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Yahoo! Inc. (NASDAQ:YHOO)

Q3 2006 Earnings Call

October 17, 2006 5:00 pm ET

Executives

Marta Nichols - Investor Relations

Terry S. Semel - Chairman of the Board, Chief Executive Officer

Susan L. Decker - Chief Financial Officer; Executive Vice President, Finance and Administration

Daniel L. Rosensweig - Chief Operating Officer

Analysts

Youssef Squali - Jefferies & Co.

Mark Mahaney - Citigroup Smith Barney

Imran Khan - JP Morgan

Anthony Noto - Goldman Sachs

Jordan Rohan - RBC Capital Markets

Mark Rowen - Prudential Securities

Gordon Hodge - Thomas Weisel Partners

Jeetil Patel - Deutsche Bank Securities

Paul Keung - CIBC World Markets

Safa Rashtchy - Piper Jaffray & Co.

Justin Post - Merrill Lynch

Presentation

Operator

Good afternoon, ladies and gentlemen, and welcome to the Yahoo! third quarter 2006 earnings conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session.

Please note that this conference is being recorded.

I will now turn the call over to Ms. Marta Nichols. Ms. Nichols, please go ahead.

Marta Nichols

Thank you. Good afternoon and welcome to Yahoo!’s third 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 would 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 results predicted and reported, and reported results should not be considered as an indication of future performance.

The potential risks and uncertainties include, among others, the successful implementation and acceptance by advertisers of the company’s new search advertising platform, the company’s ability to compete with new or existing competitors, reduction in spending by or loss of marketing services customers, the demand by customers for Yahoo!’s premium services, acceptance by users of new products and services, and risks related to joint ventures and the integration of recent acquisitions.

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. All information discussed on this call is as of today, October 17th, and Yahoo! does not intend and undertakes no duty to update this information to reflect future events or circumstances.

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 non-GAAP 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 S. Semel

Good afternoon, everyone. Today I would like to talk about our results for the third quarter and what we see ahead, the challenges and opportunities currently before us, and the strategy that we are pursuing to address these challenges and create substantial new opportunities going forward.

Let me begin by telling you that while we are very excited about a number of things happening at Yahoo!, I am not satisfied with our current financial performance and we intend to improve it.

Our results for the third quarter fell short of our initial expectations, and we are lowering our fourth quarter business outlook as well. To be clear, we are continuing to grow our business at a pace many companies would envy, and we continue to lead the industry in key measures of performance -- but that is really not good enough for us.

We are not exploiting our considerable strengths as well as we should be and we are committed to doing better.

We are moving decisively to improve our performance. First, to improve our search advertising business, I am very pleased to announce that our Panama project, our new search advertising platform, is now as of today live. Starting today, we have begun inviting advertisers in the U.S. to upgrade to the new campaign management application. In fact, we even had our first external customer transition to the platform today as well.

This marks a significant turning point in our efforts to deliver additional value for advertisers, helping them better manage their campaigns to realize increased returns. Additionally, we believe that through this platform, we will be able to unlock the full potential of our large global user base and improve our search monetization capabilities.

To facilitate a smooth upgrade, Yahoo! will transition customers from its current system to the new platform on a market-by-market basis. Invitations to upgrade will be issued in stages to U.S. advertisers over the remainder of the year and early part of next year. Since our goal is to ensure a smooth transition, we will be flexible and accommodate those advertisers that wish to defer the upgrade until after the holiday season.

I also want to reaffirm that the introduction of the marketplace design in the U.S. remains on schedule for the first quarter of next year.

Following the migration and introduction of the marketplace design in the U.S., Yahoo! will roll out the new platform in additional markets throughout the world.

We have received a lot of positive feedback from advertisers and agencies of all sizes that have seen the early demonstrations of the platform in recent months. I want to thank all of the employees involved for all of their hard work. Yes, there is a lot more to do, but it is a huge achievement to get to this point. We are very excited about the potential of the Panama Project, and we believe that Yahoo! will derive meaningful financial benefits from this new platform.

Second, we are responding aggressively to the shift in market dynamics in the graphical advertising segment. In the first-half of this year, our graphical advertising business substantially outperformed this evolving marketplace.

During the third quarter, we saw a reduction in spending by certain clients because of their own business issues. Despite this, however, we still outperformed the segment but the gap narrowed.

The market is going through a significant transition with new forms of inventory becoming available from a range of new and established competitors. Near-term, we are expecting our growth to be in line with the overall market. Importantly, that is from a much, much higher base. Still, that is not where we should be with the superior value we provide to advertisers.

So for the long-term, we are totally focused and determined to extend our leadership in graphical advertising. This market shift represents great opportunity for Yahoo! and we have already begun taking necessary steps.

First, in response to the changing mix of available inventory, we announced today that Yahoo! acquired a 20% stake in Right Media, the largest emerging online advertising exchange for buying and selling ad inventory.

Yahoo! will also join the Right Media exchange and offers advertisers the ability to bid on Yahoo!’s non-premium inventory through the open marketplace. This relationship gives Yahoo! an opportunity to lead and influence the development of this new and innovative marketplace. It makes it easier for marketers to purchase Yahoo! inventory and has the potential to increase yield on non-premium inventory.

Second, we have added important advertising partners with high-quality inventory, led by our new relationships with both eBay and Telemundo. The eBay implementation is progressing very well and full deployment is on track for the first-half of next year.

Third, we continue to build our arsenal of industry-leading tools and capabilities, such as behavioral targeting, geo-targeting, and demographic targeting. Today, we added to those capabilities with an agreement to acquire AdInterax, a rich media technology provider. This will enable Yahoo! to provide advanced rich media creative assembly and campaign management tools directly to marketers.

Finally, we continue to create the most coveted guaranteed inventory on the web. For example, our recently redesigned homepage, which was already the most visited page on the web, has resulted in significantly improved user engagement and satisfaction, with increases in total unique visitors, page views, minutes spent, and average usage days per visitor.

These initiatives will help ensure that Yahoo! continues to be the first and most attractive choice for graphical advertisers and will position us to widen the gap with our competitors.

Yahoo! is also the first and most attractive choice for consumers, and we want to stay that way. We believe now is the time to make investments in new audiences and new ways to engage them to ultimately build new revenue opportunities.

We plan to further invest, innovate and secure leading positions in the areas where we see the biggest growth opportunities -- in social media, video, and mobile access. Clearly some new players have emerged in these areas that have attracted a lot of attention but Yahoo! also has well established positions and important initiatives underway in each of these areas.

First, let’s talk about social media. Yahoo! has been a pioneer in social media. It is a long-term focus of ours, and we are a far bigger player in this space than many people actually realize. We had the foresight to buy Flickr back in the early part of 2005 and since then, Flickr has grown to some 20 million users per month, with a lot more to come.

Yahoo! Answers, which we developed internally, is alone as a standalone, one of the largest communities and social media on the web. Answers surpassed 60 million unique users -- monthly users -- and 120 million answers worldwide just 10 months after it launched, and is now available in 18 countries and nine languages.

Together, Yahoo! Answers, del.icio.us, Flickr, and Yahoo! Video have a total of almost 100 million users, which makes us the leading force in social media today. Importantly, and boy have I read about this, within this group is the largest community of the prized 15- to 24-year old youth demographic on the web, which stands at Yahoo! at approximately 30 million.

We are incredibly focused on making every part of Yahoo! a more social experience. We are convinced that the social media space will continue to grow and evolve and we plan to be a key player in this business.

So now, let me talk about how we view video. We are an early competitor in video, and we expect to be a very large player. Our goal is to make video as ubiquitous as text throughout the Yahoo! network. In order to accomplish this, we are executing on a number of priorities:

  1. We have built one of the leading video technology infrastructures, which enables us to deliver higher performance and better quality video throughout Yahoo!;
  2. We focused on establishing high quality user-generated content. To that end, we recently announced the acquisition of Jumpcut, which has a suite of online video editing capabilities. The integration of these tools will make Yahoo! an even better place for people to create, share, and discover great video online;
  3. We are moving quickly to forge partnerships with video producers. We have done more than a dozen to date, including the local news partnership we announced yesterday with CBS News, as well as the recently announced innovative partnership with Current TV;
  4. We are producing our own contextual relevant video within our leading verticals, such as sports, news, and now entertainment; finally
  5. With our superior ability to target audiences and advertisers, we are well-positioned to monetize video as its importance to advertisers grows.

It is early. We are off to a good start with one of the largest video audiences of more than 40 million unique monthly viewers, and we are going to continue to make this a key focus area over the long haul.

The third key area of opportunity is mobile. We believe more and more Internet users are going to be going mobile. Indeed, many people in emerging markets will experience the Internet first and perhaps the only way through a mobile device. We are going to leverage our current leadership position in mobile access to the Internet and we are going to continue to build our technology, develop new products, and extend the reach of our partnerships with mobile service providers.

Our recently developed flagship service, Yahoo! Go, gives consumers seamless access to information on the web through their desktop, mobile, or TV. This year, we globally launched Windows Mobile and Symbian versions of Yahoo! Go for mobile, and we expect to launch a new Java version in the early part of ’07.

We are also extending social media communities to mobile devices. To bring our Yahoo! services to mobile phones, we now have more than 50 partnerships with mobile service providers and device manufacturers, including Airtel and Hutch in India, Smart and Globe in Southeast Asia, and global deals with both Motorola and Nokia.

Within the next 18 months, we expect Yahoo! Go and other services will be available to a majority of the mobile phones in the world.

Plus, we have been delivering mobile sponsored search tests in the U.K. and Japan for the past 12 months to monetize our mobile audiences. We recently extended those learnings with a beta launch in the U.S. and the U.K. markets.

In conclusion, Yahoo! continues to be one of the world’s leading Internet companies. For more than a decade, we have seen numerous trends rise and fall, and various competitive threats come and go, but we have maintained our position as one of the leaders in this industry because we have been able to adapt and innovate and leverage Yahoo!’s many, many strengths.

When I joined Yahoo! in 2001, one of the first things I saw was that we had too many priorities and we needed to focus. We concentrated on three areas that we thought could be really good, that we could really be good at, and then, of course, it was all about execution. Five years later, we have had enormous growth, but to continue this success, we have got to get back to basics and again zero in on a few key priorities.

Moving forward, we are going to be laser-focused on these three core things:

  1. Close the gap in monetization of search;
  2. Widen our lead in graphical advertising; and
  3. Seize the opportunity in social media, video, and mobile.

I am very excited about the opportunity, confident in our strategy, and proud of all the amazing employees around the world who are working so hard to achieve our objectives.

With that, I will turn it over to Sue.

Susan L. Decker

Thanks, Terry, and thanks to all of you for joining us today. We continued to experience strong growth in the third quarter, albeit at a slower rate than we expected a few months ago. Our profitability and cash generation remains strong, allowing us to continue to invest in creating better user experiences and improved advertiser offerings designed to drive growth and profitability in future years.

I will discuss our results and our outlook, and then I would like to leave you with some important thoughts about how we continue to utilize our capital in a disciplined and opportunistic way to drive shareholder returns.

Before we review Q3 results, let me start with two brief housekeeping items. First, our G&A line benefited from a $10 million reversal of an earn-out accrual. Second, our reported effective tax rate was 49% for the quarter. This includes a one-time increase of approximately 4% to our rate, which relates to a restructuring transaction reported to you in Q405. As a reminder, our cash tax rate for the year is expected to run much lower, with an anticipated range of 5% to 8% for 2006, significantly below our reported rate because of our NOL carry forward position.

Let’s talk now about the financial results in the quarter, starting with free cash flow, which we view to be our most important financial metric as it relates to value creation.

Reported free cash flow was $288 million. Adjusting for the purchase of land made in Q3, which we noted on our Q2 call, free cash flow was almost $400 million in the quarter, demonstrating the ability of our unique collection of offerings to deliver strong cash returns.

In addition to our free cash flow, we received $42 million from the proceeds of the exercise of employee stock options in the quarter.

Let’s turn to how we invested that cash. We invested nearly $1.1 billion this quarter, repurchasing 41 million shares at an average price of $26.85 per share in the direct stock repurchase transactions that we believe will yield substantial returns to shareholders over time.

Also during the quarter, two of our previously entered into structured stock repurchases matured and settled in shares, resulting in the buyback of a little over 8 million shares.

In aggregate, we repurchased a total of close to 49 million shares in Q3.

As of quarter end, we had fully utilized our previous share repurchase authorization for $3 billion. Our Board of Directors has authorized the repurchase of an additional $3 billion of our stock over the next five years.

Given our large cash position, and our expected free cash flow generation, we currently believe we have ample cash resources to cover a wide range of operating needs and acquisition opportunities. Consequently, while our first priority is to redeploy excess cash into acquisitions and investments that improve our financial and strategic position, we believe there will also be value-creating opportunities to return cash to shareholders.

Netting out these sources and uses of cash, our ending cash and marketable securities balance was $3.2 billion. Please note that this ending cash balance does not include several other important sources of incremental balance sheet value. Our interest in Yahoo! Japan, Alibaba in China, and Gmarket in Korea, together with one outstanding structured stock repurchase transaction, collectively amount to $9.4 billion in value, or almost $6.50 per share, an important complement to the underlying values of our operating assets.

Moving now to the P&L, the overall summary is that although second-half growth rates are slower than we originally anticipated, we maintain strong profitability and cash flow while continuing to innovate for and engage our very large and growing base of users with a broad array of products and services.

Specifically, third quarter revenue ex-TAC came in at $1.12 billion, advancing more than 20% over year ago figures. Excluding the effect from the deconsolidation of China that occurred in the fourth quarter of last year, the organic growth rate was 22%.

Looking at the revenue breakdown by lines of business, global marketing, our largest service, generated $912 million of revenue ex-TAC for the quarter, up 20% year over year. To give you additional color about the drivers of revenue, as I have in the past quarters, I will comment about our owned and operated network, or O&O, which includes advertising that runs on our owned sites, and also provide directional information on the affiliate or off-network growth trends.

As we expected, our revenue continued to grow faster on our O&O sites than on our off-network sites in Q3, due to our leading position in growth in the graphical ad market. Our O&O sites were up more than 20% year over year in aggregate, led by graphical, where our top 200 U.S. advertisers grew between 30% and 35% year over year.

While growth slowed in some categories as some advertisers spent less than we initially expected, we continued to see growing penetration among the nation’s top marketers.

On the affiliate side, as expected, we generated growth in the lower double-digits year over year, somewhat slower than our O&O network for two reasons. First, MSN is no longer an affiliate in the U.S., having brought its business in-house. The impact of this move is consistent with the figures that we have been providing to you for the last year. Excluding MSN, our affiliate business continues to grow nicely.

Second, our average TAC rate was up modestly over last quarter, both including and excluding MSN in the totals, in line with our expectations that we communicated to you at the beginning of 2006.

Looking forward, we continue to expect our O&O business to outpace our affiliate growth, net of TAC for those same two reasons.

Now, let’s look more closely at volume and monetization on our O&O sites. On the volume side, we added an estimated $68 million unique users year over year, a healthy 20% growth rate versus Q3 a year ago. Keep in mind that we continue to grow off an already huge base, adding new unique users in numbers approaching the entire size of the user bases of some of the largest emerging properties on the Internet.

Page views, our best overall volume measure, grew even faster at 24% to nearly 4 billion per day in September, implying better engagement as well. Within our overall usage figures, we are very pleased with our search volumes and believe we are generally maintaining query share.

In e-mail, we are the leader on a global basis and we have also continued to trail blaze in the social media area, as Terry outlined. In short, our high quality O&O network continues to grow from an already enormous base, and we believe consumers are finding more and more relevant services on our network, enhanced by our community and personalization initiatives.

Turning to our other driver of revenue, the rate at which we monetize our O&O page views. In the third quarter, our revenue per page view was modestly less than it was in the year ago period. When combined with the average growth in page views of 24%, this explains our overall O&O growth of 21%. This slight decline in yield across the Yahoo! network included a blend of single-digit growth for graphical inventory sold in our global communication, entertainment, information and commerce properties, and a modest decline in our U.S. revenue per query and search.

As we indicated last quarter, we have anniversaried some of the coverage related initiatives that we rolled out in search in Q2 and Q3 of a year ago, which were incrementally driving RPS in earlier quarters. As we mentioned in our last earnings call, after our new advertising platform, Panama, is fully up and running in 2007, we expect our monetization growth rates in search to improve.

Turning to fees, we produced $210 million of revenue, up 23% from a year ago, or a few points less than that if adjusted for a one-time license fee that we noted in Q2 and that was recognized in Q3.

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 15.5 million paid relationships, up 36% year over year, and up over 1 million from Q2 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 overall average revenue per user of $3 to $4 per month.

Turning to revenue by geographic segment, international continued to outpace the U.S., up 25% ex-TAC over the year ago quarter to $285 million, boosted by solid growth in both sponsored search and graphical. Currencies did not have a meaningful impact in this quarter.

Let’s turn now to some of the details behind our profitability. Specifically, operating cash flow came in at $474 million, up 23% year over year, producing strong global operating cash flow margins of 42% for the quarter. Excluding the one-time benefit to our G&A line I mentioned earlier, operating cash flow would have risen just over 20% in Q3, yielding margins of 41.3% for the quarter.

As you know, the major driver of margin leverage is compensation costs, our largest expense, which continues to yield productivity improvements. Headcount ended the quarter at around 11,000, up about 475 from Q206 levels, and up almost 15% from a year ago. This was primarily related to planned investments in key talent, collectively focused on improving our user experience that will strengthen our market position.

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

Let me turn now to our business outlook. Based on our current view of the marketplace, we are revising downward our business outlook for Q4 and the year. For the fourth quarter, we now expect revenue ex-TAC to be in the range of $1.145 billion to $1.263 billion, up 13% from a year ago at the midpoint, or 16% excluding the impact of MSN and the China divestiture.

This outlook contemplates slower but still solid growth in our core advertising businesses, with global graphical and other non-search businesses collectively up around 20% year over year, and global search up in the mid-single-digits.

Turning to profitability, at these revenue levels, we expect to operate within an operating cash flow range of $475 million to $554 million for the fourth quarter, up 11% at the midpoint of the range.

Q4 margins are expected to be approximately 41% to 43%, reflecting seasonal strength in our marketing services businesses.

Moving now to what we consider to be our most important financial metric, free cash flow, we are narrowing our full-year ’06 range but maintaining the midpoint, which reflects both our updated operating cash flow expectations as well as better-than-expected anticipated working capital contributions during the first nine months. Note that our free cash flow expectation for the full year includes the aggregate purchase price of approximately $120 million for the land in Santa Clara, the majority of which was included in Q3 cap-ex.

Our free cash flow range of $1.295 billion to $1.415 billion reflects capital spending for ’06 of approximately $670 million to $720 million. On the land, we see this as an attractive asset that provides additional capacity and flexibility for Yahoo!’s future. Although we do not have an immediate plan for development, we will be analyzing our options and making decisions over the coming year.

To sum up, as we complete our third quarter in 2006, while we initially expected more growth, I believe it is very important to note that we remain in a very strong financial position, experiencing double-digit top line growth, highly profitable margin levels, and a financial model that continues to convert 60% to 80% of OCF to free cash flow.

We firmly believe that the considered and deliberate reinvestment of our revenue and our excess cash flow into key distribution, technology, marketing and various large and small acquisitions is among our most important responsibilities. We have identified many of the current trends in mobile, social media, video and emerging markets like China very early and have executed accordingly.

You often hear us say we will build, partner and buy. What does that really mean in practice? We will build where we see opportunities to provide new and differentiated services to our users, as with the extremely popular Yahoo! Answers, and with our recent investments in improving the usability of and user engagement on our homepage, yahoo.com, the most visited single page on the Internet.

We will partner, as we have recently, with global leaders like Acer, Hewlett-Packard, and eBay, to expand distribution of Yahoo! services and leverage our expertise in advertising.

We will buy where we see mutual benefits, as with Flickr, where we saw an emerging community that would benefit from Yahoo!’s distribution, as they brought us exceptional technology, people, and vision that continues to enhance other Yahoo! services.

In fact, over the last five years, we have made over 30 acquisitions, valued at around $5.5 billion. Some large and very substantial, like our $1 billion in Alibaba last year, and some relatively small that brought unique technologies and people. Whether small or large, the common characteristic is that they all leverage our existing position and assets at prices that were well-considered. When we see opportunities to deploy our strong free cash flow into our own shares, we will be aggressive about that when appropriate.

We are not standing still. We are and we will remain very focused on making the best and most profitable use of our balance sheet and our healthy free cash flow, allocating capital in a strategic and disciplined way that we believe will generate appropriately strong returns for our employees, users, partners, and for our shareholders.

With that, I would like to turn it back to Terry.

Terry S. Semel

Thanks, Sue. With the landscape changing, I am personally very, very excited about the opportunities for Yahoo! on a go-forward basis, so again, I just want to thank all of our employees throughout the world. I think we have enormous opportunity up ahead and I am very, very excited about it.

With that, I would like to turn to you all for questions.

Question-and-Answer Session

Operator

(Operator Instructions)

The first question comes from Youssef Squali from Jefferies & Company. Please go ahead.

Youssef Squali - Jefferies & Co.

Thank you very much. Terry, just to clarify something you said, when you announced the launch of Panama, you said it is now live. You are still talking about the front-end, meaning that the marketplace design or the new ranking algorithm is still slated in Q1. Do you have a date for that for us?

Second, you had mentioned some weakness or softness in the auto and finance verticals at a conference several weeks ago. I was wondering if you could just expand on that a little bit, and two weeks into the quarter, what are we seeing? Are we seeing any improvement there? Thank you very much.

Terry S. Semel

I will start with the first one, and that is the Panama question. I said it precisely the way it was said in the past. We have achieved exactly what we set out to achieve and that is, you are absolutely right, with the front-end going as of today and basically, marketplace design in the first quarter. That is how it has been said all along and that is how we are going to continue to say it. I feel very, very good about our capabilities and the people behind the steering wheel.

In terms of the advertising commitments, I am going to ask Dan to comment.

Daniel L. Rosensweig

Sure. We mentioned a few categories that were dealing with issues around their own categories. Mostly what we saw is a couple of our large advertisers who had company-specific issues, as I think Terry and Sue addressed in their comments. So there are a few categories that will continue to be a little bit slow and there are other categories that are continuing to grow quite nicely. I think that is a balance we are going to see regularly as we get larger and larger in this space, but mostly the issues were around companies who were having specific issues to them.

Operator

The next question comes from Mark Mahaney from Citigroup. Please go ahead.

Mark Mahaney - Citigroup Smith Barney

Thank you very much. I think Terry, you mentioned the market going through transition with new forms of ad inventory available. Could you help us think through or quantify the level of exposure you have to the non-premium ad inventory? In other words, what percentage of your display advertising do you think is facing greater competition from these new types of inventory? Thank you.

Daniel L. Rosensweig

I think what we are referring to is you see a whole proliferation of a lot of inventory in sort of the lower end of the non-premium range. A lot of the social media stuff, a lot of the network stuff that is being created, a lot of the ad networks are able to serve it. That is really focused on the low-end of the people who are not interested in the environments that they are in. They are simply interested in a specific performance ratio.

We think that our premium side is actually extremely well-protected and doing very well, because that guarantees time, location, environments, specific kinds of formats, rich media formats, video formats, so we think that is actually in very, very good shape.

We think with our investment in Right Media today is an example of how we can invest in capabilities and technology to actually take advantage of that part of the marketplace, so it is more we think that there is an opportunity in the future for us to leverage that part of the marketplace, along with the things that we have currently been doing.

Operator

The next question comes from Imran Khan from JP Morgan. Please go ahead.

Imran Khan - JP Morgan

Yes, hi, a couple of questions. I was trying to get a better sense like, you know, as you are going live with Project Panama, can you give us some quantitative color, like what kind of financial improvement we might see from that project? Is it going to be right away, or is it going to take time? Any color would be appreciated.

Secondly, Terry, you and I talked in the past in terms of how you consider eBay’s inventory, the premium inventory. Can you give us some sense like eBay’s inventory coming into the marketplace and some of the other sites trying to manage, like Amazon or Monster, what does that mean for your premium inventory yield? Thanks.

Susan L. Decker

I am going to take the first question on Panama. Just to review, we have launched the system, the front-end or the advertiser facing component, is now launched in the fourth quarter. Terry reiterated that we would launch the marketplace design feature in the first quarter of next year, and what we have said historically and continue to think is the case is that we would not expect a financial impact for at least a quarter after that. So the U.S. would be launching marketplace design in the first quarter of next year. We would begin to see a financial impact we believe in Q2 and that would build over time as the system and machine learns, and also as we roll out to other international countries later in 2007.

Daniel L. Rosensweig

On the question of new inventory to the marketplace, eBay’s inventory and perhaps others, we think that more premium inventory in the marketplace will actually be very helpful, depending on the categories that they come into, because it will help attract larger amounts of the big branding dollars to the Internet.

In the case of eBay, a lot of it will do with the retail category and the shopping category. For us, because we are going to serve those ads, we think it is a tremendous opportunity for us to extend the buys of some of our largest marketers in that category.

I am not sure that every category or every piece of inventory on some of the name brands that you might talk about will do as well, but eBay is a very targeted environment -- our ad technology, our targeting capability, and our ability to serve as part of the network we think will result in great results for them and for us.

Operator

The next question comes from Anthony Noto from Goldman Sachs. Please go ahead.

Anthony Noto - Goldman Sachs

Thank you. Sue, the reported page view number you quoted was up 24% year over year, which is a significant deceleration from 33% year over year in June. I was wondering if you could comment specifically on that trend. As you think about your guidance going into the fourth quarter and you talked about the component for search being up mid-single-digits, what do you think the page view growth and therefore graphical advertising growth will be? Thanks.

Susan L. Decker

Sure. Thanks, Anthony. I am going to start with your page view question. I think I want to take you back to Q2 when we had the incremental contribution of FIFA. I think we broke out that if you took the true average in the quarter and X’d FIFA, our page view growth in Q2 was around 27%, 28%. So this growth -- and we also said we thought that was a bit of an anomaly at 28%. If you go back two or three quarters before that, the growth rates have all been in this sort of 24% range, and even that number we think is very high on the enormous space we have at 4 billion per day. So we are very pleased with the overall page view numbers and think they are very consistent with our historical pattern, with the one anomaly of Q2 that we identified last quarter.

In terms of looking forward on sponsored search, I do not think we want to get into forecasting what the page views would be, but it is fair to say that we think the growth in our sponsored search business in Q4 will all come from volume. We do not expect any contribution from improving RPS until Panama is out and running.

Operator

The next question comes from Jordan Rohan from RBC Capital Markets. Please go ahead.

Jordan Rohan - RBC Capital Markets

Thank you. Sue, the lower end of the guided range for EBITDA for 4Q would imply a decline in margins on some growth in revenues. How is that really possible? Are there any big affiliate deals that have the potential to be renegotiated higher in terms of traffic costs? Or any big display ad renewals that can work against you to make that reality, or is there just a fair amount of conservatism built into that estimate on the lower end? Thank you.

Susan L. Decker

Thank you, Jordan. We put out a range that represents what we think is our best outlook right now, based on all of the trends that we identified. On the top line, we are expecting in that outlook roughly 20% of global marketing services growth on a X-search basis, and search sort of in the mid-single-digits. That is a lower growth rate than what we were originally anticipating, and on the margin side, we believe we can generate 41% to 43% margins is really a testament to how profitable we are and that we have been able to adjust in our cost base. We have actually been saying that all year, that we did not expect a lot of sequential growth in our costs. I think you saw that in this quarter and we expect to see that in the fourth quarter as well because there is a lot of front-end loaded investment.

Operator

The next question comes from Mark Rowen from Prudential. Please go ahead.

Mark Rowen - Prudential Securities

Thanks, a couple of questions. Number one, a follow-up on that sector question on autos and financials. You said it was those two sectors when you initially said you would come in at the lower end, but is your reduced guidance for the fourth quarter today, is that basically due to those two sectors, or has that started to spread to other sectors, that slowdown that you began to see in those two sectors?

Secondly, could you give us a sense -- you know, we have been talking about Panama for a long time and waiting for a long time. Can you just give us a sense from your test results, are the RPS improvements that you are seeing in those test results as significant as you expected or more significant? If you could help us there, that would be great. Thanks.

Susan L. Decker

Okay, let me get started with your first question. We did say that we had seen some weakness in September in those two categories. Those sectors were meant as examples. They are having some industry-specific issues in both cases. We have seen a couple of -- several of the various sectors showing some of that, but we think those are specific to those sectors, and we do think those will continue into Q4.

We also mentioned in Terry’s script that we factored into our guidance was a second issue, which is that there are more alternatives out there. There is more inventory available on the low-cost side and we want to make sure that we are in a position to really actually take advantage of that opportunity. We think there’s two factors affecting our guidance. The first was the one you mentioned and also the second is the more alternatives.

On the second point, it is really too early to tell anything about RPS in testing. We have had a lot of good testing with the client on the front-end and we have had enormously good feedback about ease of use and incremental capabilities and functionality, but the real RPS benefit of Panama would come after marketplace design, and that is a quite difficult thing to test, second order effects, until you are out in the marketplace.

Operator

The next question comes from Gordon Hodge from Thomas Weisel Partners. Please go ahead.

Gordon Hodge - Thomas Weisel Partners

Good afternoon. Just a question on Panama. The change in the front-end system, does it allow for more flexibility on pricing? I think your minimum click rate is around $0.10, and I think Google’s is $0.05 or thereabouts. I am just wondering if you will have more flexibility, offer more flexibility to the marketplace there.

Lastly, just on mobile, we are pretty excited about that opportunity. We are just a little curious as to how we should be thinking about the revenue opportunity there in terms of working with the carriers. Thanks.

Daniel L. Rosensweig

On the Panama question, yes. We have been working, as you know, with a cumbersome system where we have not had the ability to do that at all. Panama addresses a number of things on the front-end side, which is getting in faster, being able to list more listings, be able to buy more keywords, more recommendations, and we will have a more dynamic pricing capability, so the answer is yes to that. We think that will have an affect on our overall business as Panama begins to roll out.

On the mobile side, the way we would suggest you look at it is the way we look at it, which is the mobile side is much like the early days of the Internet, which is it is how do we establish a beachhead in terms of audience side, audience engagement. By having the relationships we have with the carriers, by having the relationships we have with the device manufacturers, we think we are in an absolute leadership position here because of the quality of our products, the size of our audience, and people’s desire to take Yahoo! with them to these places.

As Terry mentioned on the call, we are not focusing just on taking Yahoo! with you. We are focusing on the mobile first customer. The mobile first customer is somebody whose entire Internet experience may be to start on mobile or move to mobile, and that is on a global basis.

So we think there is a great opportunity, but the first period of time is going to be about acquiring audience, and then the monetization opportunities will become to be in effect. We are testing a few on the advertising now. We are testing a few with carriers on relationships of premium capabilities, but that is going to be out in the future.

Terry S. Semel

I am just going to add a few words to that. We are very excited about it. I think Dan pointed out all the highlight reasons and all the reasons why we should be excited. He also mentioned at the tail-end that we have started testing various approaches to monetization. Of course, both the carriers and a company like Yahoo! will be very interested in that as we go forward.

But with the huge amount of population throughout the world, some people say as many as 85% in the emerging markets of the audience is not coming from PCs to mobile devices but rather going to mobile devices to get to the Internet. That to us is such a large target and such an enormous audience that while we are working on testing different ideas and methods of monetization, as Dan mentioned, our first priority has been, for the last year or more and will continue to be for the next year or two, is really build large audiences having the capabilities of using Yahoo! products and Yahoo! things that they have been using on their PCs as well.

Operator

The next question comes from Jeetil Patel from Deutsche Bank Securities. Please go ahead.

Jeetil Patel - Deutsche Bank Securities

Two questions. First of all, just as you look forward and you talked about the advertising inventory, but can you give us a sense of maybe what more inventory in the marketplace, from the likes of MySpace or YouTube, could have? Is that something that you look at and say how do we adjust pricing, or what kind of impact do you envision from more inventory coming on from those types of companies in the category?

Second, I think last quarter you talked about cleaning up the search affiliate network a bit. Can you just give us an update of where you stand on that at this point? Thanks.

Daniel L. Rosensweig

I will talk about the inventory glut. It has definitely been a huge change. You can see from the page views of a lot of the social media sites that exist today. That is going to change the market dynamics. What we hope is that it is going to bring in whole new categories of advertisers who have been focused mostly on the search side to be able to bring them to the other side of the kinds of advertising that is capable.

From our standpoint, we want to be able to take advantage of that marketplace. We think we can continue to build our premium environments by continuing to have the highest rate of growth, the highest targeting, most engaged audiences. But there are many new players and there are alternatives in the market, so what we have to do is continue to adjust and evolve to take advantage of those and to build packaging that marketers cannot get elsewhere.

From our standpoint, we are going to move ahead as the market leader and better position ourselves to take advantage of this new inventory and this new market opportunity. We have products like Answers. We have products like Flickr that are not yet really monetized right now. But we have assets that nobody else has and we plan to leverage those assets, so those assets are not only the quality of our audience, which I think is debatable in some of these other environments, but our targeting capability of not only the environments that they are in, but our profiles of being able to know who they are and that is why our large registered audience base, which continues to grow, is becoming so important.

That user data about who they are and what they have done, and to be able to put ads in different formats and different kinds of buying capabilities into the contextually relevant environment. Of course, we do have we believe the world’s best sales team, who has the best relationships to be able to help shepherd the large marketers into this marketplace.

I think there is going to be a glut for a while. I think there will be a transition for a while, but I think in the end, our assets and our leadership will ultimately help us take the greatest amount of advantage of that opportunity.

Susan L. Decker

I will take the second question, and I am going to broaden it a little bit, because we did take the opportunity last quarter to talk about quality of traffic. We talked about that both as it relates to graphical, which we see as one of our wonderful strengths historically that has led to our leadership position, and also as it relates to our search offering.

We took the opportunity in the quarter to talk about the importance of eBay, which brought very high quality, or will bring very high quality both search and graphical inventory. We also took the opportunity to talk about the settlement that we had on click spam, which was very, very favorable compared to our competitor. Third, we mentioned that we have an ongoing effort to clean up traffic quality. We hold our affiliates to extraordinarily high standards in terms of conversion rates, and we last quarter and in quarters before that and ongoing, will continue to clean up that quality because we think that is what delivers the highest quality inventory to our advertisers.

Operator

The next question comes from Paul Keung from CIBC World Markets. Please go ahead.

Paul Keung - CIBC World Markets

Thank you, Terry, Sue, Dan, Marta. First question, Terry, you mentioned one of the top priorities next year is to close the gap on monetization. Meanwhile, Sue, I think you mentioned that fourth quarter outlook is largely a function of volume with little, if any, improvement in monetization. I was wondering, when you look at where your business is today and what you are trying to accomplish with Panama in the early part of next year, where has relative search monetization growth been going in the marketplace, and specifically, how has that gap been really changing with this quarter, last quarter and this quarter?

Susan L. Decker

Let me try to take that. I think that the objective that Terry outlined is to narrow that gap in the future, which would be post-Panama. I think we have been pretty open and transparent for the last 18 months that that was a priority of the company and that we were working on a system to do that.

We do not expect to have any real improvement in that until the system is fully launched in the U.S. and has the marketplace design feature fully launched, which would be in Q1, so therefore Q2 of next year would be the soonest we would expect that.

We do think there is an enormous opportunity for us in this, and as the market gets bigger and our queries hold, that makes the upside even greater down the road.

In terms of the current environment, I think I mentioned in my script that our RPS in search was off modestly year over year in the quarter, and I think in response to Anthony’s question, I said I did not expect any improvement in that in the fourth quarter. We could expect our gains in search to be driven primarily by query volume, which has done very, very well.

This is something that we expect in the future. We are ready to launch the system, and as it is out for a while, we would expect the monetary benefits to accrue.

Terry S. Semel

How about we take the next two.

Operator

Thank you. The next question comes from Safa Rashtchy from Piper Jaffray. Please go ahead.

Safa Rashtchy - Piper Jaffray & Co.

Good afternoon, and thank you. Sue and everyone else, could you talk a little bit more about the dynamics that are driving a rather low search growth for you in Q4? I understand obviously there is the Microsoft comparison, but that could not possibly count for all for this. I believe you mentioned low-single-digits, or high-single-digits, I should say. That seems, from what we see, significantly below the industry. I know, Sue, you just mentioned that you do not expect RPS to go up. Still the traffic volume that we see suggests that it should be a lot more than that, so I am wondering if there are other factors involved, maybe the involvement in Panama, or other factors that might decrease your volume, or are you just believing that this is the trend that the marketplace is seeing as well?

Susan L. Decker

Sure. Let me talk about the fourth quarter. So we said that we expected search on a global basis to grow about 5%. That is what we expect, taking into account no real improvement in RPS. The volume gains that we are seeing, which I think you have the external numbers on those from comp score and others as proxies, we do have the MSN issue, and then we did divest China a year ago, so all those play a factor, a role. I think I said that our overall revenue growth, not just search but overall in Q4 would be hurt by 300 basis points from those two factors, MSN and China, and then it would have a more dramatic impact if you just applied it to search alone.

Those are the factors. We think that that is relatively consistent with the trend line we have seen this year. It is a little slower than what we saw in the quarter, but relatively consistent with the trend line.

Terry S. Semel

Last question.

Operator

The final question comes from Justin Post from Merrill Lynch. Please go ahead.

Justin Post - Merrill Lynch

Thanks for taking my question. Could you clarify your comments on branded growth going to the industry? Is it there now, or is that something you see trending over the next couple of quarters for your top 200 advertisers? Then, kind of on a resource allocation, once you get Panama up and running in the first-half of next year, is that going to free up a lot of engineering resources that you can use into other areas to help drive growth in other areas?

Susan L. Decker

Okay, so let me start with the branded growth in the top 200. We saw growth in this quarter between 30% and 35%, which is a little slower than what we had last quarter, which was 35% to 40%. As we move forward, we are trying to take into account the two factors that we mentioned to you, that led us to believe that those early year growth rates, which were extraordinary, where we had very, very significant market share gains, probably were not sustainable in the back-half of the year. Those two factors were some account-specific factors and industry-related pressures, as well as more alternatives with inventory. So our comments were we do not really know what others were going to grow in the fourth quarter, but the gap between our growth rate and the market growth rate has narrowed a bit.

We still think in Q3 we outperformed it in graphical, and time will tell what will happen in the fourth quarter. That was meant to be a relatively short-term phenomenon as we work through this industry transition. On the other side, we expect ourselves to be even stronger and more competitive.

In terms of engineering resources, it is too early to talk about that, in terms of how it might affect guidance because we do not have an ’07 number out there, but with that, I will turn it to Dan.

Daniel L. Rosensweig

On the engineering resources side, on the engineers and the team that has been on Panama. First of all, they have done an absolutely heroic effort in the last bunch of months. You have to remember, this is the team that was not originally built. This is the team that came in to build it, and I think you are going to be very pleased with the results.

Panama needs to continue to develop over a period of time. As you know, we are rolling it out starting this quarter. Market place design is going to be next quarter, and then international, so this team is going to continue to be very busy for a period of time. Ultimately, what they have been building is expansible to many different things that we have in our strategy for the future of advertising. I think that is going to be important. Ultimately, they will be able to be freed up to invest in other areas of growth.

I think we are in very good shape on how we plan to sequence that.

Terry S. Semel

On that thought, I will just add a touch to what Dan just said. Yes, obviously at different incremental times during the next year, we expect to have some resources dedicated back for other important needs of the company. We are excited about that, and I just want to thank you all for joining us today, and have a good day. Thank you.

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