Analyst Mark Mahaney just moved from American Technology Research to Citigroup Smith Barney, and re-initiated coverage on the Internet stocks he follows. His June 8th report on Yahoo (ticker: YHOO) outlines three risks to Yahoo's stock, and makes interesting reading:
YHOO chart below.
Our High Risk rating on YHOO reflects the highly competitive landscape the company faces, several sector specific risks, and the intrinsically high valuation multiples of growth stocks, especially in the Internet sector. This risk profile is somewhat offset by the strength of YHOO’s balance sheet. These risks may impede the stock from reaching our target price.
1. Very significant competition from other Internet-related companies, including Google, Microsoft, Time Warner, Monster Worldwide, CNET, etc... – As a broad play on Internet advertising, Yahoo! competes for users, advertising dollars, and fees revenue against a very wide competitive set. For the stock, arguably the most important current competitive situation is with Google in search. In the March quarter, Google grew search revenue 95% Y/Y, a rate materially higher than the 70%-80% rate that we estimate Yahoo! grew search revenue. On a worldwide basis, we estimate that Google accounts for 50% of all search queries vs. 25%-30% for Yahoo!. Clearly, Yahoo! is #2 in the search sector. Per our Catalysts discussion below, we believe there may be a development that could materially improve Yahoo!’s search positioning. But the current risk here is that Yahoo! could lose material incremental search share to Google and (later, Microsoft), which could cause risk to our estimates.
Also, we note that Yahoo! is currently providing search services to Microsoft’s MSN property under a contract that expires in July 2006. Our 2006 estimates assume that the deal does not get renewed. (We are assuming less than $50MM in net MSN-related revenue in H1:06.) That Microsoft will not renew with Yahoo! is a view shared by Citigroup Smith Barney’s software analyst, Tom Berquist. Finally, on Microsoft, we believe the long-term risk to Yahoo! (as well as Google) is mostly due to potentially aggressive revenue share deals Microsoft may be willing to cut with affiliate partners. In terms of the P&L, this could flow through in terms of higher traffic acquisition costs (TAC). For now, we are assuming that TAC as a percentage of gross marketing services remains at around 34%.
2. Potential exposure to concerns over aggressive industry online advertising practices – For users, one of the negative developments on the Internet has been the rise of aggressive advertising practices, such as spam, click fraud, spyware, and adware. Combined, these practices have the potential to reduce users’ interest in the Internet and to hinder the willingness of marketers to shift more of their budgets online. We view this risk as material, but manageable. Likely, part of the cost of doing business on the Internet. However, a major backlash against Internet usage due to these practices would cause risk to our estimates. We note that New York Attorney General Eliot Spitzer recently sued Intermix Media for alleged deceptive advertising practices related to its spyware/adware services (i.e. supposedly downloading software on users’ computers without their knowledge that tracks their online usage and delivers ads against that usage). We believe Yahoo!’s direct exposure to spyware/adware is immaterial. Yahoo! does not directly generate revenue from spyware or adware, and we believe its revenue exposure to spyware/adware companies is de minimis. But there is headline risk here that is very difficult to handicap.
3. Why don’t more people outside the U.S. Yahoo!? -- Given that international ecommerce and Internet advertising growth rates are significantly higher than U.S. growth rates, Internet companies can benefit from international exposure. But as opposed to eBay and Amazon.com, where close to 50% of revenue now comes from outside the U.S., only 25% of Yahoo!’s revenue comes from outside U.S. borders. This is odd, given Yahoo!’s generally strong international brand and raises questions about the company’s international execution strength and competitive position. To be fair, that 25% international exposure is up nicely from 18% Y/Y. Also, YHOO does have a material stake in the leading Internet asset in Japan – Yahoo! Japan – and that stake is not consolidated in YHOO’s results. We assume that international will become an increasingly larger contributor to Yahoo!’s results. Were this not to happen, there would be risk to our estimates.
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