Yahoo! Inc. Q2 2006 Earnings Conference Call Transcript (YHOO)

| About: Yahoo! Inc. (YHOO)
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Yahoo! Inc. (NASDAQ:YHOO)

Q2 2006 Earnings Conference Call

July 18, 2006 5:00 pm ET


Terry Semel – Chairman, CEO

Sue Decker – CFO and EVP, Finance and Administration

Dan Rosensweig - COO

Jerry Yang - Chief Yahoo! and Director

Marta Nichols - Director of Investor Relations


Mark Mahaney - Citigroup

Imran Khan – JP Morgan

Anthony Noto - Goldman Sachs

Ben Schachter - UBS

Mark Rowen – Prudential

Safa Rashtchy - Piper Jaffray

Heath Terry - Credit Suisse

Jeetil Patel - Deutsche Bank

Alexia Quadrani - Bear Stearns

Gordon Hodge - Thomas Weisel Partners

Justin Post - Merrill Lynch



Good afternoon, ladies and gentlemen and welcome to the Yahoo! second quarter 2006 earnings conference call. (Operator Instructions) I will now turn the call over to Ms. Marta Nichols, Director of Investor Relations. Ms. Nichols, you may begin.

Marta Nichols

Thank you. Good afternoon and welcome to Yahoo!'s second quarter earnings conference call. On the call today are members of our executive team: Terry Semel, Sue Decker, Dan Rosensweig and Jerry Yang.

Before we begin, I'd like to remind you that matters discussed on this call contain forward-looking statements that involve risks and uncertainties concerning Yahoo!'s expected financial performance, as well as Yahoo!'s strategic and operational plans. Actual results may differ materially from the predicted results, and reported results should not be considered as an indication of future performance.

The potential risks and uncertainties include, among others: the Company's ability to compete with new or existing competitors; reduction in spending by or loss of marketing services customers; the successful implementation of and acceptance by advertisers of the planned improvements of our advertiser platform; demand by customers for Yahoo!'s premium services; and risks related to joint ventures and the integration of recent acquisitions.

All information discussed on this call is as of today, July 18th, and Yahoo! does not intend and undertakes no duty to update this information to reflect future events or circumstances. Other potential factors that could affect the Company's business and financial results are included in the Company's annual and quarterly reports, which are on file with the SEC.

On the call today, we will discuss some non-GAAP financial measures in talking about the Company's performance, including operating income before depreciation, amortization and stock-based compensation expense, which will be referred to as operating cash flow; revenue excluding traffic acquisition costs; free cash flow; adjusted net income and adjusted net income per share. Reconciliations of those measures to GAAP measures can also be found on our website under Investor Relations.

Terry and Sue have prepared remarks that should last about 30 minutes, and then we will have a brief Q&A session. Now, I would like to turn the call over to Terry.


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Terry Semel

Good afternoon, everybody. Yahoo! continues to demonstrate great strength, as we benefit from our large engaged audience and some of the industry's leading advertising solutions. During the quarter, we made important strides towards our mission to create the world's most relevant, vital and trusted Internet services for consumers and businesses. We released some of the most innovative and consumer-friendly services on the Internet, and made further progress in enhancing and expanding our services for marketers. It is exciting for me to see the next generation of Yahoo! evolve.

For the second quarter, Yahoo! reported revenue of $1.6 billion, our 13th straight quarter for record revenues, and up 26% compared to the second quarter of last year. We achieved balanced growth, with contributions across the board from our multiple lines of business and geographies. Our profitability remains very strong as well, with operating income before depreciation, amortization and stock-based compensation expense of $457 million, up 24% from the same period last year.

We believe that the next phase of the Internet is likely to be even bigger and more exciting than the past decade. While our business has grown at a remarkable pace, we are also making significant progress against our long-term investments. Our priorities are to:

  • Create next-generation user experiences in order to derive more value for and from our large, engaged audience;
  • Build key platforms and infrastructure;
  • Extend Yahoo! beyond the browser; and,
  • Enhance our monetization capabilities for both text-based and graphical advertising.

We have made investments in what we think are the right talent and resources to be in a strong position to pursue the enormous opportunity that we believe lies ahead.

It all starts with establishing the Internet's most valuable audience through deep and engaged relationships, and our ability to roll out exciting, innovative products that leverage Yahoo!'s brand, community and technologies. This past quarter was illustrative of the kinds of great services that Yahoo! can offer. Much of what we do is big, global and has the potential to make tremendous impact, which is why today we reach one out of every two people on the global Internet.

Let's look at some of the highlights during the quarter. Through the combination of rich design and new technologies such as AJAX and DHTML, we launched entirely new capabilities and superior user experience for some of our services.

The most significant was the redesign of our flagship destination, the Yahoo! homepage. In addition to the dynamic, interactive and easy-to-use consumer experience, the new incorporates registered services to also increase personalization and relevance of our content and our advertising. Together, all of the improvements have resulted in increased usage and engagement of the homepage by our consumers, and an even better opportunity for our advertisers.

Yahoo! Answers, which is now available in 18 territories and nine languages, is gaining a tremendous amount of traction. In just seven short months, it already has approximately 50 million unique users worldwide, and there have been 75 million answers across a wide spectrum of topics. Every day, questions like the best cell phone to buy or the name of a particular song are being asked. However, we have also had some of the biggest questions of our time asked by some of the biggest leaders of today; questions from people like Stephen Hawking and Bono generated a combined 50,000 answers to date, and both became global media events in and of themselves. is a great example of our ability to leverage the power of the Yahoo! network to build and run partner web sites that attract millions of global users. The site attracted record traffic numbers through the wide range of integrated offerings, including 4.2 billion page views, 73 million page views on the sites mobile destination and more than 138 million video streams.

On the subject of video, we recently released our new Yahoo! Video product, adding user-generated content, personalization and community features for rating, reviewing and sharing to our industry-leading video search capabilities. We now have a well-established infrastructure, bringing together video content by crawling the Web, accepting uploads and receiving direct feeds from partners, enabling video enthusiasts to access the largest database of videos and participate in an active and growing creative community.

There are also new things that we continue to do with many of our existing award-winning sites, such as our new chart capabilities in Yahoo! Finance, desktop-like drag-and-drop functionality in our Yahoo! Photos beta and plug-ins in Yahoo! Messenger with Voice. And, in an industry first, Yahoo! Messenger with Voice users can now connect with users of Microsoft’s Windows Live Messenger through a limited public beta, forming the world's largest IM community, approaching 350 million accounts.

We continue to extend Yahoo! into more environments so that we can deliver to consumers what they want, whenever and wherever they want it.

During the quarter, we signed a number of new deals to distribute our mobile services, including Yahoo! Search and Yahoo! Go for Mobile. The largest of these deals is a global relationship with Hutchison 3 Group, our first strategic alliance with a global mobile broadband operator. We also expanded our global alliance with Research in Motion to bring more Yahoo! services to more BlackBerry users around the world, and announced a relationship with Helio for one-click access to Yahoo! from the Helio home screen.

It is our innovation and industry leadership that enables Yahoo! to continue attracting the largest and most engaged audience on the Web, with more than 0.5 billion monthly users on Yahoo! branded Web properties. Excluding Yahoo! Japan and China, we delivered approximately 412 million unique users, up 28% year-over-year from approximately 321 million, and up from 402 million last quarter. On the same basis, our active registered user number was approximately 208 million, up 20% from 174 million in the second quarter of last year and in line with the previous quarter.

What's really exciting to me is that we have the highest share of time spent on the Internet in the US, and Yahoo! is the only company among all of our competitors that has grown minutes per visitor each quarter during the last year. Our user and engagement numbers positively impact all parts of our business, including Premium Services, which of course you know is our paying subscribers, who are the fastest-growing subset of users on the Yahoo! network. We ended the quarter with approximately 14.3 million unique paying relationships, up 1 million from the previous quarter, and approximately 4.2 million, or more than 40%, year-over-year.

Our innovation and leadership extends beyond our consumer products to our Marketing Services business. We delivered $1.4 billion in Marketing Services revenue, representing 27% year-over-year growth. Yahoo! is a leader in all forms of Internet advertising. Our trusted brand, global reach and leading media environments and capabilities make us the logical first and, we believe, the best choice for the world's biggest advertisers.

Starting with graphical advertising specifically, we continue to deliver outstanding results. We have been developing this market for many years, turning long-term relationships and trust into increased dollars. That is why we expect to outgrow the segment in 2006, with growth rates well ahead of the projected industry growth rate, which is currently in the mid 20s. Evidence of our progress is that in the US, revenue from our top 200 graphical advertisers is growing 35% to 40% year-over-year, roughly similar to the trends we have seen over the past several quarters.

We also continue to attract an extremely large majority of the Ad Age top 100 advertisers in any given quarter. So I am just giving a little alert to the few of you advertisers who seem to be missing. It's time to get aboard, because the plane or the ship is definitely moving.

Every vertical sales category in our graphical segment also delivered year-over-year growth, in large part due to our powerful verticals and our advanced targeting capabilities, which enable advertisers to reach the audiences most valuable to them across our network. We experienced significant increases in financial services, CPG, pharmaceutical and entertainment, just to name a few.

We continue to become a more integral part of companies' buying plans, while at the same time getting more value for our inventory. Our high-value inventory, which enables us to deliver the best value to our advertisers, is one of the reasons we believe we have a strong leadership position in graphical advertising. We recognize that's a strategic advantage, and we are focused on extending our leadership to also include text-based advertisers.

Let me give you three examples of the proactive steps we continue to take:

First, Yahoo! is and always has been committed to protecting advertisers against click fraud. After a thorough audit of Yahoo!'s click-through protection by a third party, it was determined that Yahoo! has the best and continues to operate a click protection system that is better than recent industry estimates of click fraud levels. We feel great about the third-party validation, but we strive to do even more, and are committed to working to build industry-wide standards on click fraud.

Second, we have strict distribution partner guidelines, and as a result we have recently terminated relationships with publishers that didn't drive traffic that met our standards. We will continue to use advanced technology to raise our standards and bring even greater value to our marketplace.

Third, we have added new partners with high-quality inventory, led by the recent announcement with eBay, that benefit both our search and brand advertising positions. Inventory quality is an important strategic issue to both our Company and to the success of our industry overall, and you can expect Yahoo! to utilize its leadership position to help drive this forward.

Moving on to another important initiative, I would like to discuss the improvements we are making to our search monetization capabilities and the introduction of our completely redesigned platform. As I described last quarter, there are three elements to the new system design: the core data platform, the advertising management applications and the new marketplace design. We have made some strong progress in a couple of key areas.

First, the underlying technology and core data platform was code complete in May, at the time of our Analyst Day. Since then, we have reached out to several hundred third-party agencies and tool providers, and have them accessing our development tools and sandbox to adapt their systems to our new platforms. This is a critical part of a successful launch, as their third-party tools must be upgraded in advance of advertising migration to the new interface.

Second, we recently did a detailed review of the advertising management application for the front end with about 175 of our most valuable search advertisers, and the feedback, I must add, was very positive. As a result, we believe we have the right functionality to help our advertisers drive demand and insight into their market.

As with any significant new endeavor, there has also been a lot of learning over the last two months. First, our comprehensive new platform approach, while complex and time-consuming, is coming together very, very well. We focused upfront on building a new system, and on various infrastructure investments that will enable us to iterate on consumer needs very quickly during the migration process by developing more automated tools and processes.

Second, we have also learned that given the complexity and importance of going to market with an application of this scale, it probably requires a little more time than we originally anticipated for two key steps. The first is the final integration and QA testing process, which is now underway. The second is the timeframe between the final QA signoff and the actual customer launch, given the legacy systems in place that will be operating in parallel.

Therefore, to meet the standards that we believe our clients should expect from us, we think it is prudent to add some extra time to our original estimates for the commercial launch. We now expect to roll out the front end, or advertising management application, in Q4 rather than Q3. We do have an aggressive plan to try to get the marketplace design piece out by year end, but because we want to collect feedback from our advertisers on the timing and cause them as little disruption as possible, for your planning purposes, we think you should plan for sometime in Q1. We believe this is the right decision, in terms of assuring the most successful commercial launch possible.

More and more marketers are coming to understand that the Internet can really help them meet their needs across the full marketing spectrum, from brand awareness, consideration, intent to purchase, trial, all the way through to transaction. To help accomplish this, Yahoo! is making the right investments in audience size, demographics and engagement, as well as important advancements in our advertising technology, to seek to deliver even better results.

So in conclusion, I would like you to know that I am very proud of the remarkable growth and progress that Yahoo! has demonstrated. We are making some important long-term strategic investments in areas such as talent, platforms and infrastructure, innovative products and enhancing our monetization capabilities as we build for the future. This is an important time for our Company, and we have always had a track record of delivering. We are focused, driven and excited about the enormous opportunity ahead.

I would now like to turn the call over to Sue, who will review our key financial highlights.

Sue Decker

Thanks, Terry and thanks to all of you for joining us today. We are very pleased with our second quarter results and what they say about our progress to-date. We have an ambitious agenda for the year that includes investments in our user experience and our advertiser offerings, designed to drive growth and profitability in future years. At the same time, we're thrilled to be able to make those investments while also delivering strong and balanced growth in each of our key financial measures, and also in our key user metrics.

Let's talk now about the financial highlights from the quarter, starting with free cash flow, which we view as our most important financial metric as it relates to value creation. As a reminder, we define it as cash generated from operations, which includes cash cost for taxes, tax benefits from stock-based compensation expense and changes in working capital less CapEx and dividends.

Free cash flow was $358 million for the second quarter, up more than 19% from a year ago. It represented 32% of revenue ex-TAC and 78% of operating cash flow, which we believe demonstrates the ability of our unique collection of businesses to consistently and efficiently deliver strong cash returns.

In addition to our free cash flow this quarter, our other significant sources of cash collectively amounted to $102 million, primarily from the proceeds from the exercise of employee stock options.

Turning to how we invested that $460 million of cash generation, we invested over $300 million this quarter in direct and structured stock repurchase transactions that we believe will yield substantial returns to investors, and $61 million for a 9% investment in Gmarket, a leading retailer e-commerce provider in Korea.

Let me give a little more detail on the share repurchase activity. We invested $51 million in direct repurchases of our stock through open market transactions. In addition, we entered into $250 million in new structured stock repurchase transactions which mature in October of 2006. Also during the quarter, two of our previously entered into structured stock repurchases matured and settled in shares, resulting in the buyback of 12 million shares.

So in aggregate, we repurchased a total of 13.8 million shares in Q2, at an average price of $31.62 per share. Year to date, we've repurchased just under 36 million shares, at an average price of about $33 per share. We continue to believe that the active investment and management of our cash will be value-creating for shareholders.

Netting out the sources and use of cash, our ending cash and marketable securities balance was just below $4 billion, an increase of about $132 million from last quarter. Please note that this ending cash balance does not include several other important sources of incremental balance sheet value:

  1. Our interest in Yahoo! Japan, which was valued at $10.6 billion at the end of Q2, representing more than $7 per share.
  2. Our investment in Alibaba, which at the time of the transaction was valued at $1.4 billion, and is currently carried on our balance sheet at that value.
  3. The $500 million in structured stock repurchase transactions that are currently outstanding and that upon maturity will result either in the repurchase of the stock or the cash being returned to the Company during this year;
  4. Our minority investment in Gmarket, valued at close to $69 million by the end of the quarter.

These four investment assets collectively amount to $12.5 billion in aggregate, or almost $8.50 per share, an important complement to the underlying values of our operating assets.

Moving now to the P&L, the overall summary is that consistent with our financial strategy, we are successfully supporting a massive and growing base of more revenue-productive users. Specifically, second-quarter revenue ex-TAC came in at $1.123 billion, our third consecutive quarter of more than $1 billion on that basis, advancing more than 28% over year-ago figures, despite the effect of the deconsolidation of China that occurred in last year's fourth quarter. Ex-China, the organic growth rate was 29%.

Let's look now at the revenue breakdown by lines of business. Global marketing, our largest service, generated $933 million of revenue ex-TAC, up 30% year-over-year.

Prior to ‘06, we have discussed the trends in our marketing services business under the categories of brand and search. However, as we indicated last quarter, this approach has become much less meaningful over time, and doesn’t adequately express the integration of how marketers are using both forms of advertising to complement and reinforce each other, both for branding and also for customer acquisition objectives.

Consequently, we are now discussing our business trends slightly different. I will comment about our O&O network, which includes the breadth of what we previously referred to as brand and search-related advertising, and collectively runs on the inventory that we own and I will provide directional information on the growth trends on the inventory that we do not own, but that we monetize for our affiliates.

Within the O&O network, we continue to lead the market in offering solutions to the nation's top 200 marketers, particularly with Graphic Labs. As we indicated last quarter, beginning in Q2, the MSN wind-down started and became evident in our figures. Consequently, our affiliate business grew at a somewhat slower rate than our O&O business, as MSN largely completed the process of moving its US business in-house.

Excluding MSN, however, our affiliate business is performing very well. Our average TAC rate was roughly flat in the quarter over last year. Adjusting for MSN, it was up modestly, in line with the expectations that we communicated to you in January. Looking forward, we continue to expect the gap between our O&O growth rate and that of our affiliates to widen in favor of our O&O network.

Turning to O&O, I will discuss both volume-related and monetization-related growth. On the volume side, our best measure is overall page views, which were relatively strong this quarter, rising about 33% year-over-year to an impressive 3.9 billion per day in June, or a still very strong 28% in that month, if we exclude the incremental impact from page views. This growth also outpaced the very healthy 25% increase in unique users adjusted for FIFA, implying improving engagement as well.

Within our overall usage figures, we are very pleased with our search volumes and believe we are generally maintaining or gaining query share. In short, our very high quality O&O network is vibrant and growing, as we believe consumers are finding more and more relevant services on our network, enhanced by our community and personalization investments.

Turning to the other source of growth, the rate at which we monetize our page views across the totality of our O&O global inventory, we generated 4% more revenue per page view in Q2. When combined with the average growth in page views, this explains our overall O&O growth of a little more than 30% year-over-year.

Additionally, given the high degree of interest and the relative monetization of our search product inventory, as compared with the rest of our network, I will provide a little more color here, as I have in the past. The modest growth rate overall in revenue per page view across the whole network worked out to a blend of 10% to 20% growth for the inventory sold across our global communications, entertainment, information and commerce properties and low-single-digit trends in US revenue per search query in the search inventory.

This US RPS trend is modestly slower than what we saw in the last few quarters, largely due to the beginning of the anniversarying of some of the coverage-related initiatives that we rolled out in Search in Q2 and Q3 a year ago. We expect this deceleration to continue in the back half, as we fully anniversary that effect. After our new ad platform is fully up and running in 2007, our monetization growth rates in Search are expected to improve.

In summary, we believe Yahoo! is very well-positioned to offer marketing services to clients seeking both mass reach and also very surgical targeting. We sell this in multiple formats -- text, display and video -- and through both direct and self-service sales channels that enable our clients to purchase advertising, both in markets in which we set the price and in markets in which they do.

Lastly, we serve these messages by a variety of matching and targeting algorithms intended to assure relevance to the consumer. Strategically, we believe we are in the sweet spot of online marketing services, offering powerful turnkey marketing solutions and consumer insight on a global scale.

Turning to fees, we produced $190 million of revenue in the quarter, up 19% from a year ago. Adjusting for the year-ago one-time pricing true-up from AT&T and the deconsolidation of China, these grew 23% year-over-year. The primary driver of this business line is our premium offerings, in which consumers and businesses pay us for our services. We exited the quarter with approximately 14.3 million paid relationships, up 42% year-over-year and up 1 million from Q1 levels. Based on our experience to date in 2006, we continue to believe we are on track to exceed 16 million paid relationships by year end, and we continue to expect them to produce an ARPU of $3 to $4 per month.

Turning to revenue by geographic segment, top line growth remained very robust internationally, up 33% ex-TAC over the year-ago quarter to $286 million, boosted in particular by strong growth in sponsored search. Holding currencies constant with Q2 2005 and adjusting for the deconsolidation of our China operations, our international revenue ex-TAC increased 38% over a year ago, outpacing the also strong 27% increase domestically.

Let's turn now to some of the details behind our strong and growing profitability. Specifically, operating cash flow came in at $457 million, up 24% year-over-year, producing strong global OCF margins of 41% in the quarter and somewhat ahead of what we had planned, because we moved some discretionary spending in marketing and hiring from Q2 to the back half.

As you know, the major driver of margin leverage is compensation cost, our largest expense, which continues to yield productivity improvements. Head count ended the quarter at around 10,500 up about 400 from Q1 ‘06 levels and up about 20% from a year ago. This was primarily related to planned investments in our key talent and various products and infrastructure, collectively designed to improve our user experience, strengthen our market position, extend new verticals and support our growing businesses.

We are very pleased that we have been able to make these investments in talent while still delivering strong profitability in margins, and we see this as a testament to the network effect of our model and our relentless focus on our key priority areas.

Let's turn now to our business outlook. We are including a business outlook for Q3 and reiterating our previous outlook for the year. Starting with the third quarter, we expect revenue ex-TAC be in the range of $1.115 billion to $1.225 billion, up 26% from a year ago, at the midpoint of the range and reflecting normal adverse seasonality for our two forms of marketing services, as compared with Q2 levels; and, a modest one-time license fee that will be recorded in our fees line.

Turning to profitability, at these revenue levels, we expect to operate within an operating cash flow range of $445 million to $505 million in Q3, up 23% from a year ago at the midpoint. Q3 margins are expected to be roughly in line with levels generated in Q2 with greater expansion in Q4, when our marketing services businesses are seasonally stronger.

For the full year of 2006, we expect revenue ex-TAC to range from $4.6 billion to $4.85 billion, up about 28% from year-ago levels at the midpoint. The outlook considers both our solid first half results and an expected slight tailwind from currency rates in the second half.

Turning to full year 2006 operating cash flow, we expect to operate in a range of $1.915 billion to $2.055 billion, representing growth of 27% year-over-year and yielding a full year margin of 42%, even after absorbing the previously announced loss of some highly profitable search revenue in the affiliate side.

On a segment basis, our expectation is that there will be some modest margin expansion in our international operations, resulting in margins being generally similar to those in the US on the international side.

Turning to our tax rate, we are currently estimated our annual reported effective tax rate to be in the range of 44% to 46%. This is about 100 basis points higher than previously estimated, and primarily reflects the impact of changes in the mix of foreign statutory earnings and higher-than-expected FAS 123R expenses. What is more significant is that our cash tax rate is expected to run at only 6% to 8% for 2006. This is significantly below our reported effective tax rate because of our NOL carryforward position. We currently have NOLs in excess of $3 billion.

As conveyed to you in our Q1 earnings call, we have a global restructuring project underway, which adds approximately 1% to 2% to our reported tax rate in ‘06 and ‘07. Thereafter, we believe we will begin to reduce our tax rate from today's levels by about 1% to 2% per year, ultimately reducing the current booked tax rate by 6% to 8%, and reducing our cash taxes once our NOLs have been fully utilized.

Moving to our most important financial metric, free cash flow, we are altering our current 2006 range to reflect the aggregate purchase price of approximately $120 million for some land in Santa Clara, the majority of which will be included in our Q3 CapEx number. The impact of this purchase reduces our free cash flow to a new range of $1.27 billion to $1.44 billion and reflects capital spending for 2006 of approximately $655 million to $735 million.

On the land, we see this as a very attractive asset that provides additional capacity and flexibility for Yahoo!'s future. Although we don't have immediate plans for development, we will be analyzing our options and making decisions over the coming year.

To sum up, as we complete our second quarter of ‘06, we are very pleased with how we performed, and as we look ahead, even more excited. Financially, at the middle of our ranges, our full year outlook for 2006 suggests a financial model that is very attractive. It calls for organic revenue growth ex-TAC approaching 30%. It suggests delivering more than 40% of that to the OCF line, and it anticipates yielding nearly 70% of that to the free cash flow line, even including our incremental CapEx for the land in 2006.

Moreover, the health of the financial model is allowing us both to show strong current growth while also absorbing significant investments to drive future growth.

In particular, we feel good about our progress to date and the early testing results from our new advertising platform, and are confident that it will help drive our search advertising monetization efforts in the future. With that, I would like to turn it back to Terry.

Terry Semel

Thank you, Sue. We continue to focus on innovative ways to create unique and sustainable environments, and to deliver the greatest value to our users and ultimately our marketing partners. I strongly believe our diversified strategy will enable us to fully take advantage of both current and future growth opportunities. With that, I would like to open it up to calls and questions.

Question-and-Answer Session


(Operator Instructions) Our first question comes from Mark Mahaney - Citigroup.

Mark Mahaney - Citigroup

Great, thank you very much. I just wanted to get into the TAC trends. Sue, is there a way you can normalize the TAC growth sequentially for the falloff in the MSN relationship? Did the cutting off of some poor traffic affiliates impact that as well? I think some of the guidance you have given before on MSN implies that TAC from MSN would have been something on the order of around $50 million. Is that the kind of adjustment we should think about, to figure out what the organic growth rate was? Thank you.

Sue Decker

Thanks, Mark. Let me just help you. The year-over-year change in MSN ex-TAC revenue was down $10 million to $20 million, and so the total effect on our revenue ex-TAC took about 2 points off of our overall growth. We expect that roughly 200 basis points impact to continue for the back half.


Our next question comes from Imran Khan – JP Morgan.

Imran Khan – JP Morgan

Hi guys. A couple of questions. Sue, if we look at your Q4 guidance and Q3 guidance, it seems like in Q4, if I take the midpoint of the numbers, it seems like you were guiding almost 15% of sequential growth. I was trying to understand, are you expecting anything from your project Panama in Q4 that you were guiding? It seems like a higher growth rate than last year’s growth rate.

Secondly, on the free cash flow side, I think almost $116 million of free cash flow came from excess tax benefit from stock-based compensation. Looking forward, if we normalize and exclude those, what kind of free cash flow growth rate should we think about? Thanks.

Sue Decker

Sure. Let me start. In terms of whether our outlook for Q4 includes anything from Panama, the answer is no. We had not been including anything from Panama prior to this conversation. With the comments Terry made about us adding a little bit more time to the testing cycle and the migration cycle, you could push off one more quarter of when we expect a financial impact from Panama.

So what you're seeing in the fourth quarter is what we would normally see, which is sequentially a little bit better trends in both our search and our performance-based marketing businesses on a seasonal basis.

In terms of the free cash flow, basically, the $116 million that you see there is the taxes that we're booking in our P&L at a full tax rate, but we are paying very limited cash taxes and that is because of the tax shield that has been created historically primarily by stock options, which amounts to $3 billion. So it's a very important source of free cash flow going forward. If you wanted to exclude it, you'd just include basically the P&L tax rate that is included in our P&L that is actually not cash.


Our next question comes from Anthony Noto - Goldman Sachs.

Anthony Noto - Goldman Sachs

Thank you. Sue, you had made the comment that you largely believe you're maintaining search query share or potentially gaining share. I was wondering if you could comment specifically on how you think you're doing on a revenue basis of search, implying what the relative change is in RPS, if you could comment on that specifically? Thank you.

Sue Decker

Sure, thanks Anthony. We don't have the information for our competitors in terms of how they are doing. But I think we have been very clear for more than a year that we thought our system was not performing as well as our competitors' on the RPS that we're converting on our network. So on a revenue basis, we clearly lost market share. That is why we put so much into our Panama efforts this year, and that is directly what the new system is designed to address.

What we do take comfort in is that the underlying core Search product to consumers is doing so well and at least maintaining or, it looks like it was gaining slight share relative to the industry as a whole. That means that when our product is ready, we have more queries to monetize. It should lead to a larger financial opportunity for the Company down the road.


Our next question comes from Ben Schachter - UBS.

Ben Schachter - UBS

On the partner quality issue, I was wondering if you could talk about how many partners you have removed? Are they primarily US or are they primarily international? How should we think about that going forward? Will there be more to go?

Also, on the Project Panama, I was wondering if you could talk about specifically what's changed since the Analyst Day, when it seems like you were pretty confident in the timing, to now. Thank you.

Dan Rosensweig

On the traffic quality issue, we just look at it as an opportunity. It has been an ongoing process and it will remain an ongoing process. So as our technology gets better and as we are able to catch these things faster and as we're able to make sure we sign on fewer partners who might have that risk -- we just believe it's an ongoing, forever process like we do in Mail with spam and other things. So we just continue to get better and better and better at that.

On the question of Project Panama and the timing, Terry did mention today that we are going to move it a quarter away. We are two months further into the process. We're actually extremely pleased with the process. We're extremely pleased with the product, the stability, as you saw from the 175 advertisers who have a chance to see it and comment. We think we have picked the right feature sets and they are extremely pleased with it.

But as we got further along in the process, we wanted to make sure that we did it right. We don't manage the Company for a particular quarter, so we focused on making sure that we did all the necessary testing. We're going through testing now. Things seem to be looking good. But we do, for example, over 20,000 different tests to make sure that these things are right, stable, it's the right advertiser experience, the advertisers get what they expect.

We would rather take the extra time to make sure that we do it right, rather than try to rush into a quarter. This, of course, remains our top priority.


Our next question comes from Mark Rowen - Prudential.

Mark Rowen – Prudential

Thanks, a couple of questions. First, we have heard in the last couple of weeks from retailers that business has been softer than they expected. Have you heard any rumblings on your end, of cutting back on advertising expenses or expecting a weaker holiday season?

Second, if I could just follow up on the last question, are you finding a lot of bugs in the system that's taking longer to fix? It's still not clear to me why you need to push it out by a quarter. Thanks.

Dan Rosensweig

I will take the second question first and then go to Sue on the trends in advertising. No, we're not finding a lot of bugs in the system. It's just the reality is we put out our best timeline at the time. We're two months further into it. To get it over the goal line the way we want to, we just think it's going to require a little bit more time to make it the quality of the kinds of products that we normally release. So we would rather do it right and take a little extra time than hurrying it out to make a particular date.

We gave you the best date we could in May, and we are giving you the best date we can now. We're very excited about the prospects of it, and you have seen a lot of response from advertisers who are also very excited about the prospects of it.

So to be specific, we just learned more about the integration, the interdependencies and those things. So it's not about bugs or quality. It's literally just what it takes to get it over the finish line. We want to do it right.

Sue Decker

Mark, on the questions about retail and the economy, like you, we're watching those trends carefully. Let's say it's early to tell whether there will be an impact. If we were to see it, we certainly haven't seen anything on our Q4 commitments, as you indicated. It's our brand business, the graphical business in which we see the most forward commitments. But retail is not as large a category as some other ones in that business.

Where it would be more visible would likely be more in the e-commerce area, which is more on the search side. That remains to be seen, and we will watch these trends carefully, as you do.


Our next question comes from Safa Rashtchy - Piper Jaffray.

Safa Rashtchy - Piper Jaffray

Good afternoon Sue, Terry and Dan. This, as far as I can see, was the first quarter that your active registered users did not grow, it was flat with the previous quarter. Can you comment on how we should read into that and what factors might have contributed?

Also on search, Sue, I just want to make sure we understand the numbers right. I think you gave a 33% growth in page views, suggesting, I assume, that that is a proxy for the overall volume growth; and mentioned that the growth to your owned and operated sites was stronger than that. Is that the way to read into it? Because if you look at the broader search revenues, it does suggest a sequential decline from Q1. Are you losing any volume to competitors, either on owned and operated sites or on your partners, ex-MSN? Thanks.

Sue Decker

Let me start. On the question about active registered users being flat, first, let me say there's no real impact in FIFA on those numbers. There is an incremental impact on our unique users and our page views from FIFA, which I broke out in my comments. So that's a relatively pure comparison, and that is relatively consistent with what we typically see in the Q2 period.

As you know, the figures that we release, our page views and our users, are a June figure. They are our last month in the quarter, so they tend to in Q2 exaggerate the seasonality of the quarter, because June is the softest month, as schools come out and summer begins. I think we might have been up 1 million or 2 million a year ago or so, but it's very consistent with what we have seen in the past, probably also reflecting a slightly larger base.

In terms of the page view growth, let me walk you through this. The 33% page view growth, again, is June over June and includes the incremental impact of FIFA. The average page view growth throughout the quarter -- not just in June -- is 27%. I also indicated that the O&O monetization rate was about 4%, leading to a low 30's growth rate in O&O. The affiliate business grew a little slower than that, so our average marketing growth, in total, was up 30%.

Now, to your question about volume versus pricing, we provided those trends last quarter as well. The 27%, 28% growth ex-FIFA in page views compares to 24% last quarter. So we were actually relatively consistent, a little higher, actually, in our volumes this quarter. The monetization growth rate was a little bit down, as I said in my prepared comments, and we would attribute that largely to RPS and search, which eased a little bit from the growth rate last quarter, because we've anniversaried a number of the coverage initiatives. We actually expect that to continue in Q3, because the coverage initiatives rolled out in Q2 and Q3 a year ago. So I think hopefully that explains the various mix of trends.


Our next question comes from Heath Terry - Credit Suisse.

Heath Terry - Credit Suisse

I was actually hoping you could talk a little bit about any kind of implications that we should be looking for from the deal that you signed with eBay, and how that could impact the model over the rest of this year and particularly into next, as you see more full development?

Sue Decker

I'll take that one. We are really delighted about our strategic partnership with eBay in the US, which runs across Search and graphical, online payments and a co-branded toolbar. So there's a lot of elements to it. We have a lot of complementary businesses, and we actually feel like we are in a wonderful position to help each other grow.

We're also very excited about the high-quality inventory that that offers, that we can offer to our advertisers that's of the par and quality that our own O&O network offers. So we are very excited.

As we indicated when we announced the deal, we do not expect any kind of financial impact in 2006. We don't plan to be up and running on a lot of these implementations until 2007, and that actually will build throughout the year. I will say, though, that there has been a heck a lot of activity since we signed the deal. There's a very collaborative process in place. We have cross-company teams working together. Design and development is underway. Testing has actually started in one component, and will extend to other components throughout the half.

In January, when we put out our business outlook for 2007, we would include any financial impact that we would expect at that time.


Our next question comes from Jeetil Patel - Deutsche Bank.

Jeetil Patel - Deutsche Bank

Thank you. Two questions. First of all, on the EBITDA, if you look at your guidance for Q3, Q4 and the year, you are up about $140 million or so on a sequential basis from Q3 to Q4. Historically you have been in the incremental $60 million to $70 million range in terms of incremental EBITDA between Q3 and Q4 over the past several years.

Can you give us a sense of, really, what drives that type of incremental profitability in the business on a sequential basis, aside from just the top line? Are there costs beyond the marketing side not ramping as aggressively? What drives that number?

Second, where do you think you are in terms of going through your traffic deals on the search side and eliminating a lot of the less desirable traffic deals? What percentage of the business is still left to transition? Or are you past that issue now?

Sue Decker

So let me start with the first question, which was second half profitability and incremental margin. Implied in our guidance for the Q3 -- and therefore, Q4 because we gave back half and Q3 numbers, so you can ascertain Q4 -- is a margin in Q3 that is very consistent with the margin we just operated at, and relatively consistent to Q1. So there is really nothing too unusual in Q3. The margins are very comparable to what we have seen in other quarters.

I think we did indicate then in Q2 our margin was a little higher than we expected, because we hired a little bit slower than we originally anticipated, and some of the marketing we had planned in Q2 is pushed a little bit back. So it's just led to a more even distribution of margins through the first three quarters. Q4 is really where we see more incremental profitability, and that is due to the fact you have two businesses. Both forms of the marketing businesses are seasonally strong in Q4, and the cost base doesn’t increase proportionately. So that leads to a little higher margin in Q4.

In terms of the traffic deals, I wouldn’t necessarily characterize it as a transition. This has been something that is new. This has been something underway for a long time. In fact, a lot of the recent outside activity and initiatives that have looked at our systems have been very complementary of the way that we approach that issue. This is an ongoing process that we do all the time, and it's very consistent with our strategic initiative to really make sure that we offer the highest-quality inventory to our advertisers and our consumers.


Our next question comes from Alexia Quadrani - Bear Stearns.

Alexia Quadrani - Bear Stearns

Thank you. When you look at the ad spending patterns among your large advertisers on the graphical advertising side, clearly, with the growth you are seeing, you're assuming still a very large portion of the traditional dollars share shift to online. But do you get a sense, looking at their spending patterns, if they are more open to or they are beginning to put a bit more of their ad spending maybe on second-tier sites or looking beyond the large portals?

Then just as a point of clarification, my second question; you may have addressed this and I missed it. There a slight change in your forecast for operating income for the full year ‘06 versus what you had previously given. Could you just explain that change?

Dan Rosensweig

I will take the first question, over ad spend trends on the graphical side. We continue to see tremendous momentum with large graphical, more traditional branded advertisers coming onto the Internet. They are looking for first tier sites, because if they are going to come spend their money in this medium, they are obviously going to go to the place where they imagine it's going to work best. Places like Yahoo! allow them to run not only large amounts and reach large amounts of people, but it's in the best environment for advertising, the best environment for quality of inventory.

These things are very meaningful for the largest advertisers, who have many goals with their advertising, from building a brand to extending a brand to reinvigorating a brand to moving products. There aren’t very many companies that can provide that entire spectrum, so I think there's plenty more for them to do with the larger sites, particularly because of our ad capability, ad targeting, measurement systems, reporting, all of those things before they think about how to move to the second-tier sites. So that's why we continue to believe we're taking tremendous market share, as I think Terry and Sue pointed out on the call, in the graphical space.

Sue Decker

Thanks. I will follow up on your second question, on operating income. I would say that's a relatively small change that has to do with depreciation and amortization. There was just an update halfway through the year on what we thought the back half would look like. Our operating cash flow outlook is exactly the same as it was last quarter.


Our next question comes from Gordon Hodge - Thomas Weisel Partners.

Gordon Hodge - Thomas Weisel Partners

Good afternoon. I'm curious if you can give us a little more detail on what you saw on the international front. I know you have a little less exposure to Europe, but we are hearing the UK ad market is drying up. I'm just wondering if there's any commentary there; then, contrast that with what you are seeing in the Asian markets, where I think you have more market share.

Sue Decker

Thanks, Gordon. I would say that the numbers that we gave out on the call, if you adjust for currencies and our divestment of China operations, were up 38% year-over-year. That compared with 41% last quarter year-over-year. So we saw a relatively strong trend in both quarters, and relatively consistent with what we would have expected when we put our original business outlook out.

We're seeing very balanced strength in both our search offerings and also our graphical offerings; very, very good trends in both. So I would not want to further break it down between the various regions, but we're pleased with our growth overall internationally.

Dan Rosensweig

One other point on the UK question. We don't see, particularly in the graphical space, advertising drying up there. We see it continuing to be extremely robust for us, very good. Should we go to the last question, please?


Our final question comes from Justin Post - Merrill Lynch.

Justin Post - Merrill Lynch

Can you talk about some of the reasons why you have improved your standing with search? Have some of the home page changes, moving the search box around, helped? What do you think is really driving that?

Secondly, can you talk about Yahoo! Answers? Any thoughts on when we might see some monetization from that?

Dan Rosensweig

Let me take the first one first. First of all, we have a tremendous opportunity across the Yahoo! Network to get a larger percentage of Yahoo! users to search. We recognize that, and as we have improved the quality of search, we have improved the way we are able to build the entire site around the world. We have improved the home page. We have improved our toolbar. We have integrated search into more logical places across the network. We've worked with our consumers to make sure they understand that search is available and how it works and setting defaults.

All of these things that we have done in conjunction with our users, we used better technology to be able to do it. We think that as users get more comfortable and familiar with it, they use it more. That has been a very big help to us everywhere in the world.

We have also rolled out a lot of great products within search, whether it be Image Search or Video Search, Local; all of these areas are doing extremely well with consumers, and allowing us to provide differentiated services to them versus other places.

Our social search activities, all of these things we think are contributing to the success. The question of Answers, which is another variable that we think is going to continue to contribute to the success, particularly in the social search area. You heard from Terry on the call how well it's doing, already 50 million users around the world, 75 million questions answered. We see this as a tremendous opportunity for advertising as we go forward.

First, we needed to establish it. We needed to understand the user patterns. We needed to build the categories in which answers are created. But we see it as an opportunity to be able to do text listings in search of categories, graphical because it's a very visual environment, and we expect that the content will be more visual as well as the advertising will be more visual. Then there will be sponsorship opportunities, and then we will actually be able to work with manufacturers in a series of categories, because consumers want information directly from the manufacturers.

We can provide a platform that no one else can provide and do it on a global basis. So we are very excited about the opportunity, not just from the consumer side but also from the business side going forward.

Sue Decker

I just wanted to add to the first question, which is the improved standing in search. I think it's important to point out that we think we have been doing very consistently and very solidly in our search market share. The issue has been that the numbers that you all are looking at from an external perspective, the COM Score numbers, don't necessarily reflect the reality of what our own log files talk about. I raised that issue last quarter. We are pleased that COM Score is looking at that, and they are getting closer to what we see as our reality, based on some of the recent revisions they made. But the year-over-year trends are still very distorted in what they are showing and what we have.

Overall, we have been seeing very consistent and steady progress in our Search numbers. Some of that is the social search initiatives that Dan mentioned, but a lot of that is web search as well.

Terry Semel

We just want to thank everyone for joining us today, and I'm sure we will have many other opportunities to speak with you all. Have a great day. Thank you.


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