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Yahoo! Inc. (NASDAQ:YHOO)

Q3 2007 Earnings Call

October 16, 2007 5:00 pm ET

Executives

Marta Nichols - Investor Relations

Jerry Yang - Chief ExecutiveOfficer, Director

Sue Decker - President

Blake Jorgensen - Chief Financial Officer

Analysts

Christa Quarles - Thomas Weisel Partners

Imran Khan – JP Morgan

Jeetil Patel - Deutsche Bank

Brian Pitz - Banc of AmericaSecurities

Robert Peck - Bear Stearns

Anthony Noto - Goldman Sachs

Youssef Squali - Jefferies & Co.

Operator

Good afternoon, ladies and gentlemen and welcome to theYahoo! third quarter 2007 earnings conference call. (Operator Instructions) Iwill now turn the call over to Ms. Marta Nichols. Ms. Nichols, you may begin.

Marta Nichols

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

Before we begin, I would like to remind you that mattersdiscussed on this call contain forward-looking statements that involve risksand uncertainties concerning Yahoo!'s expected financial performance as well asYahoo!'s strategic and operational plans. Actual results may differ materiallyfrom the results predicted and reported results should not be considered as anindication of future performance.

The potential risks and uncertainties include, among others,the implementation and results of the company’s ongoing strategic initiatives,the company’s ability to compete with new or existing competitors, thesuccessful implementation and acceptance by advertisers of the company’s newsearch advertising system, reduction in spending by our loss of marketingservices customers, the demand by customers for Yahoo!'s premium services,acceptance by users of new products and services and risks related to jointventures and the integration of acquisitions.

Other potential factors that could affect the company’sbusiness and financial results are included in the company’s annual andquarterly reports, which are on file with the SEC. All information discussed onthis call is as of today, October 16th, and Yahoo! does not intend andundertakes no duty to update this information to reflect future events orcircumstances.

On the call today, we will discuss some non-GAAP financialmeasures in talking about the company’s performance, including operating incomebefore depreciation and amortization and stock-based compensation expense,which will be referred to as operating cash flow; revenue excluding trafficacquisition costs, which will be referred to as revenue ex-TAC; free cash flow;non-GAAP net income; and non-GAAP net income per share, and reconciliations ofthose non-GAAP measures to the GAAP measures the company considers mostcomparable can also be found on our website under investor relations.

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

Jerry Yang

Thanks, Marta and welcome to all of you. Thanks for joining us onthe call today. I am pleased to be giving you an update on Yahoo!'stransformation. While we still have a lot more to do, we have taken someimportant steps and made some strong initial progress.

Over the past hundred days, we have thoroughly reviewed keyaspects of the rapidly changing Internet marketplace, our company, our strategyand our culture to identify what we need to do to accelerate Yahoo!'s growthand create long-term value for our shareholders.

As a result, we have made important decisions about ourfuture. We have defined a vision of where we want to go. We have developed aset of objectives and strategies that we will follow and devised a rigorousframework that we will use to prioritize and make future choices.

At the same time, we have also taken decisive steps toexecute against our priorities. I believe we are now more effectively organizedto execute well and ready to take advantage of the tremendous opportunities wesee ahead.

I will start by going in more detail on the new direction inwhich Yahoo! is headed. Sue will then discuss our progress against ourobjectives and strategy, and Blake will take you through our financialperformance. I will conclude as I did last quarter with a few key takeaways.

So as part of our strategic review, we first assess Yahoo!'smarket opportunities and where we can win. We believe that online advertisingmarket today is about $45 billion. That market opportunity is growing rapidlyand is expected to reach some $75 billion by 2010, just three years from now.We are one of the only few companies that have the scale, the technology, theinsights and the expertise to really take advantage of this big opportunity.

To that end, we looked at a number of options to improve ourcompetitive position and financial performance. We determined that to win inthis marketplace, we must take advantage of our unique assets to drive valueacross a broad ecosystem of users, advertisers, publishers and developers.

Now, we could have chosen to focus on a subset of the marketbut that would limit our ability to generate significant long-term value.

So the goal is to turn Yahoo! into a company that powers anddelights all of its communities by creating indispensable experiences. This isa vision and purpose for Yahoo! at which I believe we can succeed.

With our huge audience, strong advertisers and publisherrelationships and deep technology, we have all the pieces and we are workingfrom a position of strength. What we must do better is integrate these assetsand execute with a clear focus.

I talked in the last quarter’s call about three keystrategic differentiators that will be critical drivers to Yahoo!'s success --insights, openness and offer partner-of-choice solutions. Moving forward, weare going to strengthen and leverage these differentiators to a far greaterextent. We will do so by measuring how much more relevant we can become foreach member of our ecosystem.

We believe the focus on relevance as a measure will create aunifying focus to our work and drive increased value in everything we do. Suewill talk a lot more about this later but I think there is a lot of room forimprovement in driving relevance in our consumer offerings and marketingeffectiveness.

We have also established three big, multi-year strategicobjectives that will be the core of everything we do at Yahoo! for the next fewyears. First, become the starting point for the most consumers on the Internet;second, establish Yahoo! as the must buy for the most advertisers; third,deliver industry-leading platforms that attract the most developers.

Let me briefly walk through each one of these objectives.

First, let’s discuss our focus on becoming the startingpoint for the most consumers on the Internet. Consumers have and will continueto start their Internet use every day through a key set of applications thathelp them to both discover and better manage their lives.

Starting points must have broad reach and be incrediblyrelevant to a massive number of people. Today, Yahoo!'s key starting points ofthe homepage, My Yahoo!, mail, and search drive a tremendous amount of trafficand intent to the remainder of Yahoo!, thereby comprising much of the value toYahoo!.

In addition to the web on your PC, the mobile experience isemerging as an ever-growing and more important part of that starting pointexperience.

Therefore, it is critical for us to continue to invest,innovate, and create whatever is necessary to gain more consumers to use Yahoo!as their starting point.

So with respect to all of our consumer offerings goingforward, we will prioritize our talent and resources based on how we will fullyinvest and improve our starting points. We are also identifying services thatenhance and support the starting point mission.

For example, sites like Yahoo! Finance, Sports, and News arecategory leaders in their own right and their high quality impact enhancespeople’s choice of Yahoo! as their starting point.

As part of this prioritization framework, there are servicesthat don’t apply to Yahoo!'s key starting points. In these instances, we willeither not fund or will not direct additional resources.

For example, we have de-emphasized our focus aroundsubscription music in favor of advertising supported music. We have integratedYahoo! photos in a flicker as a single offering. We intend to transition Yahoo!360 to a more integrated Yahoo! experience, with things like podcast option inthe U.S. andplan to shut down a number of other one-off services throughout the world overthe coming months, and we have announced that we are assessing our options for Kelkooin Europe.

These are but a few examples of areas that we’ve identifiedand we continue to work through many others. We will be relentless in ourpursuit to ensure that we have the leading set of offerings for consumers tobegin their experience on the web each and every day.

Our second strategic objective is to establish Yahoo! as themust buy for the most advertisers, as the online ad market continues to growrapidly in the years ahead. As we have discussed previously, the lines continueto blur in the online advertising space between performance and brandadvertising. We believe having a principal position in both search and displayadvertising is critical to creating that long-term shareholder value.

Yahoo! is poised to lead the industry by providing trulyend-to-end advertising products and services. We have taken already importantsteps to transform Yahoo! from selling primarily just our own and operatedinventory to an advertising platform company that delivers comprehensive,integrated and targeted solutions, both on and off Yahoo!'s network.

Sue will give you much more details on the progress we havemade there.

Our third strategic objective is to deliver industry leadingplatforms that attract the most developers, for which we’ll allow for rapiddelivery of new products and services from third parties to our consumers andcustomers.

In the past, we have unintentionally made it more difficultfor developers to benefit from our technology platform and data infrastructure.We intend to change this and provide flexibility and access to criticalplatforms.

Besides building on open APIs, which we are doing more ofevery day, we are looking at many different ways to open up Yahoo!. We intendto be more flexible with our infrastructure and allow others to benefit fromwhat we have learned. By doing so, we can open up Yahoo! to an ecosystem thatis larger than what a closed Yahoo! can provide.

This includes opening up our web pages to let third partiesplug in their applications, opening up our data so applications integrateseamlessly into Yahoo!, and building services that other can integrate intotheir applications.

Our goal is to create a motivated community of developersall building uniquely compelling applications that reach hundreds of millionsof Yahoo! users by plugging into the most popular properties or services.

Our users, advertisers and publishers benefit from the richdeveloper community by having access to the vast array of highly personalizedand relevant services to choose from.

While we are early in our pursuit of this objective, we willbe investing in driving to transform Yahoo!'s infrastructure and software inthe next few years to be a leading platform choice for web developers.

So to summarize, during this past quarter, we’ve establisheda clear view of our market opportunity, a focus set of business objectives anda strategic framework for execution. We will plan, invest, align ourorganization, and prioritize everything we do around the three big items I’vejust reviewed.

In June, Sue and I realized that in order for us to succeed,we had to change Yahoo! from the inside out. We’ve been doing just that. We arestreamlining our organization, eliminating silos, aligning our leadership team,and putting ourselves in a position to execute quickly and decisively.

We know that we need to act as one Yahoo!, both with ourcustomers and consumers as well as inside the company, and we have establishedinternal milestones by which we will all check our progress.

This is the result of an intense amount of work throughoutthe quarter by our senior leadership team, much of which hasn’t been visible tothe outside world, but that will make all the difference for how we moveforward.

We are transforming from a business model that has beenfocused on developing and selling our own inventory to a much broader businessthat incorporates strong, owned and operated inventory, broad partnerships, andend-to-end capabilities both on and off Yahoo!'s network.

We will continue to work through this transition in the nextfew quarters. Having said that, we did a little better in the third quarterthan we would have thought three months ago. There are several fundamentalsthat we believe are starting to improve, as Sue and Blake will talk about.While our overall revenue growth was approximately 14% year over year in thethird quarter, we saw encouraging underlying trends with our global owned andoperated marketing services growing 22% year over year.

While we are still in a period of transformation, we feelgood about this growth and are focused on cycling through some of the factorsthat are slowing our business, such as transition of our low quality searchaffiliates.

We’ve started to execute against some of the strategicobjectives I’ve talked about. Acquisitions like Zimbra, BlueLithium, Rivals.comamong others will help us. We are also busy building out our publisher networkwith high quality partners, such as the four we announced today.

In conclusion, the Yahoo! we envision today is verydifferent from the Yahoo! of a year ago. We are going to be substantially moreopen, generate and leverage our insights in an exciting new ways, and enableour partners to derive greater benefits from our technology platform and datainfrastructure.

We believe we have the outstanding talent and culture thatcan strengthen and build on our key assets to become much more competitive andcapture the large and growing market opportunity.

Since the company’s founding, Yahoo! has created tremendousvalue for our users, our partners and our shareholders. We have much of whichto be proud. However, our work is not done. Our mandate now is to marshal oursubstantial strengths to drive growth and create value.

We recognize that we still have considerable work to do andI believe our new strategy puts us on the right path.

With that, I would like to turn the call over to Sue.

Sue Decker

Thanks, Jerry. As Jerry has noted, we’ve been deeply engagedover the last few months reviewing our strategy and business priorities andhave made tremendous progress. We are excited by our plan to transform Yahoo!and feel good about the actions already underway.

Yahoo!'s leadership team has worked closely to identify ourchallenges and our opportunities and we feel a renewed sense of energy, urgencyand purpose. And even as we focus on strengthening Yahoo!'s business, ourrelationships with every element of our ecosystem, users, advertisers andpublishers, are becoming stronger. We plan to stay laser focused on buildingoff this strong base.

I’m going to focus my comments today on three primary areas.First, a business and market update; second, how we are driving toward faster,smarter execution; and third, why we believe there is so much upside ahead.

Let’s kick off with a business update and talk about some ofthe progress we’ve already made against our three major strategic objectives.Jerry noted we are focused on making Yahoo! the starting point for the mostconsumers on the Internet and we’ve got a great base on which to build.

We ended the quarter with 477 million users, up 14% from ayear ago. Our internal estimate of page views grew even faster, up about 20%,implying growing engagement. This is relatively consistent with the growth ofthe last few quarters, notwithstanding that Yahoo! has the largest user base onthe web.

Turning to our starting points, let’s first look at Yahoo!Mail, a worldwide leader for 10 years and our single largest starting pointbased on numbers of users. There were two major mail developments in Q3. InAugust, we began rolling out the new Yahoo! Mail with industry-leadingfeatures, including built-in instant messaging, text messaging to cell phones,unlimited storage, drag-and-drop functionality, preview panes, and fast andintegrated search.

In addition, we recently acquired Zimbra, a leader in nextgeneration e-mail and collaboration software. We believe we can extend some ofZimbra’s very intuitive user features to our consumer service while alsoaddressing a new market for Yahoo!, web-based mail for universities, ISPs, andsmall businesses.

Search is another critical starting point for Yahoo! usersand we just launched our most significant consumer-facing update to ouralgorithmic search technology since inception. This patented IP is the mostadvanced assist technology available on the market. It understands when peopleneed help finding what they are looking for and suggests related searchconcepts to help them.

By better understanding user intent, we believe the newYahoo! search puts the best results with the most complete information,including multimedia integration across video, images and audio, right into thesearch results page for the most popular queries, such as music, movies,travel, sports and much more.

Let me give you an example. Users can now play trailers orbuy movie tickets, watch music videos or hear song snippets, see their favoritesports star’s current stats and much more directly on the first search resultspage.

Longer term, our ambition in search is to change the gameand in so doing, gain query share. Our research suggests that 85% of all usersfind they don’t get what they want on their first search with the currentstate-of-the-art search algorithms. We think Yahoo! is in a wonderful positionto provide an integrated experience that goes beyond search to actuallycomplete tasks.

Let’s talk now about our most visible starting point,Yahoo!'s front page and some of the leading anchor properties that support andreinforce its leading position.

As part of our consumer-facing strategy to provide userswith the most relevant experiences, Yahoo!'s front page recently launchedintegrated inline video. The result is a faster, more seamless and intuitivevideo experience, which consumers love.

We’ve seen a significant increase in front page engagementand we are in the process of extending this enhanced video experience acrossthe network.

We are also beginning to open up the front page to outsidecontent providers to further our goal of offering consumers access to the mostcomprehensive and relevant content on the web.

When we look beyond starting points, we are equally focusedon key anchor properties that support and reinforce users’ starting pointchoices. Three of these anchor properties, News, Sports, and Finance, nowsimultaneously hold the number one com score spot for the first time ever intheir respective categories in terms of both audience size and engagement.

As we’ve more fully integrated video throughout the network,we’ve also seen a huge increase in video streams. In news alone, we are nowstreaming more in a single month than we were in an entire quarter a year ago.

With our recent acquisition of BuzzTracker, we aredelivering on our commitment to connect our users to the information they’reseeking while enhancing the Yahoo! news experience by bringing in the best andmost relevant content from blogs and traditional news outlets.

Our broader ambition is to focus our efforts around buildingplatforms that attract third parties and user generated content, whilede-emphasizing original entertainment programming and our premium musicbusiness.

Finally, let’s discuss mobile, the biggest emerging startingpoint. One Search, an entirely new search service designed just for mobile,gives consumers better results and instant answers. One Search has been warmlyreceived by consumers, allowing us to continue rapidly expanding itsavailability.

We recently announced a global agreement to be the mainsearch engine on Telefonica handsets, potentially reaching over 100 millionconsumers in 15 countries and bringing the total potential reach of One Searchvia partnerships to more than 200 million consumers around the world. The dealalso leverages other Yahoo! services like Flicker and Yahoo! Mail.

Let’s now move from consumers to advertisers and publishers.We’ve been executing on our objective to become the must buy and most essentialmarketing partner for the most advertisers on the web.

Starting with search monetization, I’m very pleased to saythat our global rollout of Panama is nearing completion. Substantially all ofour global advertisers have now been migrated to the new system and we launchedthe marketplace design algorithm in Japan, the U.K. and Korea in Q3. Over thenext few weeks, we will have the new ranking algorithm operational in all ofour major global markets, a bit faster than our initial expectations.

The financial gains we began to see in Q2 have continued inQ3, with another quarter of double-digit RPS improvement on our U.S.owned and operated search, up over 20% and bringing U.S.owned and operated search revenue up to over 30% from a year ago.

The international markets where we’ve been launching morerecently are also seeing very strong RPS gains as well. Panama’s developmentplatform gives us the ability to rapidly launch enhancements, including twovery important features -- quality-based pricing in Q2 and domain controls, whichwe launched yesterday, providing advertisers with more control over whichdomains were on their listings.

Both of these features should help increase performance andreduce costs for our advertisers.

Now let’s turn to display inventory, which characterizesabout 90% of all advertising industry inventory on the web and also for Yahoo!.As we shared with you a year ago, social networking and a proliferation ofpublishing tools has fragmented user attention and this trend continues, justthe opposite of the situation in search, which has become more concentratedwith the top two players.

On the advertiser demand side, this is creating significantfriction for advertisers seeking to connect with the users they most want toreach. Similarly, there are major friction points on the publisher side due toclosed networks, Byzantine approaches to price discovery, and still limitedtools and technology.

We believe these issues are the major reasons for rapid adnetwork growth in the last 12 months in the display world. According to ourresearch, while the display market in the U.S.is expected to grow 20% to 25% this year, pure ad networks and exchanges aregrowing much faster, while sites not associated with the network are seeingrevenue growth of only 10% to 15%.

While this presented some short-term challenges for Yahoo!in the past, we are already starting to see signs of progress from our recentefforts to address this market shift and we see significant long-termopportunities that Yahoo! can uniquely address.

Let me start with the short-term results. After seeingdeceleration in revenue growth for five quarters, we realized an accelerationin year-over-year global display growth in Q3 to nearly 20% versus low to midteens last quarter.

Ad impression growth is strong, although we have continuedto see a shift from guaranteed placement to non-guaranteed buys. As we said inthe past, U.S. CPMson a like unit basis increased year over year across the board, although themix shift toward non-guaranteed buys in impressions has resulted in modestyield dilution on an overall weighted average basis.

Importantly, the price of non-guaranteed advertising hasclose to doubled in a positive sense since early 2006, while guaranteed pricinghas also risen modestly. Those dynamics have narrowed the gap between the twopricing points considerably, making guaranteed pricing more competitive nowwith broader market conditions.

What about the longer term? As we think about why thesetrends reversed in Q3, let’s remember that Yahoo! started from a position ofstrength. We have long led in both display ad revenue and inventory. Ourcritical requirement was to supplement this with better direct marketing toolsand a focused off-network ability to aggregate quality audiences on which we’vemade considerable progress.

Supplementing our late 2006 and early 2007 exclusivepartnerships with e-Bay, Comcast and the newspaper consortium, we are veryexcited about some of our newest strategic partnerships, including Bebo, WebMD,Cars.com, Forbes.com, and Ziff Davis Media.

The WebMD and Bebo deals include both search and display,while Forbes.com, Cars.com, and Ziff Davis are display deals. We’re beginningto see a real gravitational pull into our ecosystem as we execute on ourpartner of choice strategy.

As we expand our partnerships and the growing cache ofattractive ad inventory available in one-stop shopping, we must also continueto build out the capabilities in tools that allow Yahoo! to fully addressadvertiser needs on both Yahoo! properties and the sites of our growing base ofpremium publishing partners.

To this end, we just acquired BlueLithium, the fifth largestad network in the United States, the second-largest in the United Kingdom, andthe fastest growing independent. With their performance management andtargeting expertise, BlueLithium will provide access to valuable audiences andgive Yahoo! and our partners increased re-targeting capabilities to sellperformance-based campaigns both on and off Yahoo!.

In Q3, we also closed on our acquisition of Right Media, theindustry’s largest emerging online advertising exchange. Right Media bringsindustry-leading performance tools to our sales force, as well as broadermonetization opportunities. We are now in the process of migrating ournon-premium inventory to the exchange and expect to have the majority migratedby year-end.

As we look forward, building a scalable monetizationplatform across display advertising to supplement and ultimately integrate withour search platform is our highest priority area of investment. We are focusedon scaling the exchange to handle significantly greater volume, as well as ondeveloping advertising and publishing ad management tools that take the best ofwhat Yahoo! has to offer in serving premium inventory and the best of whatRight Media has to offer for third party inventory into a winning combinationfor advertisers to better reach their customers and for publishers to bettermonetize their sites.

Our newspaper partners will be among the first to benefitfrom these new capabilities. We are also working with some of our newoff-network publishing partners to give their sales channels the opportunity toextend their buys to identified audiences on Yahoo! and vice versa. You’ll hearmuch more about this aggressive roadmap in 2008.

Now that I’ve completed the business update, let me turn nowto how we are executing more quickly than in the past. First, we are a muchmore aligned organization. We announced last quarter that we were integrating oursearch and display sales teams and this is now well underway. We are receivingvery positive feedback from our customers on this change and many have asked tobe pilots with us as they consider streamlining their own organizations.

This quarter, we announced further strategic andorganizational alignment, bringing together the leadership across ad supply anddemand in our newly formed Global Partner Solutions Group, while also movingour local markets and commerce properties to the division in which our audienceproperties are housed.

As is clear from our many publisher wins, these changes arealready helping us to quickly identify and secure the off-network ad inventorythat best meets our advertisers’ objectives and that will supplement our keystarting points and anchor properties on Yahoo!.

In addition to structural changes, we are focused on betterprocesses to drive speed and discipline in decision-making, cleareraccountability and excellence in execution. We’ve consolidated a number ofsenior positions and decision-making over a broader span of control with ourbest leaders and have removed impediments to get things done by better and moreexplicitly defining roles and responsibilities.

We expect to build on these early organizational and executionimprovements in the quarters ahead.

Before closing, I want to touch on why we see so much upsidein the strategy we’re pursuing. By employing an open platform strategy,attracting best-in-class outside content providers and developers, andutilizing our industry-leading insights about users across Yahoo! and our manypartners, we believe we can make Yahoo! experiences meaningfully more relevantfor all of our key constituents, users, advertisers, and publishers.

Let’s consider an illustration of what this means. Theclick-through rates on some of our algorithmic search results can be north of40%, which is 10 times higher than that on the today module, the featuredcontent at the center of our homepage. A similar order of magnitude gap existsbetween the clickthroughs on the large branded ads on many of the areas of ournetwork versus the content in the today module.

Pricing for the ads follows suit. Search ad pricing can bemultiples higher than ads elsewhere in the network. This difference exists insearch because we can match user intention to a much more comprehensivedatabase of information, while elsewhere we often don’t take intention intoaccount or where we do, we match that to a more closed and less comprehensivedatabase of information, content, services, and offers.

Our objective is to apply the search relevancy paradigmwherever possible to create far more relevant experiences on Yahoo!, both incontent and in advertising.

As a simple example, we want to move to a place that willshow American Idol in the today module to American Idol fans and World Serieshighlights to baseball fans, rather than showing the same content on thehomepage to everyone, as we do today.

Yahoo!'s large scale means slight gains in relevancy canhave a material impact on our financial performance. A simple 100 basis pointimprovement in aggregate network clickthroughs can generate an addition 2billion page views per month. To put that number into context, that’s theequivalent of four New York Times.com sites, two ESPN.coms, or one Amazon.com.This means that we both have the potential to create better monetization byproducing more relevant content in advertising through personalization andtargeting and we can potentially produce much more inventory to monetize.

We have a number of initiatives underway that will helpunleash this value in the coming years.

In conclusion, we are working diligently to transform Yahoo!on multiple fronts. Specifically, we are sharpening our organization,empowering our leaders and improving processes to ensure focus, speed andaccountability.

We are prioritizing our user resources around key startingpoints and creating strong differentiation in those products. This massive andgrowing user base creates inventory that offers meaningful incrementalmonetization opportunities.

And finally, our inventory and that of many publishers onthe web, is significantly undervalued in both search and display, which makesus very optimistic that our ability to create value for shareholders throughplatforms like Panama and what we are now building and extending in display aswe strive to become the must buy for the most advertisers.

Although there is a lot more to do, we are really excitedabout the challenge and encouraged by the progress we’re making. With that, letme turn it over to Blake to provide more detail on our financial results andoutlook.

Blake Jorgensen

Thanks, Sue and thanks to everyone for joining us thisafternoon. Before turning to the quarter, I would like to briefly touch on thefinancial side of our strategic review. As Jerry and Sue mentioned, our goal isto generate the maximum long-term value for our assets. We’ve been reviewingour business strategies and where our resources are deployed to determine ourhighest value opportunities. Given the dynamics of our industry, we view thisas a continuous process rather than a one-time event. As such, we are likely tosee a continuing evolution in our operations and in the way we do business.

Despite this environment of change, however, we will notchange our focus on growing free cash flow, since we believe that is the bestway to measure our progress and to deliver value to our shareholders.

We had a very business Q3, and now let’s take a look at ourfinancial results.

I'll begin with free cash flow, which was $310 million inthe third quarter, reflecting solid, underlying profitability. Free cashrepresents 66% of operating cash flow; again, at the high end of our long-termtarget of 50% to 70%.

Our cash and marketable securities balance was $2.8 billionat quarter end. We invested $320 million in acquisitions that closed during Q3and we repurchased $350 million of stock in the open market at an average pricebelow $24 per share.

Also during Q3, a $250 million structured stock repurchasecontract matured, resulting in the return of approximately 8.4 million sharesof stock to the company. With these transactions, we have now repurchased over$1.6 billion of our stock during 2007.

In addition to our cash and marketable securities balances,our ownership stake in several entities provided incremental balance sheetvalue. Our interest in Yahoo! Japan, the Alibaba Group in China,and G-Market in Koreawere valued at approximately $9.2 billion, or over $6.50 per share at quarterend. Since the end of the quarter, we have also closed the Blue Lithium andZimbra acquisitions, in which we invested approximately $550 million in cash.

Now let's move to the P&L. Beginning with the top line,third quarter revenue excluding traffic acquisition costs, what we refer to asrevenue ex-TAC, came in at $1.283 billion, advancing 14% year over year andwithin the range we provided in July. We saw solid growth in both our marketingservices and fees businesses.

Drilling down on marketing services, we generated $1.059billion of revenue ex-TAC in Q3, up 16% versus the prior year. We areparticularly pleased with the revenue growth from our owned and operated sites,which continued to accelerate to 22 % growth in Q3 from 18% growth in Q2, and14% growth in Q1.

U.S. O&O search revenue grew more than 30% year overyear, improving on the strong growth we posted last quarter. RPS, or revenueper search, grew over 20% year over year and out paced last quarter’s mid-teensimprovement. Growth in our O&O display advertising business alsoaccelerated during the quarter, showing improvements in both brand andperformance marketing ad sales. Our internal estimates of page view growth werearound 20% year over year in Q3, with good growth across all three majorcontent and service areas: communications, media and search.

As we've indicated for the last couple of quarters, wecontinue to face headwinds related to rising TAC rates and to our trafficquality efforts in our affiliate search business. Revenue ex-TAC continued todecline on a year-over-year basis. It's important to note that while the trendin the affiliate search business has impacted our overall growth rates thisyear, we believe that this part of the business will represent only about 10%of our overall revenue ex-TAC base at the end of 2007.

I'd also like to reiterate that our network quality effortsare part of a deliberate strategy to ensure that we are delivering the highestvalue traffic to our advertisers, and we believe we're executing on thatstrategy.

Now let's look at fees revenue. We produced $224 million offee revenue, up 7% from the same period last year. Excluding the impact of amodest one-time license revenue item in last year’s third quarter, our feesrevenue grew 12%. The primary driver of this revenue line is our premiumofferings. That is, those services for which consumers and businesses pay us.We exited the quarter with 18.7 million paid relationships, up over 20% yearover year and up 1.8 million from Q2 levels. This strong performance was drivenby our access relationships including our new relationship with New ZealandTelecom; Fantasy Sports, which is typically strongest in Q3 with the start ofthe football season; and incremental subscribers from our acquisition ofRivals.com, which provides premium coverage to fans of college and high schoolsports.

Looking at our international results, revenue ex-TAC grew13% in the quarter, or 8% excluding the impact of foreign currencies. On theinternational side, growth was negatively impacted by our affiliate trends, asI mentioned a moment ago. However, our international O&O marketing servicesrevenue grew over 25% during the quarter. Display growth was strong across Europe,in Asia, and in the emerging markets and we anticipatethat the completion of the Panamarollout internationally will accelerate international search growth in thecoming quarters.

Turning to profitability, operating cash flow came in at$466 million, producing global OCF margins of 36% for the quarter. Despitesignificant headcount growth in Q3, our margins came in ahead of plan as wecontinue to focus on managing our cost base while investing in our highestpriorities. Timing helped a bit as well, with a variety of small one-off itemscontributing to a roughly $5 million reduction in Q3 costs and a substantialportion of our headcount additions occurring late in the quarter. By geography, international OCF increasedwhile the U.S.was down due to investment in some of the initiatives that Jerry mentioned, andthe impact of the recent acquisitions.

Our effective tax rate for the quarter was 40.6%. Wecontinue to expect our effective tax rate for 2007 to be approximately 43% to45%. We expect our cash tax rate for 2007 to be between 15% and 17%.

We added approximately 1,200 employees during Q3. Thisincludes net additions from acquisitions, as well as the transition of OvertureJapan'semployees to Yahoo! Japan in connection with the sale of Overture Japan.The majority of our new hires were in product development. In addition to ourhiring being concentrated later in the quarter, we were also successful inpulling forward some of our anticipated Q4 hiring into Q3, as some of our keyinitiatives began to ramp.

That brings me to our business outlook. Our revised outlookfor the full year reflects the Q3 upside as well as the inclusion of bothZimbra and Blue Lithium in our Q4 results. For Q4, we expect revenue ex-TAC ofa $1.31 billion to $1.45 billion. We expect operating cash flow of $480 millionto $550 million. Our outlook contemplates the hires we made in Q3 as well asthe impact of the sale of Overture Japanand the acquisitions of Rivals, Right Media, Zimbra and Blue Lithium.

We've already discussed the acquisitions, but let me provideadditional color on the impact of the Overture Japan transaction. We believethat by enabling the Yahoo! Japan sales team to present a unified offering tocustomers, this deal will be a significant positive to both parties in the longterm. As we discussed last quarter, this transition will reduce our reportedGAAP revenue and TAC in Q4 and into 2008, resulting in a modest net decrease inrevenue ex-TAC.

Yahoo! Japan will pay us a service fee for providing searchadvertising and support services, and we expect this transaction to be slightlypositive in OCF in the short term compared to our previous affiliatearrangement with Yahoo! Japan. As we mentioned in July, we received a smallupfront payment and we believe that the majority of the value of this deal willbe realized via our long-term relationship with Yahoo! Japan.

Turning now briefly to free cash flow, we anticipate afull-year 2007 range of $1.2 billion to $1.3 billion, reflecting capitalspending for 2007 of approximately $625 million to $675 million.

In conclusion, we are pleased with our results for Q3 and weare still continuing to invest in several major growth initiatives. We facechallenges in the marketplace, but we are encouraged by the early signs ofimprovement and the significant opportunities on the horizon.

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

Jerry Yang

Thanks, Blake. Let meconclude by emphasizing a few key points. First, we determined that to win inthe marketplace we must take greater advantage of our unique assets to drivevalue across a broad ecosystem. We believe having a principal position in bothsearch and display advertising is critical to creating that long-term value.

Second, Yahoo! zeroed in on three big multi-year objectivesaround which we'll organize, fund and prioritize our resources. We want to makeYahoo! the starting point, become the must buy for advertisers, and developindustry-leading platforms for the developers.

Third, we'll use our strategic differentiators of insights,openness and partner of choice to make Yahoo! more relevant and indispensable.

Fourth, we are sharpening our organization, empowering ourleaders and improving process to ensure focus, execution and accountability.

Fifth, we're making some initial progress towards executingagainst our strategy through the launches of a new Yahoo! Search and Mail,gaining category leadership in sports, news, and finance and continuedimprovement of our search monetization. Several new publisher relationships andacquisitions of Right Media, Blue Lithium, Zimbra, and BuzzTracker.

Sixth, this is a multiple-year effort. As we transform ourbusiness over the next few quarters, we are pleased with the growth we'reseeing around our owned and operated business. We will continue to work throughthe headwinds, such as the transition of our lower-quality search affiliates.

We have a lot more work to do, but we're generally excitedabout where the company is headed. Now let's open the call to some questions.

Question-and-AnswerSession

Operator

Your first question comes from Christa Quarles - ThomasWeisel Partners.

Christa Quarles - Thomas Weisel Partners

Could you just go through some of the organic numbers, bothon remnant or total display as well as user and potential page view implications?And also, on the paid relationships? Thanks.

Sue Decker

I'll start on the marketing services side and then hand itoff to Blake on the subs and the rest. The organic numbers on display that wetalked about were that we grew about 20% in global display revenue thisquarter, up from the low teens that we did last quarter. This was the firstquarter of acceleration in five quarters. Page views, as we said, were up about20%. Why don’t I turn it over to Blake on the sub side.

Blake Jorgensen

Hi, Christa, nice tobe able to speak to you without a chaperone present. In terms of the subs, isthere specific data that you're looking for? I guess you can't answer, so let'sjump to the next question and then we'll come back with some more detail onsubs for Christa.

Operator

Our next question comes from the line of Imran Khan – JP Morgan.

Imran Khan - JP Morgan

Two questions. You equated a lot of traffic to yourpartnership, building the ad network and now through the Blue Lithiumacquisition, which has a good targeting technology, how do you try to scale theBlue Lithium product to better target this partner traffic and how can youincrease the yield of that?

The second question is probably longer term. If your searchgrowth rate is 30% plus and 20% plus is driven by monetization, how should wethink about the search growth in the longer term after you anniversary thismonetization improvement? Thank you.

Jerry Yang

I'll start with the search query question and then Sue willtalk a little bit about the Blue Lithium. As we've all said on the call, we'vebeen spending obviously a lot of our resources in the past year around Panama,and this year we're starting to focus around our ability to generatealgorithmic search query share. We've just had the beginning of our new productset launched earlier this month actually, with Search Assist, as Sue referredto.

I think what we are talking about is a reinvestment andredoubling down of our effort in creating better algorithmic search products tocontinue to drive query share, and it's something that we are really focused onfinding ways to change the game through product enhancements. Obviously we'regoing to continue to look at distribution opportunities, as well as making surethat it integrates better and better with the rest of our network.

Sue, do you want to talk about the Blue Lithium?

Sue Decker

Sure. I will justpoint to three legs on the broader stool of inventory here. We have the largestamount of inventory on Yahoo! owned and operated sites, of course, and we'resupplementing that with high-quality exclusive partnerships, several of whichwe announced today and had announced earlier in the year, in addition to BlueLithium which is the fastest-growing independent ad network.

The third leg on the stool would be the Open Ad Exchange inRight Media. Our objective here is to be able to take our very strong internalinventory and be able to leverage that significantly by a multiple in terms ofour go-to-market ability to offer advertisers access to audiences all over theweb, and exactly the audiences they want.

Both Blue Lithium and Right Media bring to us some directmarketing capabilities and tools which supplement where we were, which is very,very strong premium inventory and serving. So collectively, we think we have apretty comprehensive offering now and we're working quickly to integrate. Wejust closed Blue Lithium so we haven't done much integration yet, but we haveplans for that very quickly and we have fully integrated Right Media on anorganizational level and are already moving a lot of the inventory from ournon-premium inventory from the Yahoo! sales to the Exchange.

So collectively, we believe this will reduce friction forbuyers, will increase monetization for sellers, and as the largest seller, thatshould benefit Yahoo!.

Operator

Your next question comes from Jeetil Patel - Deutsche Bank.

Jeetil Patel - Deutsche Bank

First of all, can you talk about the Blue Lithium and RightMedia acquisition contributions that you saw in Q3? What do you expect in Q4?

Second, with your current ad partners, what percentage ofyour users webwide activity do you see today, and what is the threshold atwhich point you can actually start to increase your targeting in terms of adsthat these users see among your partner sites as well as your own site?

Blake Jorgensen

I'll start with the first part and then turn it to Sue. Wedon't disclose or will not disclose the Blue Lithium and Right Media revenuesdirectly. I think as we made note at the times of the acquisition, there wouldbe some revenue in the back half of the year, growing in 2008 and we would beneutral in terms of our cost and revenue components.

Sue Decker

On the percentage of user activity, measured by page views,Yahoo! O&O sites are roughly 8% or 9% of all page views. In terms ofrevenue contribution, because it's such premium inventory, it's well higherthan that; into the teens.

When you take into account the partnerships that we havealready signed up, that adds actually more inventory collectively, if you takepartnerships and the acquisitions of Blue Lithium and the Right Media Exchangethat we have on Yahoo! and also brings significantly more revenue share.

So on and off Yahoo! we are very quickly assembling thelargest ad network out there and that's why we believe our ad revenue growth indisplay has reaccelerated to roughly in line with what the industry growthrates are expected to be this year.

Operator

Our next question will come from the line of Christa Quarles- Thomas Weisel Partners.

Christa Quarles - Thomas Weisel Partners

I guess they put meback in the queue because I couldn't ask the other question, but I was justtrying to understand if you could give any indication around what the contributionwas on the page view side? It sounds like you aren't going to comment on therevenue side from Right Media.

While I'm at it, if you could just highlight some of theinnovations that you're starting to see emanate from the open platforms on theremnant display side? Thanks.

Blake Jorgensen

Christa, I'll let Suedo the second part. I think your original question that we didn't get answeredwas around the fees business, and the note that I had made earlier was therewas a one-time fee licensing payment in 3Q06 and when you strip that out thefee revenue grew 12% year over year. We had 18.7 million subscribers. That's up1.8 million from the previous quarter.

Sue Decker

I'll take the other questions. I'm not sure I totallyunderstand the page view question, maybe we can follow up afterwards. Our pageviews were up about 20% in the quarter. Those wouldn't include any page viewsfrom off-network companies or anything. That's the O&O Yahoo! properties.

In terms of the open platforms for remnant inventory, we'rewell under way in the migration of what we call our non-guaranteed inventoryinto the Right Media Exchange, but a lot of that process is happening right nowso it's a little early to be too definitive on what kind of pricing benefit wewill actually realize from the much broader price discovery across userfrequency.

Our initial look of it has been strong and consistent withwhat Right Media has seen in the past as publishers have moved onto itsexchange, which is a meaningful lift in their monetization rates.

Operator

Your next question comes from Brian Pitz - Banc of AmericaSecurities.

Brian Pitz - Banc of America Securities

On Q4 guidance, any commentary on your expectation from newpartnerships? Because if you factor in the new partnerships plus your betterO&O performance, it would suggest to us that the guidance may be a littleconservative.

A second part to that, should we be expecting TAC to go upas a percentage and maybe you could talk to some of the factors that drovethese new publishers to switch to Yahoo!? Thanks.

Blake Jorgensen

Let me start and thenI'll let Sue talk a little bit about the TAC piece of the equation. The midpoint of our range reflects our best estimate of where we believe thebusinesses will perform in any given period. Included in that, we did raise ourQ4 revenue outlook for the impact of the acquisitions, including Zimbra andBlue Lithium which have just closed. While display has performed better thanexpected, we believe in the third quarter we were helped out by a few itemsthat may not reoccur in the fourth quarter such as large movie budgets andother spending.

With that, I think we'll continue to maintain our practiceof providing guidance and we'll revisit the guidance for everyone for 2008 at theend of the next quarter.

Sue Decker

I just want to add one point here, that when we look at theaffiliate business across Search and Display, and what that means and how wegenerate value, just to reiterate some of the things that we've said in the pastwhich is that after traffic acquisition costs, we don't expect thesepartnerships to be meaningful profit centers on a standalone basis. The displaymarketplace is probably a little less competitive in terms of trafficacquisition costs in Search, but we expect them to converge very quickly.

The most important thing to understand though is thatincremental scale in display is significantly more important even than insearch, since only two players provide 75% to 80% of all of the inventory insearch, and that's actually getting more concentrated. The off-network piecebeyond those two players is relatively modest.

In display, we're the largest with about 8% of the pageviews and close to double that in premium revenue share; but if anything, theinventory is getting more fragmented and we see an amazing opportunity for usif we can aggregate incremental supply of premium inventory to bundle with ourexisting inventory to reduce friction for the advertisers out there.

So when we think about value creation, it largely accrues toour O&O through pricing and reduction of friction benefits as opposed tolooking at the affiliate business on a standalone basis. As far as the displaydeals we just announced, we wouldn't expect them to add much in this year andlonger term, we do expect the scale benefits to be very important to Yahoo!.

Jerry Yang

Brian, one of the factors you asked about to drive partnersto come to Yahoo! is, I think to Sue's point earlier about being one of thecombined offerings both in terms of search solutions as well as displaysolutions. We're starting to also, as Sue alluded, to have sales forces frompartners who have sales forces avail themselves of inventory that arepotentially bundled on Yahoo!.

So there's a multiple way, a multiple offering which we areoffering to our partners to monetize their site and we are helping them or theyare helping themselves. So again, this is just the beginning for us but we'restarting to see the power of combining the sales forces, as well as anend-to-end advertising platform.

Operator

Your next question comes from Robert Peck - Bear Stearns.

Robert Peck - Bear Stearns

You mentioned that RPS was up about 20% and I was wonderingif you could give us a breakdown of that? Was it driven by clickthrough rates,CPCs, coverage, et cetera?

Jerry, I was wondering if you could comment a little bitabout where you stand on the social network side. You mentioned Yahoo! 360;obviously Yahoo! Mash is coming along here. Could you talk about where you seeyourself as far as the investment phase? Do you ultimately see or need a largedeal with a Facebook or maybe some of the other social players out there tocapture more and more of the page views where they are growing on the net?Thanks.

Jerry Yang

Bob, I'll start and then Sue can talk a little bit about theRPS. As I said in our comments, we are much more focused around a broad set ofthings that users will do to start their experience on Yahoo! and we have someof the very strong applications around home page content, Search, Mail. We havealso openly stated that we feel connecting our users with people who they careabout is going to be a priority and that remains such, but only as it fits intoour starting point strategy.

We have some offerings out there that have socialcomponents. Things like Flickr and Answers continue to be one of the largersocial networks, but you can count on us to find ways to integrate our socialcapabilities even more as we really focus around the starting point strategy.

Sue Decker

On the RPS side, it probably doesn't make sense to get intothe individual components of growth, but it's fair to say that the new rankingalgorithm is very sensitive to the relevancy of the listings, and thereforeyou'd imagine that the clickthrough rates are probably moving in a positivedirection.

Operator

Your next question comes from Anthony Noto - Goldman Sachs.

Anthony Noto - Goldman Sachs

While the revenue acceleration is obviously a move in theright direction, the level of profitability on an operating income basis isgoing in the opposite direction, down 5.5% in the quarter, worse than the 4%decline in Q2 based on our accounting methodology, which is slightly differentthan yours.

I was wondering if you could comment on what's driving thatdeterioration in profitability, both on a year-over-year basis and then interms of growth rate? Incremental margins about 1%.

Blake, you'd mentioned about some one-time benefits in thequarter for advertising. Do you think the economic environment is causing themto be one-time or do you just think the box office slate will be slower in thefourth quarter? Thanks.

Blake Jorgensen

On the first part around the margins, we're clearly nothappy with where our margins are today. We still are focused very much so onbalancing the margin growth with the continued investment in the keyinitiatives that Jerry and Sue defined. Critical to that, we're continuing toadd employees, as we mentioned, in the third quarter and somewhat in the fourthquarter, but we'll continue to keep our focus on improving those margins overtime.

In terms of the one-time benefits in the third quarter, Ithink most of those were more seasonal. We are conscience of economic slowdown.We haven't seen that in any specific sector, but we're conscience that theadvertising industry across the board is worried about potential slowdown.

Operator

Your final question comes from Youssef Squali - Jeffries& Co.

Youssef Squali - Jefferies & Co.

Your guidance does not seem to show any margin improvementin Q4 over Q3 out of the higher revenue rate that you're guiding to. In prioryears, you've certainly shown that the model scales Q3 to Q4, so can you speakto that? Lastly, can you just clarify how you will classify the Right Media andBlue Lithium revenue since some of it is O&O and some of it is network?

Blake Jorgensen

In terms of the guidance, I think as we mentioned, we hired1,200 people in the third quarter. Some of that is planned hiring from thefourth quarter, but that will continue to impact our margins in the comingquarter. That's why we've continued to maintain the guidance as we have, aswell as the acquisitions of all of the different pieces that will drive bothrevenue up but also bringing on headcount and associated costs in the near term.So no OCF impact on the positive side.

In terms of the Zimbra and Blue Lithium revenues we, as Isaid before, have not disclosed how those revenues will be integrated into therevenue statement. I think in future quarters when we give some guidance aroundthe full year we might provide some better visibility on how those will impactthe overall 2008 numbers.

Jerry Yang

I want to thank everybody for joining us today and have agreat afternoon.

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Source: Yahoo! Q3 2007 Earnings Call Transcript

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