Yahoo! Has Work to Do Before It Recovers

Criticism of Yahoo (YHOO) has reached a fever pitch. In September, the firm announced that advertising revenue growth would fall because of weakness in the automotive and financial services sectors and the company would delay the release of its next-generation ad placement technology (Project Panama), forcing analysts to revise their estimates. While this isn't new news, real trouble could have been detected much earlier this year as free cash flow from operations deteriorated and search share was lost to Google (GOOG). While much debate focuses on the meaning of Google's purchase of YouTube and Yahoo's need to acquire Facebook, investors may want to consider the following two factors in assessing YHOO shares as the firm reports its latest earnings results this week:

1) Continued Management/Execution Risk

Poor management execution has allowed Google to steal search share and the associated, text link-based high-margin ad dollars. YHOO has been unable to fully develop products from its 2003 Overture acquisition in a timely manner, and by placing strategic business focus on multiple properties/services that rely more heavily on traditional display advertising, management has exposed the company to economic cyclicality. Amidst these difficulties, anecdotal evidence also persists that some important clients have migrated their display-based ad dollars to YHOO properties' competitors, as they may believe that the firm has not provided a compelling reason to allocate their capital solely to YHOO.

I'm also concerned that YHOO provides excessive management compensation while its financials deteriorate. CEO Terry Semel netted over $400M in stock sales from option awards during the last three years as the company ceded search share to GOOG and margins stagnated. Several other execs have received large options awards, and rumors persist that the firm had to significantly increase existing compensation packages to prevent management defections.

Can management introduce its Panama ad platform quickly enough to stem its current ad revenue growth decline and help rebuild its competitive standing? Time will tell.

2) Deteriorated Free Cash Flow (Core Operations)

In 2005, the firm generated $5.2 billion in revenue and experienced a net change of $600 million on its cash flow statement, but that cash stemmed from non-operating sources -- sales of marketable securities (Google stake, etc.) of $1 billion and "proceeds" from common stock issuance (stock options exercised by employees) of $746 million. From the latest 10-Q, YHOO generated $3.14 billion in revenue in the first six months of 2006, but only $430 million in operating income while spending $317 million in capital expenditures and $55 million in net cash from acquisitions. Annualizing these figures, and even adding back the non-cash depreciation charge of $139 million to operating income, YHOO trades at a free cash flow yield of 1%, which makes its stock, even with its depressed operating margins, still very expensive.

Most analysts cite the nearly $11 billion in assets on YHOO's balance sheet and nearly $4 billion in cash as proof of the company's financial strength, including $3.4 billion in goodwill and intangible assets that the firm booked against acquisitions. However, much of that cash also stemmed from non-operating sources or one time events -- the issuance of $750 million in debt in 2003 and the sale of marketable securities, including its original Google investment and patent settlement stock award from the firm.

Also, in the last four years, YHOO has spent $3 billion in cash for acquisitions or equity ownership in 5-10 firms that have enabled it to increase its revenue but provided no substantive improvement in operating margins and associated free cash flow.

EBITDA figures cannot adequately replace free cash flow from core operations in any valuation analysis. The company needs to spend between $500 million and $1 billion in capital equipment expenditures each year to replace its short-dated, rapidly depreciating technology and to augment its existing infrastructure to compete with Google and Microsoft (MSFT). YHOO has no choice but to make these expenditures, which are not discretionary and reduce the assumed flexibility of cash flow suggested by EBITDA. In this scenario, EBITDA thus overstates the real cash-generating ability and financial strength of the firm.

How did this happen? YHOO generates nearly 90% of its revenue from ad sales and has been unable to generate meaningful profits from its fee-based offerings (Mail, Photos, DSL partnerships). It failed to fully leverage and augment bidding technology gained through its Overture acquisition to compete with Google's AdWords platform. Thus, Yahoo has to prove to investors that its technology can attract ad clients, properly monetize its user base and acquisitions, and thus generate more actual free cash flow for shareholders. The firm could then focus on building its search share and diminish concerns that advertisers may be diverting their spending away from YHOO to other online competitors.

As an example, if YHOO possessed a bidding tool that could increase ad revenues, Wall Street may have reacted more positively to the news of a possible Facebook acquisition and the ability to target its 10+ million users with relevant advertising. I have reevaluated my analysis of Facebook -- I now believe that the community it has created and the loyalty and passion of current Facebook users will enable the firm to retain its young user base well into adulthood. However, YHOO will not fully realize the benefits of an acquisition without improved ad placement technology that would convince advertisers that it can properly reach subcategories of Facebook's members.

Until YHOO management executes on its ad placement technology implementation and rebuilds the firm's free cash flow, its shares could continue to decline to the low $20s, and some reports surfaced this week that management may attempt to privatize the company. Although a private equity buyer could position YHOO's $11 billion in assets against its $35 billion market cap, the lack of free cash flow that we've discussed would create formidable challenges in raising the debt required to purchase it from the public.

All told, I still believe that the current criticism could create a buying opportunity. With its user base of nearly 200 million, YHOO could begin generating additional cash quickly with the release of new ad tools, and as the stock declines, the firm's valuation has become more reasonable. Poor management execution and overcompensation do concern me, and we'll need to witness much stronger execution of the its business strategy to improve operating margins.

Individuals typically gain no advantage by investing in overwatched stocks, but around $20/share, little long-term debt, $4 billion in cash and pessimism at a peak, YHOO could eventually reward those patient enough to buy once fear for the firm's future reaches an extreme. If the firm can increase its revenue base by 25% from $5.2 billion to $6.5 billion next year, improve its operating margins to 30% to yield $1.95 billion in op income, minimize cash outflow for acquisitions and spend about $600 million on capital expenditures, net income could increase to about $810 million (assuming a 40% tax rate).

Adding back depreciation and amortization of about $450 million results in $1.26 billion in free cash flow and a free cash flow yield on the stock of about 4.3% on a stock price of $20/share (1.484 billion shares outstanding). While everyone touts Google's operating margins and growth rate, its free cash flow yield remains under 2%; at that level, and if YHOO can meet the financial metrics just stated, investors could value its stock at around $40/share. Can it get there? Will investors pay the same multiple for YHOO that they do for GOOG if YHOO can increase its growth rate and margins? Let's first see what the company says this coming Tuesday.

As a final note: In a sector whose companies' shares always seem expensive, individual investors have little choice but to exercise discipline and wait for public technology firms to experience a bout of unpleasantness to gain an attractive buying opportunity. Unfortunately, much of the current money made in tech investing occurs from idea to acquisition, an area to which the individual, outside, passive minority investor has limited access. Managing risk remains the most important consideration. Alternatively, while you wait to determine if YHOO can revive its business fortunes, you can always consider USG.

YHOO 1-year chart: