Stifel Nicolaus Internet analyst Scott Devitt upgraded both Google (GOOG) and Yahoo (YHOO) yesterday, leaving himself with a "hold" rating on Google and a "buy" on Yahoo. After reading his upgrade note on Google, his comparison of Google and Yahoo's business models makes interesting reading, particularly because of his focus on investment methodology. Because of its originality and thought-provoking nature, here's a longer than usual excerpt (as always with the analyst's permission):
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Looking Back - Business Models
There are all shapes of sizes of business that cross our path in the consumer discretionary / consumer technology category. Those that we have become most familiar with over the years include brands (See's Candy, Tiffany, Coach, Proctor and Gamble), natural monopolies with lock-in (Microsoft, eBay, the real estate MLS, the IPO process), low cost structure models creating a sustainable competitive advantage, most relevant in commodity industries (Dell, Nebraska Furniture Mart, Costco, GEICO, Southwest), and innovators (AOL, Adobe, Apple, Expedia, Intuit, Netscape, and Sun Microsystems).
Our experience leads us to believe that brands, monopolies, and low cost business models (in commodity businesses) leads to the least volatile returns over time. Someone once said that many times it's the innovators that wind up with arrows in their back; whether, that will be true in this instance or not remains unknown but we believe its fair to assume that Google is the most innovative company in the online media sector. Yahoo! has purposely positioned itself as a media company to eschew the limelight, yet it has created quite a technology business along the way. To be sure, all the companies we mentioned above have a brand; however, it is worth noting that the only businesses to fully leverage the excess profit associated with brands over the long term are companies not in rapidly changing industries with high levels of innovation risk. We purposely displayed both large and small "innovator" examples above to display how small, innovative companies can exist and thrive given the ability to function below the radar, while the large businesses with the most significant market opportunity many times run into challenges. Apple, is the greatest innovator story, but it has also had a volatile existence up until the last two years. If Amazon created a digital music offering and partnered with a hardware provider to offer a heavily discounted MP3 player, could the digital music business become commoditized? Probably not, given the scale of the iPod user base today but, more importantly, is Apple priced for that risk? The risk of standardization and commoditized is the greatest risk to innovators in the consumer technology sector; yet, that risk never seems to get priced in until the change is well in progress. On that subject, it is worth noting that, in our own experience over the past six months, we have found search results in general and in particular on Google to have become cluttered with blog results (in fact, a Google search for "blog" returned 1.84 billion results last evening). While Yahoo! has similar quality challenges, the company has begun testing a beta version of blog results which show up in the upper right hand corner of the search results page and totally separate from the core algorithmic results.
Looking Forward - Regression to the Mean
In Against the Gods, Peter Bernstein stated, "There are three reasons why regression to the mean can be such a frustrating guide to decision-making. First, it sometimes proceeds at so slow a pace that a shock will disrupt the process. Second, the regression may be so strong that matters do not come to rest once they reach the mean. Rather, they fluctuate around the mean, with repeated, irregular deviations on either side. Finally, the mean itself may be unstable, so that yesterday's normality may be supplanted today by a new normality that we know nothing about. It is perilous in the extreme to assume that prosperity is just around the corner simply because it always has been around the corner."
We view Yahoo! as a competent number two in the online media sector, we do not believe this to be a Dell v. Compaq type scenario in terms of market share. We believe Yahoo!'s initiatives to be integrated over the next twelve months will begin to close the gap with Google, including – (1) Yahoo! Publisher Network; (2) content match via YPN; (3) improved monetization of keywords and users; and (4) advertiser and publisher tools to better manage ad programs. At a minimum, we anticipate that Yahoo! will stem the market share losses that have occurred over the past year with its new products.
As to Google's higher profit margins currently and its lesser reliance on human beings (employees) to run its business, we point to a comment from Jeremy Grantham in a recent Barron's interview, "Profit margins are provably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism. If high profits do not attract competition, there is something wrong with the system and it is not functioning properly." We agree with Mr. Grantham with the one caveat that natural monopolies do exist even in capitalist societies. The question remains as to whether Google is creating a natural monopoly in its core Adwords and Adsense product offerings, given the lack of switching costs in its core business, the competitive forces becoming apparent across the entire Internet sector and traditional media, and Google's recent foray into politics (China censorship and U.S. privacy) which could make the limited lock in and lack of switching costs a more relevant issue than it seems today.
So, the past and future bring us back to our view of the present and our recommendation to begin opportunistically building a position in Yahoo! shares. Yahoo! has a fairly complicated business structure which includes over $700 million in a structure stock repurchase program which is not reflected in cash or reduced shares at present, a $1 billion investment in Alibaba in China, and a 34% stake in Yahoo! Japan valued at approximately $11 billion but which we only deduct 50% or $5.5 billion from Yahoo!'s enterprise value to account for the lack of liquidity, potential tax consequences, and our discomfort with our ability to fair value Yahoo! Japan as we reside in Manassas, VA, USA. On this basis, we believe Yahoo! to currently have an enterprise value of $39.3 billion or $11 billion lower than its equity market capitalization and we anticipate almost $2.5 billion in core EBITDA in 2007, for an EV/EBITDA multiple of 16x. We are comfortable believing that Yahoo! shares could justify a forward EV/EBITDA multiple of 20x, as the company executes over the next year, hence our $42 target price.