Yahoo! Q2 2007 Earnings Call Transcript

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

Q2 2007 Earnings Call

July 17, 2007 5:00 pm ET


Marta Nichols - Investor Relations

Jerry Yang - CEO

Sue Decker – President

Blake Jorgensen – CFO


Youssef Squali - Jefferies

Mark Mahaney - Citigroup

Ben Schachter - UBS

Imran Khan – JP Morgan

Douglas Anmuth - Lehman Brothers

Jordan Rohan - RBC Capital Markets

Anthony Noto - Goldman Sachs



Good afternoon, ladies and gentlemen and welcome to the Yahoo! Q2 2007 earnings conference call. (Operator Instructions) I will now turn the call over to Ms. Marta Nichols. Ms. Nichols, you may begin.

Marta Nichols

Good afternoon and welcome to Yahoo!'s second quarter earnings conference call. On the call today are members of our executive team: Jerry Yang, Sue Decker, and Blake Jorgensen.

Before we begin, I'd like to remind you that matters discussed on this call contain forward-looking statements that involve risks and uncertainties concerning Yahoo!'s expected financial performance as well as Yahoo!'s strategic and operational plans. Actual results may differ materially from the results predicted 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 system; the company's ability to compete with new or existing competitors; the implementation and results of the company's ongoing strategic initiatives; 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 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, July17, 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, which will be referred to as revenue ex-TAC; free cash flow; non-GAAP net income and non-GAAP net income per share.

Reconciliations of those non-GAAP measures to the GAAP measures the company considers most comparable can also be found on our website under investor relations.

Jerry, Sue, and Blake have prepared remarks then we'll have a brief Q&A session. Now I'd like to turn the call over to Jerry.


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Jerry Yang

Thanks, Marta and good afternoon. I'd like to start by saying thanks to all the employees, customers, partners, friends, and shareholders who have provided me with overwhelming support and encouragement since I became CEO about a month ago. What's clear to me is that so many people want Yahoo! to win and I'm committed to making that happen.

Our second quarter results were largely in line with our previous outlook. Our revenues are near the midpoint of our guidance while operating cash flow is above our midpoint. Consistent with what we discussed on June 18th, we also have revised our revenue outlook towards the mid to low end of our previous outlook for the second half of 2007.

Despite these lower revenue expectations, we think it's critical to maintain the same investment profile to ensure that we're putting the necessary resources and capital in place for our longer term success. Blake will provide more details about our financials a bit later on.

Looking ahead, we want to dramatically improve our performance and capture the major growth opportunities we see ahead for the Internet. I intend to spend the next 100 days or so focused on mapping out a strategic plan for the long-term success, working with our teams to put the right organization and the right people in place, and making any necessary changes.

We are well on our way with a top to bottom review of our business in order to effectively address the company's challenges and capitalize on our many great opportunities. On today's call, we'll give you a high level overview and I look forward to giving a more detailed progress report in the fall.

I have a great sense of urgency to move fast and in a focused way. I truly believe we're in the midst of the most important transformation in Yahoo!'s history. I've taken this role not out of obligation, but out of desire, because this a company that I believe can and will win.

Although I've only been in the CEO role for about a month, I co-founded this company and I've been thinking about our place in this industry for over 15 years. I mat not have all the answers as of today, but I have a pretty strong idea of where I want to go. Starting with the fact there will be no sacred cows and we need to move very quickly.

I believe Yahoo! is too often defined by the competitive landscape rather than by what we can accomplish with the assets we have. I am determined for us to define our own path.

The starting point is this: above all, Yahoo! is a deep and active marketplace. It's an ecosystem that involves several hundred million participants every single day; consumers, advertisers, publishers and developers. What I have encouraged our leadership to think and to remember is that the way we will strengthen Yahoo! is to strengthen this marketplace. The healthier and the more powerful the marketplace, the healthier and more relevant Yahoo! will be.

I am very well aware of the challenges we face. There is a significant gap between where Yahoo! is and where we need to be, given the competitive environment. For example, while we're the largest consumer destination on the web today, we are becoming smaller as a percentage of the overall web's activity. While advertisers of all size are starting to utilize the web more and more, we need to develop the right integrated, comprehensive services to deliver the performance-driven results-oriented advertising that is necessary to compete successfully.

While we're one of the biggest services on the web, we need to develop scalable, data-driven open platforms and infrastructure to easily bring in new customers, consumers and publishers. That is why I am taking a fresh look.

The good news is we're starting with some awesome assets. We have half a billion of consumers in our network who have several trillion dollars in buying power; hundreds of thousands of advertisers with tens of billions in total marketing budgets to invest in order to capture the attention and dollars of our consumers; and, an important and growing network of publishers and developers who are after both consumers' attention and marketers’ ad dollars.

So to successfully exploit our ecosystem, Yahoo! is going to take advantage of three core strategic principles: insights, openness, and being a partner of choice. That, we believe, will differentiate us from our competitors and help accelerate the development of our marketplace.

Insights are valuable because we can build a better, more personalized experience for our consumers, enable marketers to reach targeted audiences and tap into consumers' enormous buying power; and help publishers and developers to bring better experiences to consumers and gain a share of advertising dollars. Today we are greatly under-leveraging those insights and so going forward, we're going to fix that. In the process, we can fuel the economic engine of our marketplace.

Our commitment to openness extends across both our consumer and advertising experiences. We believe we need to accelerate our efforts to open our services to consumers, content and commerce partners. At the same time, efforts like Right Media gives us a unique opportunity to drive value on the advertising side. All of this will allow us to capture and use insights much more effectively, which will result in more users, more advertisers and more publishers.

We should get an exponential return on being a good partner. Today, we are good at partnering and we intend to scale that in an aggressive way. In the future, it will become one of Yahoo!'s biggest and deepest differentiators. We need to be the trusted partner of choice.

When I step back and think about how we can fully leverage our ecosystem, I see a world where Yahoo! is a place that consumers love. Yahoo! is the place that provides the best value for advertisers and Yahoo! is a place that provides the most successful model for publisher and developers.

Now, we could simply choose to focus on one of these components, but I believe we can create a much more valuable company for our shareholders by pursuing this loftier goal. It is the harder road to take and it is going to require a lot more work, but I think it's a Yahoo! that can win.

As we look to capitalize on this huge opportunity and address the challenges, Sue and I and our team are intensely focused on a number of near-term priorities and let me go through those, many of which will help the way Yahoo! operates. Let me briefly talk about each of these priorities.

First, we will accelerate Yahoo!'s transformation to drive greater growth and profitability. Our intention is to invest heavily in those areas that we believe are most critical to our success. At the same time, we will also be identifying – and in many cases, de-emphasizing -- parts of our business that are underperforming or don't fit our vision. Make no mistakes though, we are in investment mode.

Second, we will focus our technology in developing platforms that enable us to scale, innovate and open up Yahoo! to our consumers and partners. As I said earlier, the ability for Yahoo! to leverage our data and insights for all three of our key constituents is one of the best ways for us to change the game. It will require a greater emphasis on technology in order to succeed.

Third, we are absolutely committed to faster decision-making, improving our speed of execution, and better integrating our capabilities. We intend to further refine our organization around key customer groups of consumers, advertisers and publishers. We will focus on developing differentiated products for each of these segments that will positively feed our ecosystem.

Finally and most importantly, I want to set a new bar for the Yahoo! culture. One that prioritizes teamwork, leadership, and the desire to win and do a better job of attracting, developing, and motivating talent at all levels of the organization. Yahoo!'s employees are the key to our success and I am personally focused on strengthening our leadership team to galvanize Yahoo! around our goals. We're well underway with our technology leadership search, and Sue and I are planning to bring on additional leaders across the company. We already have some terrific senior people in place from within the company that continue to step up and take on greater responsibilities.

In summary, I'm confident that Yahoo! can improve performance and deliver value to shareholders. While leveraging our key differentiators of insights, openness and being a partner of choice and by sharpening our focus, building our technology and talent, and investing in key growth areas, we can put Yahoo! on the clear path to fulfill its potential as an Internet leader.

I would like to turn the call over to Sue.

Sue Decker

Thanks, Jerry. Let me reiterate up front that we understand the critical need to accelerate the transformation of Yahoo! To do this, we're making marketing services a much more explicit element of our business objective with the goal to power the largest marketing ecosystem on the web, creating more value for advertisers and publishers than any other company. We believe this will create more value for shareholders than any of the other options before us.

We plan to build this on the principle of openness and the belief that if we make it easier for any company in the industry to bring their value to anyone else in the industry, the entire community of advertisers, publishers and audiences will win. We intend to accelerate this plan by striking more key partnerships that break down the walls among those three critical contributors to the ecosystem.

Over the last several months, we've made considerable progress achieving greater focus within each of our three core operating groups. We are now intensifying efforts to integrate those capabilities across the company. This will take time and continued investments, but as Jerry said, we are operating with a great sense of urgency.

As we indicated a month ago, our revenue in the second half of '07 is expected to be lower than originally forecasted, but we are encouraged by the strong growth from some of our new initiatives and we believe that many of the legacy issues that are hampering growth will soon be behind us.

I'm going to break down my comments into three areas. First, I will discuss a few notable areas where I think we could have done a better job in the past and tell you how we're addressing them. Second, I will discuss what I see as the critical role of an evolving organizational structure to drive our strategy and priorities home. And third, I'll provide a business update on areas of strength and areas still dragging growth.

Let's begin with a review of the areas where I think we could have done a better job and how we've adjusted our focus. First, we initially chose to keep Overture a standalone business. Overture had a great product, pioneering in the market at the time, but its core emphasis was on sales and distribution. It is now apparent that by not integrating right away, we did not see as quickly as we might have the requirements to invest in the core product applications and technology platforms, delaying the development of Panama and allowing our competition to establish a monetization lead. While we have more work to do, we are now fully integrating Overture throughout the organization and are very pleased with the initial performance of Panama.

Second, we have at times been risk adverse to making hard personnel decisions. In recent months, you have seen changes in this behavior. Many observers have focused on recent turnover as a sign of concern and while some departures are inevitably regrettable, in many respects the changes are necessary and a sign of renewed discipline. They have opened up many opportunities for new talent that is most able to drive our business forward based on today's business requirements.

Third, we have not continually driven innovation in our display business, but instead, focused on what we knew and excelled at, selling display advertising on Yahoo! properties to brand-oriented advertisers. Consequently, we were slow to see the growing demand for performance marketing capabilities as well as the requirement to better address smaller advertisers in the tail with better self-service capabilities.

We have begun to act decisively to address this. By integrating our search and display sales forces, acquiring and integrating key direct marketing tools from Right Media, introducing our innovative new Smart Ads for display advertising, and extending our reach with third party publishers, we are beginning to execute against our goal of making Yahoo! the easiest place for marketers and publishers to achieve their objectives.

Now let's turn our attention to the company's organizational structure and why continuing its evolution is one of my highest priorities. Simply put, putting the right people in the right positions to focus on the right opportunities is fundamental to maximizing shareholder value.

Prior to this year, our organizational structure was fairly complex and largely focused on our audience properties. This complexity drove slower decision-making and impeded our ability to identify and capitalize on new emerging advertising opportunities. This changed with the reorganization in December when we organized around the three primary contributors to the ecosystem -- audience, advertisers, and publishers -- raising the prominence and creating separate organizations around the latter two for the first time.

Let me provide a few examples of what we've done, because I believe the changes are much more significant than what may be commonly understood. First, we recently announced our plans to integrate our two sales teams, search and display, in order to better serve all the needs of marketers. This allows us to optimize for the customer solution rather than having multiple points of customer contact with separate sales forces focusing on different ad products.

Second, as a part of our integrated sales force we created an integrated marketing products group and charged them with thinking about how we can best address the full spectrum of advertiser and publisher needs, regardless of ad format, targeting choice, or whether the ad is served on a PC or on a mobile device. We have significantly increased our staffing and product and technical talent in this group and plan to continue to invest here. Panama is one of the many platforms and products that this group focuses on.

Third, we integrated our search and display distribution capabilities and gave this team much higher prominence in the organization to ensure proper prioritization for the needs of publishers, a critical segment of the ecosystem. This has allowed the team to develop compelling value propositions, enabling them to secure such hallmark partnerships as the newspaper consortium and the Comcast deal.

Finally on the audience side, we have integrated Yahoo!’s various consumer-facing properties, including the home page, search, mail, Messenger, and others under a single leader allowing greater focus on prioritization.

In short, during the last six months we've integrated search and display across product, engineering, and distribution and are moving rapidly to do so with sales. We've also dramatically changed our approach to display products from an internal service orientation to an external enterprise class solutions orientation.

We couldn't be more pleased with how the changes are beginning to transform Yahoo!. The moves have brought greater focus around a common vision, greater alignment of priorities, and faster decision-making. We'll continue to look for opportunities to create a frictionless organization that allows our users to fall in love with Yahoo! all over again and our advertisers and publishers to benefit from the new level of marketing services excellence.

Now let's turn to a quick report card on how we're doing across the three dimensions of the ecosystem. We believe our execution has materially improved over the last six months, but that various legacy clouds are masking these points of light. I really want to share some of these bright spots though, and what will need to happen to make them more visible to you over time.

First let's start with marketing products, most notably Panama. Thanks to the legions of Yahoo! who moved mountains to make it a reality, the global rollout of Panama is progressing extremely well. I'm pleased to say that we're seeing real financial gains as of this quarter. We saw double-digit RPS improvements year over year in Q2 in our U.S. owned and operated traffic, up 15% to 20% and reversing the downward trend of 2006. We are planning for continued double-digit year-over-year U.S. RPS gains in the second half of 2007.

In fact, we're seeing record levels of RPS and of daily revenue in our U.S. owned and operated search operations. The marketplace is clearly more responsive to changes in the algorithm than we originally planned for. The platform approach gives us the ability to rapidly launch enhancements such as redesigned keyword detail page, alerts to notify advertisers of campaign opportunities, and many others we've already launched this year. We expect this ongoing improvement in the product to continue.

After successfully completing a rollout of the new ranking in the U.S. in Q1, we completed the advertiser migration in Japan in Q2 and turned on the new ranking algorithm there last week. As we saw in the U.S., feedback from advertisers has been strong with click-through rates up and the prices that our clients pay for leads being down.

In Europe, advertiser migration is almost complete and we expect to launch the new ranking algorithm in the UK in just a few weeks. In Taiwan, Hong Kong, Korea, Brazil, and Australia, migration is underway and we expect all of them to be operational with the new algorithm before year end.

In addition to the international rollout, we continue to add more features and capabilities to Panama. For example, we rolled out quality-based pricing in the U.S. late in Q2, which will help increase ROI and reduce costs for our sponsored search advertisers over time, and we plan to roll out domain controls in the second half, providing advertisers more control over which domains run their listings.

Moving to the display side, two weeks ago we launched Smart Ads, the most significant innovation in display products since we released behavioral targeting. Much as search delivers relevant ads based on search queries, Smart Ads delivers relevant ads based on the insights we have about our users through micro-targeted, dynamically generated customized ad messages. This is an important example of how we can lead the industry with advertising innovation, consumer relevance and creative scale. We've introduced Smart Ads in Yahoo! Travel and by year end we'll be rolling it in to other key categories.

That covers our marketing products update. Let's turn now to an update on the second segment of the ecosystem, our publishing partners and the Right Media Exchange. The major event since we spoke with you last is that we completed the acquisition of Right Media. I'd like to take this opportunity to welcome Mike Walrath and his team to the Yahoo! family. Right Media will help expand our ability to enable advertisers to reach their customers wherever they are across the Internet. In addition to opening up the display advertising to competitive bidding on an unmatched scale, we are excited about building on the reporting and campaign management tools that Right Media has developed.

We believe the Right Media exchange will deliver value for publishers via higher CPMs and will bring important tools to convert CPM buys to CPA buys for performance marketing advertisers. We'll migrate the vast majority of inventory to Right Media this year and Right Media will play a major role in accelerating the realization of our open strategy.

In our two most significant publisher partnerships, we saw improved results and expanded commitments in Q2. With eBay we're seeing an encouraging increase in demand and pricing for advertising both in search and display and we continue to expand the partnership, having recently added Yahoo! Paypal Checkout to the other areas of business collaboration.

The newspaper consortium partnership has continued to expand as well, and now includes 17 newspaper companies which published nearly 400 daily newspapers. We've launched 49 Hot Jobs co-branded career sites and have an exciting product road map which includes display and search advertising, distribution of newspaper content on Yahoo!, and cooperative sales opportunities.

The newspaper deal and our growing partnership with eBay are great examples of how our commitment to being the industry’s partner of choice is gaining traction. These partnerships and the exchange are important parts of our investment plans for the rest of the year and in 2008.

Now let's talk about users, the fuel that drives the entire ecosystem. We've made significant strides here as well. We ended the quarter with 463 million users, up 13% on a reported basis, or up 16% year over year if the year-ago figures are adjusted for the one-time [goose] from FIFA. This is a consistent growth rate with what we saw in each of the last two quarters, notwithstanding attracting more users than any other company on the web.

According to comScore, we're number one in several categories and leading growth among all competitors in several others. We believe this user base offers meaningful incremental monetization opportunities.

Adding to our sports leadership, in early July Yahoo! acquired, the leading online destination for college and high school sports and recruiting information. Many of our web 2.0 acquisitions have been enjoying strong growth after deeper integration efforts, including, and flickr. Flickr in particular has benefited from an international rollout, transitioned from a photo site and integration into image search.

Yahoo! Mail’s installed base of 250 million uniques around the world is one of the web's largest dormant social networks and one that we are aggressively pursuing ways to activate.

In addition to these primarily PC-based audience initiatives, we're making significant progress in mobile. Yahoo! Go is planned to be available on 400 different kinds of phones by the end of the year and will be preloaded on new devices from Nokia, Motorola, Samsung, HTC, and LG all rolling out this year. In addition, One Search, our innovative search product designed specifically to meaningfully enhance the mobile search experience is now live in 13 countries. It is our goal to ensure that our most valuable constituents -- advertisers, publishers, and users -- love Yahoo!'s offerings increasingly as we improve our focus.

I noted earlier that it may take a while for some of the financial benefits of these recent successes to meaningfully reaccelerate growth. We are actually already realizing an acceleration in our combined search and display O&O growth in Q2 versus Q1, but this is being masked by transitions in our off-network search affiliates. The good news is that because our search affiliates are becoming a smaller percentage of our financials, they will not be nearly as an important headwind to future growth.

In display advertising, notwithstanding slower growth in2007 than what we experienced in 2006, we're still seeing double-digit gains and many of the steps we're taking to drive growth in the future across sales, product and distribution will become much more visible in the years ahead. Blake will provide much more detail on these issues shortly.

In conclusion, we're working diligently to get Yahoo! on the right path and we are committed to addressing the root causes of our challenges rather than making only short-term cosmetic changes that will compromise or delay true changes and long-term value. While we've been hard at work for the past 12 months addressing many of these issues, it will take time for the benefit to become apparent. You can count on us to aggressively look for opportunities to allocate our capital and talent in the most effective ways to drive growth in the future.

With that, let me turn it over to Blake to provide more detail on our financial outlook.

Blake Jorgensen

Good afternoon. Thanks Sue and Jerry, and thank you for the very strong welcome in my entry to Yahoo!. I'm happy to be here and discuss second quarter results with you and the outlook.

As you know, I've been at Yahoo! for about six weeks. I've spent a lot of time meeting with leaders throughout the company and getting to know the finance and corporate development team, and I'd like to share some early observations with you.

My background is in operations, management consulting and investment banking and the opportunity to leverage all of my past experiences to help Yahoo! achieve a new level of success as an Internet leader was a key draw in bringing me here. I am very fortunate to be working with the world-class organization Sue and her leadership team have built. Yahoo! has clearly benefited from their deep functional expertise, focus and discipline.

But as Jerry and Sue noted from their remarks, we believe all elements of Yahoo! will benefit from a fresh look. As we seek to improve our organizational effectiveness, for example, I will be working closely with the team to further simplify our systems and processes and ensure we're allocating resources to the most important future growth and profitability initiatives.

We are also reviewing our financial and operational metrics to ensure we continue to have relevant measures of our success. This quarter, for example, for the first time we have broken out our marketing services revenue for you in more detail so you have a clearer picture of the revenues generated by Yahoo!'s owned and operated sites as distinct from our distribution network of third-party sites, what we call our affiliates. We'll discuss these new lines in more detail in a moment, but I hope they will make clear that our highest quality source of revenue from Yahoo!'s own sites is also our fastest growing and is outpacing our overall top line.

As the company strives to refine our strategy, I believe two key imperatives will not change. First, our focus on free cash flow is the most important metric for measuring value creation. Second, our disciplined allocation of capital among value-creating investments, acquisitions, and share repurchases.

With that as a backdrop, let me dive into the Q2 numbers. I'll begin with free cash flow, which was $328 million in the second quarter, reflecting solid underlying profitability. Free cash represented 69% of operating cash flow at the high end of our long-term target of 50% to 70%. We also received $132 million of proceeds from exercise of employee stock options during the quarter.

Turning to how we invested our cash in Q2, we repurchased $418 million worth of stock in the open market at an average price below $29 per share, bringing our total repurchases during the first half of 2007 to over $1 billion. We generated slightly more cash than we utilized this quarter, yielding a healthy cash and marketable securities balance of $3.2 billion at quarter end, up a bit from where we ended at Q1 and we continue to have significant financial capacity well beyond that.

In addition to the cash balance, our ownership stakes in several entities provide other sources of incremental balance sheet value, including our interest in Yahoo! Japan, Alibaba in China, and Gmarket in Korea. The value of these collectively amounted to$8.4 billion or almost $6 a share at quarter end.

Let's move now to the P&L. Beginning with the top line, second quarter revenue ex-TAC, or traffic acquisition costs, came in at $1.244 billion, advancing 11% year over year. As was noted on our call June 18th, the growth acceleration verses the 9% we reported in Q1 was driven by improved monetization of our owned and operated search properties.

Drilling down on marketing services, we generated $1.032 billion revenue ex-TAC in Q2, also up 11% versus the prior year. While we clearly aspire to faster growth, we do see an encouraging underlying trend in that our highest quality revenue from our owned and operated sites is growing much faster than the total. Specifically, revenue ex-TAC growth on Yahoo!'s owned and operated properties accelerated to 18% year over year in Q2 from 14% in Q1, driven by a notable pickup in worldwide O&O search growth. In fact, while both search and display grew double-digits this quarter, O&O search substantially outgrew display, up nearly 25% year over year, boosted by the double-digit improvements in revenue per search that Sue mentioned earlier, along with continued volume gains.

Total page views grew 18% year over year in Q2 with good growth across all three major content and service areas: communications, media, and search.

Turning to our off-network affiliate partners, revenue ex-TAC was down in the high teens year over year in Q2 for three primary reasons. First, ongoing increases in our TAC rates; second, the diminishing ability for some of our partners to generate search volume; and third, the near-term impact of our efforts to continue pushing the quality of our traffic even higher with the introduction of Panama.

On the third point, we plan to continue making investments in driving network quality. As a result, we expect declines in the affiliate business to continue through the end of the year. We believe these efforts, including the introduction of quality-based pricing and domain controls, improve our quality mix and will raise the long-term value of our network for advertisers. This will ultimately benefit both our high quality affiliates and our O&O traffic.

However, we anticipate that there will be a lag effect between the impact we're seeing now and the expected future benefits. While the drag on growth from affiliates has been notable this year, it has diminished as a percentage of both our revenue and our operating cash flow and by year end should represent only 10% of our revenue ex-TAC.

Now let's look at fee revenues. We produce $212 million of revenue, up 12% from a year ago quarter. The primary driver of this revenue line is our premium offerings; that is, those services for which consumers and businesses pay us. We exited the quarter with 16.9 million paid relationships, up 18% year over year and up 400,000 from Q1 levels, driven primarily by continued growth in our access subscriber partnerships.

Looking at international results, revenue ex-TAC grew 8% in the quarter, or 4% excluding the impact of foreign currencies. Overall, international is reflecting slower growth in both O&O and affiliate search, neither of which benefit from Panama until late this year. Our ecommerce business in Europe has also experienced some competitive pressure.

Turning to profitability, operating cash flow came in at $474 million, up 4% year over year, producing global OCF margins of 38% for the quarter. These results are a little stronger than we expected when we spoke to you in mid-June, due to some expense timing differences.

Looking at the geographic breakdown of operating cash flow, U.S. was up 6% while international declined 4%. Our international profitability was impacted by the top line factors I mentioned and ongoing investments we're making in growing our presence in emerging markets, building a more robust technology backbone in Asia and Europe and rolling out Panama internationally.

Let me end on one of the most important investment initiatives, our people. As Jerry and Sue noted, we have continued to make investments in future growth by hiring in key areas such as technology platform development, ad sales and geographic expansion. Specifically in Q2, headcount ended the quarter at 12,400 people, up 700 from last quarter. We continue to recruit aggressive will in selective areas.

That brings me to our business outlook for the third quarter and full year 2007. Note that this outlook incorporates the impact of several transactions which I'll touch on in a moment.

We are lowering our outlook for the second half of 2007 consistent with what we told you in mid-June to reflect a continuation of the business trends we experienced in Q2, including slower growth than originally expected in display and greater than originally forecasted search affiliate declines.

For the third quarter, we expect revenue ex-TAC to be in the range of $1.17 billion to $1.31 billion, up 11% from a year ago at the midpoint. At these revenue levels, we expect to operate within an operating cash flow range of $380 million to $450 million, implying margins of approximately 32% to 34%. Q3 margins are expected to represent our lowest this year due to seasonality of advertising revenue, incremental marketing spending and the timing of headcount additions, as well as the impact of recent acquisitions.

For the full year, we expect revenue ex-TAC to range from $4.89 billion to $5.19 billion, up about 11% from year ago levels at the midpoint. This outlook assumes marketing services revenue from our owned and operated properties grows in the mid-teens for the remainder of 2007, partially offset by lower search affiliate revenues.

Turning to operating cash flows, we expect to operate in the range of $1.775 billion to $1.955 billion for the year, yielding a full year margin of approximately 36% to 38%. This reflects the factors we noted that are affecting our affiliate line, which are masking relatively stable margins in the rest of our business. Note that outside the recent acquisitions, our cost profile for 2007 remains relatively consistent with what we forecasted at the beginning of the year.

As Jerry and Sue noted, we feel the investments we're making in key audience, advertiser, and publisher products are critical to driving future growth. The ranges I've just discussed for Q3 and the full year include the estimated impact of recently closed acquisitions, notably Right Media and, as well as the transaction with Yahoo! Japan that we expect to close during Q3.

The two acquisitions are expected to increase revenue ex-TAC by more than $35 million in the second half of the year, but both of these entities are still in investment mode and will be slightly dilutive to profitability.

Let me spend a moment on our pending deal with Yahoo! Japan. We've been working towards transferring ownership of the sales operations of Overture KK in Japan to Yahoo! Japan. We're excited about this transaction because it should allow us better alignment of search and display advertising sales in Japan, making the business more competitive and essentially securing a favorable and very long-term revenue stream to Yahoo!.

The terms are not yet final, but once the deal closes, you will see several changes in our financial statements. We will no longer pay TAC to Yahoo! Japan and they will instead pay us a service fee, which we expect will be included in our marketing services revenue. As a result of the transaction, our GAAP revenue is expected to be between $200 million and $250 million lower in the back half of 2007 and TAC will come down commensurately.

Revenue ex-TAC will decrease modestly under the new structure as the new service fees will largely offset the lost affiliate revenue. The impact to operating cash flow is expected to be broadly neutral near term, but accretive for both companies long term, versus our prior arrangement. The transaction is structured to deliver value through a long-term service fee arrangement with only a very nominal upfront payment to us.

Now turning briefly to free cash flow. We anticipate a full year 2007 range of $1.125 billion to $1.275 billion, reflecting capital spending for 2007 of approximately $625 million to $675 million. In that figure, we are assuming cash taxes in the range of 12% to 15% versus approximately 6% in 2006.

In conclusion, I'd like to reiterate that our financial performance is not what we would like to see long term. Our outlook for 2007 reflects current challenges that we are working diligently to address as well as continued investments in initiatives important to our future growth. We are seeing some good results such as the early returns from Panama and we expect other actions currently underway, including the efforts to improve the quality of our affiliate business, the display plan Sue outlined and the additional steps we'll share in the future. All of this will position us for a more improved performance in the future.

Again, while I recognize there is much hard work ahead, I am happy and extremely excited to be here and to be partnering with Jerry and Sue, David Filo and the rest of the management team to take Yahoo! to the next phase of its growth.

With that, I'd like to turn the call back to Jerry.

Jerry Yang

Thanks, Blake. I'd like to leave you with six key takeaways.

First, we're committed to improve our performance. We're working with great urgency to accelerate Yahoo!'s transformation, we see some positives in the quarter. As Blake mentioned, one bright spot is that revenue on our O&O properties is up 18% for the full year, driven by the pickup in our search growth rate.

Second, we are investing for growth. We'll increase investments in key growth areas and deemphasize non-strategic businesses. There are no sacred cows, and this is the basis for our second half outlook as we continue to invest in initiatives such as our advertising products and our platforms.

Third, we intend to improve the speed of execution. We're driving sharper focus and more integrated capabilities across Yahoo!. We've already made a fundamental shift in the way we're operating and more changes will come.

Fourth, we plan to create value through our ecosystem. We'll develop the most open, vibrant online marketplace for our consumers, advertisers, publishers and developers. Insights, openness and partnerships will be our key differentiators.

Fifth, we plan to define and focus our technology assets in order to develop platforms that enable us to scale, innovate and open up Yahoo! to our consumers and partners.

Sixth, I am committed to develop our talent and culture. We will set a high bar to create a winning Yahoo! culture. Talent is key to success, and I'm deeply involved in making sure that we have the best.

Now I'd like to open the call up for some Q&A.

Question-and-Answer Session


(Operator Instructions) Your first question comes from Youssef Squali - Jefferies.

Youssef Squali - Jefferies

Blake, can you provide us with the revenue from your top 200 advertisers, which we typically are provided with and we use as a proxy for branded advertising?

Second, Sue, how much of the weakness in the branded business is actually coming from a lack of the right inventory versus really just maturation of verticals such as financials and [OTOs] and consequently, do you feel you have enough assets in Right Media, the newspapers and eBay deals to cause growth to reaccelerate by year end to hit your guidance? Thanks.

Jerry Yang

Youssef, thank you. I'll hit the first question. Actually that was two questions, though, right? First, you've asked the top 200. We're actually going stop providing the top 200 customers because we feel the split between the O&O and affiliate business that we've now started to provide is much more insightful and over time will show a much better understanding of the underlying profitability of our business.

Sue Decker

Thanks, Youssef. On your second question, let's say that the slower growth in our display business, which is now in the low to mid-teens on a global basis, is not due to maturation of verticals as much as to interest in inventory and competitive inventory that's out there at attractive prices.

It is also due to the observation that I made on the call that we are not as well-positioned to sell direct response historically as we are to sell branding-oriented inventory and campaigns. We see that as a great opportunity for us because we have pockets of real strength in direct response capabilities within our search group, within our telemarketing group, and most importantly within Right Media which we just acquired, and that will allow us to importantly have the conversation about how to convert a CPM to a CPA buy because they have those tools.

As well, based on the reorganization of our sales force, that will allow us to populate the direct response center of excellence throughout the sales operations and be able to sell to major marketers both the opportunity to brand and to direct response.

We think that plus the growth in the inventory in the web that is increasingly driving less premium inventory are what has caused our growth rate to slow, but it's still a double-digit growth rate and that's implied in the back half too.


Our next question comes from Mark Mahaney - Citigroup.

Mark Mahaney - Citigroup

You gave a couple of reasons why margins should come down to very low levels in the September quarter, seasonality acquisitions. You also mentioned some marketing investments. Could you give a little more detail on what kind of investments you want to make organically in the September quarter that will cause those margins to be hit? Is there any product or R&D investments that you're also considering for that quarter?

Jerry, you had mentioned you're on a 100-day plan. Could it be that a quarter from now we'll come back and hear about more investments for the December quarter? Thank you.

Blake Jorgensen

Mark, this is Blake. Let me touch on first just some of the overall investments and then Sue may want to add to that in terms of more color around marketing activities. On the broader investments we are, as I mentioned, continuing to grow our headcount and primarily that headcount is directed at continuing to invest in our search business, to reinvest in our display business, to continue to build our sales strategy that Sue has mentioned, and build out our mobile platform. All of those have underlying marketing investments, which Sue might be able to touch on a few of them.

Sue Decker

Sure, I'll just add to that. I think Jerry up front outlined that we want to continue the current plan, stay the course in terms of the investments this year notwithstanding a little bit slower revenue growth in the back half than we were originally were forecasting.

Among the areas that we are most focused on are things in the marketing product side and underlying platforms. In marketing products Right Media, getting that integrated, getting it up to the scale we think it's capable of operating at and getting it aligned toward our product road map is a very high priority.

A second area is the newspaper consortium that we've announced. We're effectively building a full ASP business from scratch, and it will rely on our world-class behavioral targeting and other innovative ad products like Smart Ads. This will be a very, very important deliverable for next year so we're investing ahead of that. Certainly the ongoing rollout of Panama internationally, there's a well-defined product road map there; Smart Ads are some other key areas that we think are important.

I think as an observation, we and others looked at a number of acquisitions, nearly $10 billion of value changed hands in the online marketing industry in the last quarter. We feel operationally that we can achieve much greater gains than what would have been possible through billions of dollars of acquisitions that will be fully integrated with the road map across search and display, so we think it's the right thing to do just to continue to the course of investments. We're very excited about what that road map looks like longer term.

Blake Jorgensen

Just one other note just to remember is our third quarter tends to be a lighter revenue quarter historically and so the margin differences look more dramatic than they might, particularly with the stronger investment path we're taking.

Jerry Yang

Mark, it's Jerry. I think your question about whether there will be more investments, as I said, I think we're really focused on understanding how Yahoo! as an ecosystem can drive value long-term, and we're big believers in that. I think we're definitely looking to making sure that we are competitive on the marketing services and marketing products side. As Sue mentioned, I think that's where a I think both the window of opportunity with Right Media and integration and changing our sales force is spent.

I would say that we continue to look at ways in which we can reallocate money from one part of the company to the next to focus on the growth opportunities to enable and activate the ecosystem. We'll definitely be giving you guys a much clearer view of where we are in the fall when we speak again, but I think that the philosophy and the focus of activating an ecosystem in a very fast way is what we're focused on.


Our next question comes from Ben Schachter - UBS.

Ben Schachter - UBS

Jerry, a couple times you mentioned taking a fresh look and de-emphasizing some non-core areas. Is there a specific timeline for when you may come back and announce certain areas being shut down, or will it be more evolutionary?

Sue, I was wondering if you could talk a bit more about Smart Ads and behavioral, talk about perhaps quantifying what you've seen so far? The whole idea around behavioral on display has been around since the beginning of the Internet, better targeting display ads. What have been the barriers and what do you think is going to happen in the near term that can make that more of a reality in the near term? Thanks.

Jerry Yang

I think as a process, one of the things Sue and I and our teams want to do is obviously spend the time to make sure that we really fully understand a framework that allows us to go and compete effectively and win. We will always be making adjustments as a philosophy of how we continue to make decisions of shifting resources around and really act much more as a one company rather than a bunch of smaller entities within a bigger company. So that's a philosophical point.

To that, we probably won't be having sort of big bang announcements about this or that. We probably will be a lot more ongoing in terms of talking about what we want to emphasize and not emphasize. Obviously we'll keep you guys posted through our conversations.

Sue, do you want to talk about the behavioral piece?

Sue Decker

Sure, thank you. On the Smart Ads side, we've just launched this and it's starting with Yahoo! Travel, and we're going to be rolling it out as the year goes on so I wouldn't expect any major impact this year; it would be reflected in the business outlook that Blake provided.

Longer term, we're quite excited about this, we do think it's the biggest innovation since behavioral targeting. I think it's fair to say that we lead the industry in behavioral targeting, it's one of the reasons why the newspaper consortium has decided to come with us rather than use Double Click or other different ad serving companies that they've used because it is such a strong capability.

What we need to do longer term are to combine the ASP functionality of the exchange with some of the reservations and targeting functionality of our internal ad serving to produce the next generation and that's what we're planning to do.

It is fair to say behavioral targeting is outgrowing all of our other ad revenue and we expect to extend that over time to the exchange and maybe even to search, and we think there's a lot of innovation ahead.


Our next question comes from Imran Khan - JP Morgan.

Imran Khan - JP Morgan

I have a housekeeping question for Sue and then one question for Jerry. Sue, I think you talked about that RPS is up 15% to 20%. Given that growth rate, is it fair to assume that RPS growth rate will accelerate in the second half this year because last year in the second half you had RPS decline sequentially.

Secondly for Jerry, I think you talked about building an ad network and I think you talked about improving targeting capabilities and bringing the tail end of advertisers. How quickly can we expect to see the pricing growth for the non-premium inventory impact your revenue and earnings numbers? Thank you.

Sue Decker

Imran, thank you I'll start with your first question. Yes, I did say it was between 15% and 20% in Q2. I think Blake indicated that our owned and operated growth across both search and display was up 18% in revenue. That break down is roughly 25% plus in worldwide search, and low to mid-teens in display on a global basis. That's what we saw in Q2.

You could talk with Blake about this further after the call, but we're assuming broadly similar trends in the back half in terms of revenue per search and search revenue growth. We think that we're pleased we got a more responsive marketplace sooner than we expected, so we think we got some of that growth in Q2 and we don't think it's prudent to be assuming acceleration from here, although as we move into '08 and the international markets are fully operational with the new algorithm we'd certainly hope and expect to see some continued improvements there.

Jerry Yang

Imran, on pricing, I would say that even for our premium inventory we'll continue to see strong demand. I think as Sue mentioned, the non-premium is where there's a lot more inventory available; in fact, I would say that we're seeing pricing growing in our non-premium, as well. I don't know, Sue, if you want to comment about this specifically, but we see that, that is actually a part of our business that is growing. We're working diligently on trying to get some volume to that business thus the Right Media piece, but Sue, maybe you want to take some of that.

Sue Decker

No, I think you said it well, Jerry and just remembering some of our comments in prior quarters that we're seeing strong pricing, strong demand across all of our various forms of inventory on a same-store sales or apples-to-apples basis. The mix issue is causing a greater percentage of our impressions to be in the non-performance area and that causes the weighted average yield to be flat to down just a slight amount. I think it actually improved a bit this quarter versus last quarter.


Our next question comes from Douglas Anmuth - Lehman Brothers.

Douglas Anmuth - Lehman Brothers

You talked a lot about building out your partnerships and obviously doing more with other publishers. Can you talk more about how you become a partner of choice with more content players when a lot of them are concerned with how competitive you are with them?

How do you really focus on getting more value out of your assets in Asia going forward? Thank you.

Sue Decker

I think in terms of being a partner of choice, I would say that we feel really pleased with what we've been able to accomplish so far, notwithstanding the monetization differences in our system that we've been very public about historically prior to Panama, and also what we've been able to achieve in display.

You look at the number of affiliates we have in search on a global basis, both in the U.S. and overseas that are up double digits year-over-year in number of partners we work with. On the display side, the deal that we struck with eBay that has broadened and extended since we struck it was really a pioneering deal in terms of our ability to serve display results off our core network.

In addition, the newspaper consortium, which is a unique deal in the industry and has only grown since we announced it, really takes that to another level, which is to basically allow ASP functionality so that the newspapers can open up and sell our inventory and use our technology. Those are pretty significant partnerships and certainly the Comcast partnership announced earlier this year on display would corroborate that, as well.

We think ultimately we respect content, we respect licenses, we have a very strong record of dealing with partners, and I think as we go out and pitch new business, it becomes a very strong calling card because it's very important to us that we deliver on our commitments and we've gotten great feedback and I hope you hear the same in the marketplace.

Jerry Yang

Doug, just to add to that, I think it's important to know that we're really thinking about partnerships across multiple dimensions, not only just traffic but also in the way we can deliver technology as well as dollars. So think about us being able to really broaden what we can bring to a partner across multiple dimensions. As Sue mentioned, these partnerships are deep and meaningful, they are scaled and we need to do a lot more of that, so hopefully that really creates a differentiator in the marketplace..

On Asia, I would just start by saying that we've always said and I've always said that we have a very long-term perspective about Asia. It's where the growth is happening over the next decade in so many different places. At the same time, I think our deal with Yahoo! Japan that Blake talked about is creating the kind of strategic synergies where they are now aggressively going after the marketplace with a potentially combined display and search with a back end that is Panama that is hopefully going to drive up the performance in terms of sales platform.

Those are going to make, again, an impact to Yahoo! today. There are rumors about what Alibaba was going to do with their assets. I think you'll see that come off later this year as our investments we've been making there start to come true. We are still in I think a pretty early stage in those markets over there and there are markets we have to fix, but I think overall, if you step back and look at the position and where we are in these major markets, we're doing pretty well. I think you'll continue to see both balance sheet values as well as real P&L value generated.

Next question, please.


Our next question comes from Jordan Rohan - RBC Capital Markets.

Jordan Rohan - RBC Capital Markets

A little bit of a tangent here. If you categorize the search query volume that comes from the access relationships and partnerships with AT&T and others within the O&O results, what would happen if Yahoo! was forced to bid market rates for that traffic just like it does for a regular search? Can you talk about the status of renegotiation talks with AT&T when that might come to a head? Thank you.

Jerry Yang

Yes, we do include the search queries from our broadband partners in the O&O numbers. As for AT&T, we have not announced anything and when we have anything to talk to you guys about we will. I would say the partnership is going pretty strong in many ways. We are finding multiple ways of working together than just the strict portal deal, but I think that the plan is we need to find a way to redefine our relationship and we'll talk to you guys about that when we're done.

Can I get the last question, please?


Our final question comes from Anthony Noto - Goldman Sachs.

Anthony Noto - Goldman Sachs

Sue and Jerry, you both talked about the display business and the slowdown that you've seen thus far in 2007. The more we meet with private companies, the more we have a feeling that much of the inventory that they're generating in terms of page view growth is actually potential premium inventory i.e. high quality audiences that are measurable that previously have not been sold by a professional sales force with a guaranteed time or guaranteed place.

As we go into 2008, how much do you see this as a new risk, potentially a pricing pressure on your current premium inventory or a potential mix shift away from your product to others if you do not lower prices? Thanks.

Sue Decker

Sure. I'll get started. I think you're raising a really interesting point, which is one of the reasons that we feel longer term our positioning is really strong, which is that when you think about the kind of inventory that's created early on it was a bit difficult to monetize, but through behavioral targeting, through context, through user frequency, capabilities which we will have with Right Media, we think we can add a lot of value to that kind of inventory over time, much more than we have been able to.

I think we feel that our strategy must focus both on our owned and operated and our user strategy as well as off-network, and those are very, very high priorities as Jerry mentioned in his comments about the ecosystem up front.

When we look at the page view generation we have, just looking at this quarter for example, we're up 22% year over year if you adjust for the FIFA deal a year ago and we're continuing to see from a very extraordinary base north of 4 billion page views per day, 20% plus growth. So we're generating a lot of growth on our own network and in addition, we're very aggressively striking partnerships off the network so that we'll have more and more inventory as we have the tools and capabilities to monetize.

Jerry Yang

I think, Anthony, we see what you're describing as a real opportunity for us as Sue mentioned that one of the focus is to build a much more robust platform for us not only to deal with fixed inventory and premium inventory but also with the performance based inventory as well. I think we see these potential sites as a way for us to partner with them and build a larger ecosystem together.

With that, I want to thank everybody for joining us today and we'll talk to you guys soon.


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