Yahoo Restructuring: Will It Work?

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 |  About: Yahoo! Inc. (YHOO), Includes: AOL, BIDU, GOOG, MSFT
by: Bill Maurer

Yahoo! (NASDAQ:YHOO) may be about to start a massive restructuring plan, including cutting thousands of employees, as new CEO Scott Thompson tries to put his stamp on the company. The changes would most likely come to non-core parts of the business, which include products, research, marketing, and public relations.

Yahoo has been struggling, but is a restructuring plan really the best idea? Expenses have not really been the main problem for the company. The real problem is a lack of growth. Financially, the company is in good shape, but it is struggling to keep market share. I'll admit that I spend a large portion of my day on Yahoo, but other than the dozen or so fantasy sports teams I manage and Yahoo Finance, I don't use the site for anything else. Yahoo has some good assets in Asia, but they recently failed to strike a deal involving them, and that sent shares lower again. Let's look at where the company stands.

Financial Results:

The following table shows key income statement for Yahoo over the past four years, in thousands except per share data.

Full Year 2008 2009 2010 2011
Net Revenues $7,208,502 $6,460,315 $6,324,651 $4,984,199
Cost of Revenues $3,023,362 $2,871,746 $2,627,545 $1,502,650
Gross Margin $4,185,140 $3,588,569 $3,697,106 $3,481,549
Operating Income $12,963 $386,692 $772,524 $800,341
Net Income $418,921 $597,992 $1,231,663 $1,048,827
EPS $0.29 $0.42 $0.90 $0.82
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As you can see, Yahoo's revenues have come down significantly over this time period. However, the company has been able to keep costs in check, which has sent net income higher, despite the loss of revenues. As a note, the company's operating income in 2008 was impacted by a $487 million goodwill impairment charge. I'll have more on that later.

Margins / Expenses:

Given the above data, the following table shows Yahoo's three primary margins over the past four years.

Margins 2008* 2009 2010 2011
Gross 58.06% 55.55% 58.46% 69.85%
Operating 0.18% 5.99% 12.21% 16.06%
Profit 5.81% 9.26% 19.47% 21.04%
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*Excluding goodwill impairment charge of $487 million, operating margin for 2008 would have been 6.94%.

Yahoo has actually increased its net profit margin each year since 2008, which can be hard to do for a company with this kind of revenue declines. Where are they achieving this success? Well, gross margins is the main area. As you can see, gross margins increased by more than 11 full percentage points from 2010 to 2011. However, they have had some trouble with costs further down the income statement, which is why the massive restructuring plan might just work. Let's look at some of their other expenses.

Expenses 2008 2009 2010 2011
Sales & Marketing $1,563,313 $1,245,350 $1,264,491 $1,122,302
% of Revenues 21.69% 19.28% 19.99% 22.52%
Product Development $1,221,787 $1,210,168 $1,082,176 $1,005,090
% of Revenues 16.95% 18.73% 17.11% 20.17%
General & Admin $705,136 $580,352 $488,332 $495,804
% of Revenues 9.78% 8.98% 7.72% 9.95%
Amortization $87,550 $39,106 $31,626 $33,592
% of Revenues 1.21% 0.61% 0.50% 0.67%
Restructuring $106,854 $126,901 $57,957 $24,420
% of Revenues 1.48% 1.96% 0.92% 0.49%
Total* $3,684,640 $3,201,877 $2,924,582 $2,681,208
% of Revenues 51.12% 49.56% 46.24% 53.79%
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*Does not include goodwill impairment charge in 2008.

As you can see, Yahoo's two biggest expenses in this area increased as a percentage of revenues in a big way in 2011, reaching four year highs. This has led to the impact on operating margins you saw above, which increased less than four full percentage points, despite an 11 plus point increase in gross margin. General and administrative expenses also hit a new four year high, increasing almost 29% year over year (as a percentage of revenues). While amortization and restructuring charges have been kept in check in recent years, they account for such a small portion of total expenses.

When these five expense lines jump more than 7.5 full percentage points year over year, it is quite troubling. Yahoo needs to keep some of these costs in check. The company had about 14,000 employees at the end of 2011, and getting rid of a few thousand might get these expenses back down to the sub-50% level. Yahoo's effective tax rate (not including equity interest earnings) also increased from 2010 to 2011, jumping from 20.7% to 29.2%. That is why you saw the net margins increase by less than two full percentage points.

Balance Sheet / Financial Flexibility:

The following table shows some key balance sheet data and financial ratios at the end of each calendar year.

Financials 12/31/08 12/31/09 12/31/10 12/31/11
Current Assets $4,745,498 $4,594,772 $4,345,548 $3,452,536
Total Assets $13,689,848 $14,936,030 $14,928,104 $14,782,786
Current Liabilities $1,705,015 $1,717,728 $1,625,872 $1,207,361
Total Liabilities $2,420,887 $2,417,394 $2,331,694 $2,201,439
Current Ratio 2.78 2.67 2.67 2.86
Working Capital $3,040,483 $2,877,044 $2,719,676 $2,245,175
Debt Ratio 17.68% 16.18% 15.62% 14.89%
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Yahoo has reduced the size of its balance sheet slightly in the past two years, shrinking total assets by about $150 million. However, they have reduced total liabilities by more than $215 million, so their debt ratio (liabilities to assets) has improved quite nicely in recent years. While the amount of Yahoo's working capital has decreased over the past few years, the current ratio has improved, as Yahoo is reducing its current liabilities faster than the decline in current assets. Financially, Yahoo is in very good shape.

Competition / Other Names to Consider:

Yahoo! Finance's website says that Yahoo's main competitors are AOL and Google (NASDAQ:GOOG). For purposes of this argument, I'll also throw in Microsoft (NASDAQ:MSFT), which has the increasingly popular Bing search business, and Baidu (NASDAQ:BIDU), the Chinese search giant. Let's look at some analyst predictions.

Analysts YHOO GOOG AOL MSFT* BIDU
Analyst Rating 2.6 1.9 2.7 2.1 1.8
Current Price $14.41 $604.96 $17.04 $31.56 $133.27
Average Target $17.26 $705.09 $19.20 $32.85 $188.14
Potential Upside 19.78% 16.55% 12.68% 4.09% 41.17%
Rev. Growth '12 1.30% 22.60% -4.00% 5.60% 59.00%
Rev. Growth '13 3.90% 18.80% -1.20% 8.00% 41.50%
EPS Growth '12 0.00% 17.73% 233.33% 0.00% 56.12%
EPS Growth '13 12.20% 18.01% 40.00% 11.52% 40.96%
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*Microsoft's fiscal year ends in June, all others December.

If we throw out AOL because of the negative revenue growth and the extreme earnings growth this year (jumping from 12 cents to 40), Yahoo is the lowest rated company by analysts. It does have the second highest potential upside based on the average price target from analysts, but remember, a lot of analysts had priced in the Asian asset sales, which didn't occur. Also, Microsoft started 2011 under $26, so it already has made a huge move. Yahoo's revenue and earnings growth this year will be basically flat, and there isn't much hope for next year either.

Conclusion:

Yahoo investors were hoping on a purchase, which could take these shares to $20. It didn't happen recently, which has forced the stock lower. Now, the company appears ready to start a huge restructuring plan. Over the long term, it will cut expenses, which jumped in 2011. However, Yahoo doesn't need to worry as much about expenses. It needs revenue growth first. It just isn't in the same ballpark as many others right now, and new CEO Scott Thompson has a lot of work to do.

Until this name can shake things up tremendously or find some ways to grow revenues, it might be a tempting short for the next few months. Once the new CEO has been in there for a few months, this might become a decent buy if we get down into the $12 area or so.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in AAPL over the next 72 hours.