Full Transcript of Yahoo’s 3Q05 Conference Call - Prepared Remarks (YHOO)

| About: Yahoo! Inc. (YHOO)

Here’s the entire text of the prepared remarks from Yahoo's (ticker: YHOO) Q3 2005 conference call. The Q&A is here. We recognize that this transcript may contain inaccuracies - if you find any, please post a comment below and we’ll incorporate your corrections. And please note: this conference call transcript is a Seeking Alpha product, so feel free to link to it but reproduction is not permitted without the explicit permission of Seeking Alpha.


Good afternoon, ladies and gentlemen. And welcome to the Yahoo Third Quarter 2005 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 Mr. Paul Hollerbach, Vice President, finance and investor relations. Mr. Paul You may begin.

Mr. Paul Hollerbach, Vice-President, Finance and Investor Relations

Thank you and 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 and Dan Rosensweig, and Jerry Yang. Before I 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 in indication of future performance. The potential risk and uncertainness include among others the company's ability to compete with new or existing competitors, a reduction in marketing services spending, adoption of our premium services and risks related to the integration of recent acquisitions. All information discussed in this call is as of October 18, and Yahoo undertakes no duty to update this information. 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'll be discussing some non-GAAP financial measures in characterizing the company's performance. Reconciliation’s of those measures to GAAP measures can be found on our investor relations website. Terry and Sue will spend the next 30 minutes on prepared remarks, which will then be followed by a Q&A session that will lastly until 3 p.m. Pacific Time. Now I'd like the call over to Terry.

Terry Semel

Thank you, Paul and good afternoon, ladies and gentlemen. Yahoo has continued its run of exceptional growth. Our relentless focus on our consumers and continued investments in people and infrastructure has led to increased product quality and a powerful rate of innovation, which are really paying off. As Yahoo's relationship with its users grows stronger, the costs we have chosen to build the world's largest global online network of integrated services is being further validated.

This is a very exciting time. For the third quarter we reported revenue of $1.3 billion, up 47% from the third quarter of last year and our 10th quarter of record results. We achieved balanced growth with contributions across the board from our multiple lines of business and geographies. Operation income before depreciation and amortization in the third quarter was Yahoo's highest ever at $385 million, up 48% year-over-year. We were able to deliver these results even while investing in and pursuing emerging opportunities and launching some of our most exciting and innovative products to date.

These results clearly highlight the power of our brand, products and business model. Yahoo reaches 73% of all Internet users in the U.S. in any given month, which speaks of the importance of the extraordinary breadth of our product suite. In fact, there is no doubt that Yahoo reaches more people in more ways than any other company on the web. Most importantly, Yahoo has deeper relationships with its users, which is essential to success in the next growth phase of the Internet. This helps provide our users and advertisers with richer and more relevant experiences. The broadband and mobile Internet is always on, always fast, and always with you. As users depend on the Internet for more things in more places and on more devices, we believe Yahoo with its integration of search, content, community and personalization has the best product suite to provide the greatest value to users around the world. By building both breadth and depth of usage globally, our consumer relationships also enable us to take advantage of multiple moneterization opportunities, which includes offerings all forms of advertising as well as premium services and commerce.

As a global network among the biggest future growth opportunities of course is China. That is why we signed an agreement with Alibaba in China during the quarter in which we combine our assets and have approximately a 40% economic stake in the new entity. This transaction is expected to close in this fourth quarter. We believe the combination of Alibaba and Yahoo is the best approach for Yahoo to win in China. Together the two companies can combine to deliver the best search, commerce and communications under the management of a very strong local team. This arrangement will further strengthen Yahoo's position as a pre-eminent destination in Asia, where we are a leader in many of the most important markets in that region. We have been on a mission globally and it is really coming to fruition.

Let's look at some of the specific highlights for the quarter. We ended the quarter with approximately 411 million unique users up 26% from 325 million for the same period last year. Our active registered users now stand at approximately 191 million, up 22% from 157 million in last year's third quarter. The fastest growing subset of users continue to be our paid subscribers as people find more value in Yahoo's suite of premium services. In the third quarter we ended with 11.4 million unique paying relationships up approximately 1.3 million subscribers from the last quarter and up 50% from last year. When we look further into our numbers, we are extremely pleased that we have achieved important share gains across many, many key verticals. Additionally, the average number of Yahoo services used by consumers and frequency of usage in many of our key verticals are also up.

As an Internet network, we look at these trends and we know that we're moving in the right direction. We have always said great products lead to a great business and this quarter you have seen us launch some of our best products to date. I'll now give you a quick overview of some of them. In communications, Yahoo messenger and mail made significant advances. We announced the industry's first major IM inter- operability agreement together with Microsoft to form the world's largest consumer IM community with more than 275 million users. We also made significant upgrades to Yahoo messenger with high quality PC-to-PC voice and interactive photo sharing, which we launched in 18 countries. This was the next step in our voice strategy which you'll see unfold further over the coming months.

Yahoo mail hit a significant milestone becoming the largest global web-based e-mail provider according to ComScore Media Metrix. We recently launched a new beta featuring a completely redesigned intuitive user interface with the speed and responsiveness of a desktop application. Industry experts called it “Far superior to competitors, sleeker, faster and smarter than its predecessor and stunning in its simplicity.” Our media group began its first phase of expanding its content initiatives and its integration with world-class community features. We introduced well-known and respected columnist within the personal finance area and launched Kevin sites in the hot zone. The user feedback on Kevin sites has been absolutely great. You can read thousands of comments from our users around the world on the site. Additionally, the integration of both professional new sources with citizen journalism with further advance through with the integration of blocks, flicker photos and my web links with Yahoo news search. Yahoo music continues to grow at a strong pace. Increasing our leadership position as the number one music destination on the web. The integration of community through Yahoo messenger enables people to find, use, rate, discover and share songs. To date, there have been more than 6 billion ratings from our community of users. And that is billions. Yahoo music unlimited was launched to highly favorable reviews and user acceptance, validating the strategy of giving the choice to listen, to subscribe or download music. We're very pleased with the growth rate of our subscription service and believe that as more devices come into the market place we are well-positioned to take advantage of the increasing consumption of digital music. Audio consumption overall is growing rapidly and users expand beyond just music.

With that in mind, last week we also launched Yahoo's innovative new podcasting service that will serve as a platform for all kinds of media casts in the future. Through the integration of community into all of these services Yahoo is at the forefront of the marriage of great professionals and user generated content. The success of our products in our relationships with our users has allowed us to once again forge and extend important partnership. Four years ago, we talked about the possibility of creating truly unique broadband partnerships, combining the great assets of Yahoo's brand, its Internet audience and expertise with the leading telecommunications companies brands, audience and communication infrastructure.

Yesterday, we reinforced our position as a pre-eminent broadband partner of choice by announcing the new alliance with Bell South who offer their DSL subscribers co-branded services Internet services. The Bell South Yahoo alliance also brings us to closer to a full national reach in the U.S. with access to approximately 92% of the U.S. population living in the footprint of our broadband partners. This relationship is also a very important inclusion in our global broadband distribution strategy, which includes some big broadband wins in the last 12 months including the extension and expansion of the SPC Yahoo DSL alliance, the signing and subsequent launch of Verizon Yahoo for DSL. The continued and ongoing success with Rogers Yahoo high speed in Canada and the extension of BT Yahoo broadband in the UK, which was announced just last week. These relationships open up additional channels through which we share premium services today and provide an avenue for possible future moneterization opportunities tomorrow.

All of our accomplishments are possible because Yahoo attracts the best and most accomplished scientists, engineers, design specialists, marketers and product visionaries. Talent is our most important asset and during the quarter, we had tremendous success attracting, hiring and retaining highly qualified and accomplished people across multiple disciplines and geographies. They thrive on the opportunity Yahoo provides to solve some of the most technically challenging problems benefiting hundreds of millions of users across a range of areas such as search, communications, media, mobility, community, data and advertising. Our innovation and leadership extends beyond our consumer products to our business model.

So let's turn now to the moneterization side of the equation. We are making significant investments in our diverse moneterization capabilities and we continue to see excellent results. Our marketing services business delivered almost $1.2 billion in revenue for the quarter representing 46% year-over-year growth as a result of strong contributions by all forms of advertising.

In brand advertising, we're clearly the number one player and we continue to outperform the segment and grow our share. The largest brand advertisers continue to come back and spend more. In fact, the top 200 U.S. brand advertisers on Yahoo from the prior year had more than a 90% renewal rate. As it grew, the top 200 brand marketers are growing faster than all our marketing services on a revenue extax basis. This shows that the Internet and Yahoo are firmly established as must buys for brand advertising. This is due to our unique and powerful brand advertising solutions such as advance targeting, innovative rich media formats and network wide marketing packages that are helping the world's largest and most important marketers derive great results. Targeting in particular is gaining in popularity amongst our clients. This provides a more relevant experience for our users, more effective results for our advertisers and allows Yahoo to maximize revenues and efficiently utilize our inventory. We also saw the volume of video streaming ads across the Yahoo network almost double year-over-year with much of this driven by consumer packaged goods companies.

Search advertising continues to be a very, very exciting opportunity for us and of course, as one of our most important priorities. We're right on plan improving and growing our moneterization capabilities and see this area as providing real upside for Yahoo in the near future. In August, we launched an invite only beta of our new self-serve publisher network. While we've been very successful in attracting large publishers like Viacom and iVillage and USA Today we haven't yet tapped the small publisher market. We believe this service will ultimately position Yahoo as the preferred advertising partner for small and medium sized publishers and enable us to garner new revenue sources by participating in this fast-growing segment.

This month also completes two years of planned integration between Overture and Yahoo. I want to thank Ted Meisel for staying with us during this period and overseeing this important process. Moving forward, the search marketing sales team will be operating under the same management as the brand sales team and we believe the future is about even closer alignment of these two groups. This is important, because we are seeing trends that indicate an increasing percentage of our advertisers are spending in both brands and search marketing. Already 50 of the top 200 U.S. brand advertisers are also in the top 200 U.S. search advertisers. What advertisers are finding and as our research demonstrates is that the more they utilize both forms of advertising on the Yahoo network, the better they do with each. Our industry leading advertising tools, the best environment for brand and performance dollars and a sales culture that will help marketers learn and take advantage of what the web can really offer who serve us well as the market rapidly expands.

So in conclusion, we're very proud of what we've accomplished so far, but fully embrace the belief that we are still at the beginning of significant long-term opportunities. And as the web evolves into the next exciting phase, we believe Yahoo is in the best position to lead, and our business model gives us the competitive edge to take advantage of the growth opportunities on the Internet. So now I will turn it over to Sue who will review more of our key financial highlights.

Sue Decker

Thanks, Terry and thanks to all of you for joining us today.

Very pleased with our third quarter results because they clearly underscore two fundamental business model strengths. Excellent growth and great balance and it is not an accident. We've been careful, deliberate and persistent about committing the appropriate investment to both internal operations and external acquisitions. At the same time we are aware that our mission is not simply to deliver strong returns for a few years, but to make the appropriate investments and capital allocation decisions to build value over the long-term. This would not be possible if our source of strength were a single product or if we were reliant on a narrow customer base. We still have a lot of work to do, but we feel very good about our progress on delivering this combination of value to shareholders.

Before we review Q3 results let me start with a couple of housekeeping items. First, our earnings in Q3 contained a non-operating pretax gain of $27 million from the disposal of two non-strategic investments, which we recorded in other income. In addition, our effective tax rate for the quarter was unusually low. Earlier in the year we had estimated a full year effective tax rate of 41% to 42%. We now believe that rate will be about 100 basis points lower, owing to greater use of tax credits than originally planned. As a result in order to adjust our nine-months tax rate to this level that we expect for the full year our Q3 effective rate was 34%. Excluding these items and assuming an effective tax rate of approximately 40% in Q3 consistent with our revised expected effective tax rate for the year, our earnings for the quarter would have been $221 million or $0.15 per diluted share in the quarter up 77% from a year ago and up 15% from the $0.13 we earned in Q2.

Let's talk now about some of the highlights from the quarter starting with free cash flow, which we consider to be our most important financial metric. As a remainder we define free cash flow as cash generated from operations, which includes cash costs related to taxes and changes in working capital plus capital spending and dividends received.

Free cash flow came in at $335 million in the quarter, a new record, up 71% and advancing our trailing 12 months free cash flow to over $1.2 billion. This quarterly free cash flow represented 37% of revenue extax and a conversion rate of 89% of operating cash flow. A testament to the exceptionally high cash productivity of our business model. One very interesting relationship is to compare our earnings to our free cash flow. Q3 free cash flow was 45% larger than our normalized earnings whereas for most companies free cash flow is less than earnings. As compared with most companies we continue to benefit economically from large tax loss carry forwards even though our earnings are fully taxed for GAAP purposes, and from relatively limited requirements to invest in our balance sheet to grow.

Let's look now at what we did with that cash and what happened to our balance sheet. Our ending cash and marketable securities balance was $4.8 billion up almost $1.7 billion since the same time last quarter and down about $160 million since last quarter. Our primary sources of cash in addition to our free cash flow collectively amounted to close to $220 million. These cash sources were comprised of proceeds from the exercise of employee stock options, the sale of the two non-strategic equity investments and the receipt of cash back from previously initiated structured share repurchases on which we earned an annualized rate of approximately 16%.

We invested these cash proceeds in various transactions that we believe will yield substantial returns to investors. In Q3 we invested over $700 million. First we repurchased $208 million of Yahoo stock at an average price of $32.89 per share. Second, we entered into $500 million in structured stock repurchased transactions, which mature in two troches through April of 2006. At the final maturity depending on the price of our stock we will have either repurchased up to 16.3 million shares of these funds or will have received up to our initial $500 million investment plus an annualized premium of 18.5%. It's important to note that our ending cash balance of $4.8 billion is net of both the $500 million in structured share repurchase transactions referenced before and also of $350 million in similar transactions that were previously entered into, all of which mature over the next three quarters. Looking forward, we plan to continue to use our strong balance sheets and free cash flow to enhance value for shareholders through acquisitions, investments and share repurchase activity as appropriate.

Moving now to the P and 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, which has allowed us to exceed both our longer-term revenue and operating cash flow growth objectives. Specifically third quarter revenue ex-TAC came in $932 million advancing 42% over a year ago figures and up 7% from Q2 '05 despite normal adverse seasonality in the brand side of marketing services.

The 42% growth broke down into 40% growth in underlying organic revenue particularly strong considering tough comparisons against strong year ago gains and 2% related to acquired companies owned for less than a year.

Let's look now at the revenue breakdowns by lines of business.

Global marketing, our largest service generated $762 million of revenue extax for the quarter up 40% year over year roughly consistent with both the very strong gains we saw in the first half of 2005 and also with the growth rates we experienced in '03 and '04. This strength was nicely balanced across our various offerings to advertisers from paper performance to branding. In short we believe Yahoo is sitting in the catbird’s eat relative to competitors as we have both strong brand and strong search offerings and this strong positioning is showing up in the numbers. We believe we are on track to gain market share of the global online ad business for the fourth consecutive year.

Let me give you a little more color on what we see happening across our two forms of marketing. Terry mentioned that we're seeing an increasing overlap in the client that sponsor search and brand marketing. Historically sponsored search within driven by more direct marketers that experience transactions from their web sites rather than from the OEM type of companies that typically define the brand business and sell offline and generally through distributors. However, more and more research on the buying cycle is demonstrating that the consumer conducts their primary research on the web, often conducting multiple searches to find what they're looking for. Once they make a decision based on that research the majority of that actual purchases generally occur offline. This has led an increasing number of OEM type companies such as automobile manufacturers, brick and mortar retailers and traditional financial services companies to begin to spend directly in search marketing and to value search beyond immediate online conversions to the search's overall influence in the buying process. We see this in our numbers. Growth in spending from these types of advertising is outpacing our overall marketing service growth rates as advertisers are using the different media to complement each other rather than one medium replacing the others. Considering the size of many of these companies direct marketing budgets you can imagine how much potential there could be if this becomes more pervasive.

Turning to fees, we produced $170 million of revenue, up 55% from a year ago excluding acquisitions principally music match fees grew a very healthy 41%. The primary driver of that business line is our premium offerings in which consumers and businesses pay us for our services. We ended the quarter with approximately 11.4 million paid relationships, up 50% from 7.6 million a year ago and up 1.3 million from Q2. This strong performance was driven by content bundled with access, fantasy sports, which is typically strongest in Q3 for the football season, music and small business. Last quarter we raised our expected paid ending relationships forecast to indicate that we could exceed 12 million by the end of 2005. Based on our third quarter experience and taking into account Q4 is typically seasonally challenged versus Q3 in fantasy sports, we saw meaningful incremental subscriber growth from new season. We now believe we're likely to approach 12.5 million as the Verizon deal gains momentum and other services continue to grow. We continue to expect these relationships to produce an average ARPU of $3 to $4 per month in 2005.

Turning to revenue by geographic segment, top line growth remained very robust internationally up 50% extax over the last year quarter to $228 million and boosted in particular by strong growth in sponsored search as more and more inventory becomes monetized. On an organic basis and holding currencies constant, our international revenue extax increased 48% in the quarter even faster than the strong 37% increase domestically. As a result, international revenue extax represented 25% of total revenue extax in the quarter advancing from 23% a year ago and consistent with expectations.

Let's turn now to some of the details behind our strong and growing profitability. Specifically operating cash flow came in at $385 million, up 48% year-over-year and above the high-end of our business outlook. Consequently global OCF margins were 41% somewhat above what we had planned despite the timing of spend relating to the new Yahoo Music Unlimited service and seasonal challenges for the brand business in Q3. As you know, the major driver of margin leverages is compensation costs our largest expense, which continues to yield productivity improvements.

Head count ended the quarter at around 9660 and up about 880 from Q2 05’ levels and of 38% from a year ago. Most of this was attributable to planned organic investments and key talents in 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've been able to make these investments in talent while still delivering improvements in productivity and margins. We see this as a testament of the network effective our model and our relentless focus on key priority areas.

Let's turn now to the business outlook, which we are upwardly revising due to better expected results and better visibility into Q4. In addition, the updated outlook that follows includes the impact of four other factors.

First, the expected impact of the pending transaction with Alibaba in Q4 and 2006. Upon on closing of this dealing in Q4 Yahoo China will no longer be consolidated in our results. In the first quarter of 2006, we will begin recording our more than 40% economic share of the new Alibaba entity through our equity interest line. For the full year 2006 we expect the transaction to be neutral to free cash flow and modestly diluted earnings due to the amortization of intangibles. In addition, at the time we close this transaction, we expect to record a non-cash gain based on the difference between Yahoo China's fair value and its cost basis. Adjusted for our continued ownership interest in the newly combined entity. We are anticipating a non-cash pretax gain of approximately $300 to $350 million in Q4 or somewhere between $0.20 and $0.23 per share.

Second, the impact of MSN comprising less and less of our overall search network traffic and economics. Over the course of 2005, MSN has declined in significance to our overall network and we expect that this trend will continue as MSN sells an increasing number of links on their own. That relationship is now expected to generate approximately $70 to $75 million of revenue extax in 2005. We expect this erosion to continue in Q4 and through the anticipated termination of the relationship in June of 2006. For the first half of 2006 we are estimating $20 to $25 million in revenue extax from MSN.

Third, the impact of the dollar modestly strengthening from the last time we provided our outlook in July relative to other currencies in which we operate and fourth, the impact of the pending acquisition of Whereonearth, which we signed today is still in investment mode from the perspective of the PNL and does not generate revenue. We see this asset contributing to our ability to offer more relevant and monetizable listings in 2006 and beyond.

Taking into account all of those factors, we expect fourth quarter revenue ex-TAC to come in a range of $1,032 million to $1,082 million up about 35% from a year ago at the mid point. At these revenue levels we expect to operate within an operating cash flow range of $452 to $482 million representing a 50% margin on incremental revenues and yielding a 44% margin at the midpoint.

This Q4 outlook is expected to drive a full year range for 2005 of $3,660 million to $3,710 million in revenue extax, up 42% from year ago levels to the midpoint. Excluding the impact of acquisitions in the past year, our organic growth rate is expected to be about 40% for the year. On the operating cash flow side, combining our positive third quarter results with the outlook for the balance of the year. The full year operating cash flow is now expected to be $1,550 million to$1,580 million up 52% from year ago levels and approaching our 50% flow through goal for incremental revenue conversion. We expect our full year OCF margins to be 42% in 2005, up from the 39% in 2004 with most of this margin expansion coming from our international operations.

As we said previously, our domestic operations are now approaching an operating level that seems to strike close to the right balance between appropriate levels of current profitability and ongoing investments in future growth. Moving to free cash flow, we are upwardly revising our 2005 free cash flow range by $88 million to $1.2 to $1.250 billion up 45% from year ago levels and representing an OCF conversion of approximately 78%. The high end of our longer-term target range of 60 to 80%. This outlook contemplates capital spending for 2005 of approximately $390 to $405 million. Our capital spending shifted in a similar way as our overall bunnies mix with search and mail becoming proportionately more important to both our operating cash flow and our CapEx levels.

To sum up, as we take stock of our financial vital signs for the third quarter we are very pleased to have 2005 is performing. First, at the middle of our ranges, our full-year 2005 outlook suggest a financial model that is extremely attractive relative to most businesses. The calls for a third consecutive year of growing more than 30% in organic revenue extax. It's suggesting delivering cost of 50% of that to the OCF line and it anticipates yielding more than 70% of that to free cash flow. Second, we're delivering balanced growth across all of our contributors to revenue, whether measured by business line or geographic region. And third, we're very pleased with the underlying consumer and advertiser metrics that drive these results. Users, usage and moneterization. And this is really the best part of the story while Yahoo is continuing to extend its reach to new users we're also becoming better at serving the needs of existing users by listening to them and investing in better and more relevant products and services.

This deepening engagement is really the magic that attracting advertisers to our global platform and users to our premium offerings. We expect this dynamic to continue to occur creating sustainable growth for the foreseeable future. With that I'd like to turn it back to Terry.

Terry Semel

Thank you. So some of our recent offerings are just a glimpse of the potential of Yahoo and the value we can create for users and marketers. Our intention is to continue capitalizing on our industry leading assets in order to deliver consistent and powerful growth over the long-term. We really are blessed with amazing talent throughout the organization that will help ensure that we stay at the forefront of change and innovation for the years to come. Now I'd like to open it up for questions.

Question-and-Answer Session



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