming quarter.
Zimbra, Blue Lithium… maybe guidance later re 2008.
Disclosure: Henry Blodget has a long-term position in Yahoo.