Ten Questions For Yahoo! (YHOO)

Includes: GOOG, YHOO
by: Mark Mahaney

Mark Mahaney Smith Barney CitigroupCitigroup analyst Mark Mahaney on Yahoo!'s (NASDAQ:YHOO) upcoming Analyst Day, the first in two years:

Yahoo! will host an Analyst Day on 5/17. With the stock off 20% YTD and closing in on its 52-week low, there is clearly a lot of concern/skepticism about long-term growth drivers and increasing competition from Google (NASDAQ:GOOG) and Microsoft (NASDAQ:MSFT).

This being Yahoo!'s first Analyst Day in two years, we are expecting lots of details around Yahoo!'s three core businesses -- search advertising, display/branded advertising, and fees/subscriptions. We're also looking for updates on Yahoo!'s international expansion strategy, its mobile/wireless initiatives, and its new vertical launches (e.g. Yahoo! Tech). But search advertising -- particularly the status of the search engine "fix" -- will be the single most important issue.

We detail in this report what we believe are the Top 10 questions/issues facing Yahoo! at this time. We reiterate our Buy rating and our $43 Price Target.

1. What’s the status of the search engine “fix”? Search is Yahoo!’s biggest and highest margin revenue stream – almost 50% of its estimated 2006 net revenue, with EBITDA margins in the 50-60% range vs. 42% for the company as a whole. So this “fix” is crucial.

Although Yahoo! has been implementing -- and is planning to further implement -- a series of changes to its search engine, the key aspect we’re focused on is its monetization rate or the revenue that Yahoo! generates per search. As we detail below, we believe that Yahoo!’s RPS (revenue per search) is materially below Google’s. Due to higher click-thru rates, possibly higher coverage ratios, and likely higher bid pricing, we believe that Google’s search monetization levels are at least 20% higher than Yahoo!’s and could be materially higher. If Yahoo! is able to bring its monetization levels closer to Google’s by running its algorithms through both price and relevance screens, among other innovations, there is potentially significant opportunity here.

Yahoo vs. Google Search Monetization Analysis [click on image to enlarge]

2. So you “fix” the search engine...how do you get more people to use it? The exhibit above highlights the monetization gap between Yahoo! and Google. The exhibit below highlights the scale gap between Yahoo! and Google. Since the beginning of 2005, Google’s share of global search queries has increased from 50% to 60%, while Yahoo!’s has declined from 24% to 20%. There are a lot of caveats with the comScore data used below, such as the fact that it carries limited representation of some key Asian markets where Yahoo! is very strong. But we believe it directionally accurate in terms of capturing overall market shares and trends.

So among the open questions for Yahoo! are: a) What new marketing campaigns can you run to help regain share against Google and others?; b) How significant are new incremental search opportunities across the increasingly large Web platform that Yahoo! is building?; and c) Which geographic markets are the most promising for Yahoo! in terms of search advertising growth?

Global Search Query Share Trends [click on image to enlarge]

3. How significant of a problem is click fraud and what is Yahoo! doing about it? We raised this question at the Google Analyst Day, and we’ll raise it again here. We raise it because we continue to view click fraud as one of the few key risks that could directly challenge the strong secular growth of online search advertising. As datapoints, we note the 2005 State of Search Engine Marketing report by the Search Engine Marketing Professional Organization [SEMPO] that revealed that 16% of survey advertisers considered click fraud a “significant problem we have tracked.” In 2004, only 6% of respondents answered this way. Further, the Click Fraud Network announced in late April that the average click fraud rate of companies running online advertising campaigns through Tier 1 search providers like Yahoo! and Google was 12%. We find these datapoints very hard to corroborate, but we are not surprised that click fraud is rising. As keyword search prices have risen, the incentive to commit fraud (either to boost one’s own revenues or to increase the marketing costs of competitors) has risen as well.

After digging into this issue in late 2004, we have concluded that click fraud has become a cost of doing business in search advertising. Akin to credit card fraud for retail businesses. There have been a series of legal and technology solutions Google and Yahoo! have implemented to counter click fraud. An update on these at the Analyst Day would be helpful.

4. Just how much stronger can display/branded advertising get for Yahoo!? We estimate that display/branded advertising will account for approximately 30% of Yahoo!’s 2006 net revenue, with EBITDA margins similar to those of the company as a whole – 42%. Although Yahoo! does not unfortunately break-out this segment, we estimate that the Y/Y growth for Yahoo!’s display/branded advertising has remained solidly around 35% for the past three quarters. These are impressive growth rates. And we believe they are reasonably sustainable for the foreseeable future as Yahoo! remains the #1 buy for brand advertisers on the Internet, we believe.

But answers to the following questions would be very useful: a) Is Yahoo! seeing signs that certain verticals -- like pharma, real estate, and sporting goods – which have historically under-indexed on the Internet in terms of their ad spending are finally ramping up?; b) How strong is the demand – and price leverage – for video & multimedia ads?; and c) How much success is Yahoo! having in cross-selling inventory against strong demand for its premium display/branded advertising segments?

5. How many follow-ups are there to Yahoo! Tech? Yahoo! recently re-launched its Tech Channel, and we were very impressed with the quality of the new user interface. The integration of video and multi-media graphics, the enhanced functionality, the ease of search, and the just plain intuitive feel of the site...we hadn’t expected this. We viewed this launch as one of the best Yahoo! has delivered in years. Frankly, we viewed the relaunch as a very worthy competitor to CNET in some ways.

What we’re wondering is whether this is part of a reenergized campaign by Yahoo! to go after high CPM (cost per impression) verticals – like technology, health, consumer finance, etc... Based on our initial impressions of Yahoo! Tech, we believe that this would be a smart, aggressive strategy by Yahoo! We believe that a re-design of the core Yahoo! Finance site is in the offing, but a broader, successful play against other high CPM verticals could provide major positive catalysts.

6. What are the most promising fees/subscriptions growth areas for Yahoo! now? During its March quarter earnings call, Yahoo! management stated that the company was on track to exceed its 2006 year-end goal of 16MM paying customers. This is a key differentiator for Yahoo! Google doesn’t have 16MM or 10MM or 5MM or even 1MM customers paying it monthly subscription fees. But Yahoo! does. We’re particularly focused on the co-branded Internet access deals that Yahoo! has – SBC, BellSouth, Verizon, etc... As well as on Personals, where IACI’s Match.com is showing very strong growth. And on Yahoo! Music, which we view as one of the most underappreciated assets that Yahoo! has. Very near-term, there is the FIFA World Cup offering that Yahoo! will have. This is a potentially major event for Yahoo! In the June 2002 quarter, this event helped caused a spike in Yahoo!’s Q/Q revenue growth for fees/subscriptions. But we’ll also be looking for longer-term new growth area ideas.

Despite the retrenchment from what may have been HollyNet aspirations, is the idea of a significant original content subscription offering completely out-of-bounds?

7. The most promising international markets? In the March quarter, non-U.S. revenue accounted for 24% of Yahoo!’s total revenue. What’s somewhat surprising is that this level has held relatively constant for the past two years. The exact mix itself isn’t hugely important...what’s key is that Yahoo! doesn’t appear to have gained the international traction that companies like Google, eBay, and Amazon.com have. The question is – what is Yahoo!’s strategy for generating more international growth, especially now that it has fully consolidated its stakes in Korea and in Europe.

8. What are the product development pipeline plans for future mobile/wireless offerings? Mobile and wireless market opportunities appear to be a significant element of recent M&A and R&D initiatives by several of the leading Internet companies, including Yahoo!, Google, and eBay. We view mobile search as one category that is still well in its infancy with plenty of developments (technology, marketplace, usage) still required to make this category material. We don’t view this as a 2006 or a 2007 story, but at some point we believe that a mobile presence will be a key part of any Internet aggregator/service provider’s offering.

9. How material are the social networking revenue opportunities for Yahoo!? And just exactly how does Yahoo! monetize these? User-generated content is clearly ramping up aggressively on the Internet, as the soaring usage patterns at MySpace.com indicate. Against the social networking opportunities, Yahoo! has consistently maintained the #1 position in the U.S. market in terms of total unique visitors. And it has consistently grown its user base in the U.S. at least at market rates for the past year.

One very intriguing social networking application has been the recent rollout of Yahoo! Answers, which allows any registered user to post a question to the Yahoo! community and any registered user to post a response. One featured question we saw recently was – Is there a cure for autism? – a serious and highly topical question. Among the 41 responses we saw posted were several that appeared very thoughtful and practical. What’s the revenue opportunity here? Well if usage ramps materially, there should be the ability for Yahoo! to post highly relevant ads alongside some of the results.

10. Will Yahoo! be an even more aggressive buyer of its own shares? During the March quarter, Yahoo! spent approximately $750MM under a share repurchase program – 22MM shares at an average price of a little under $34. Well, the company now has the opportunity to average down...

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