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Executives

Marta Nichols - Investor Relations

Jerry Yang - Chief Executive Officer, Director

Susan L. Decker - President

Blake J. Jorgensen - Chief Financial Officer

Analysts

Youssef H. Squali - Jefferies & Co.

Jeffrey Lindsay - Sanford C. Bernstein

Brian Pitz - Bank of America

Ross Sandler - RBC Capital Markets

Mark S. Mahaney - Citigroup

Christa S. Quarles - Thomas Weisel Partners

Imran Khan - JP Morgan

James Mitchell - Goldman Sachs

Justin Post - Merrill Lynch

Heath Terry - Credit Suisse

Yahoo! Inc. (YHOO) Q1 2008 Earnings Call April 22, 2008 5:00 PM ET

Operator

Good afternoon, ladies and gentlemen, and welcome to the Yahoo! first quarter 2008 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 first 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 would 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 implementation and results of the company’s ongoing strategic initiatives, the company’s ability to compete with new or existing competitors, 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, risks related to joint ventures and the integration of acquisitions, and risks and uncertainties arising in connection with Microsoft’s unsolicited proposal to acquire Yahoo!.

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. Additionally, more information about factors that could affect the company’s projected financial performance and its three-year plan is included in the company’s report on Form 8-K dated March 18, 2008, which is also on file with the SEC.

All information discussed on this call is as of today, April --

Apologies for the technical difficulties. Good afternoon and welcome to Yahoo!'s first 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 would 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 implementation and results of the company’s ongoing strategic initiatives, the company’s ability to compete with new or existing competitors, 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, risks related to joint ventures and the integration of acquisitions, and risks and uncertainties arising in connection with Microsoft’s unsolicited proposal to acquire Yahoo!.

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. Additionally, more information about factors that could affect the company’s projected financial performance and its three-year plan is included in the company’s report on Form 8-K dated March 18, 2008, which is also on file with the SEC.

All information discussed on this call is as of today, April 22, 2008 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 comments that should last about 30 minutes and then we’ll have a brief Q&A session. With that, I would like to turn the call over to Jerry.

Jerry Yang

Thanks, Marta. Welcome and thanks for joining us today. We are very proud of our Q1 results and have many positive updates to discuss.

We delivered Q1 revenue and operating cash flow that are both in the upper half of the ranges we provided in January, and we are raising our cash flow guidance for the year. Today’s results are a direct outgrowth of our strategy, our increased discipline, and our terrific people. And they are all the more remarkable when you take into account the recent economic environment and the uncertainty stemming from the Microsoft unsolicited proposal.

Even beyond the financial performance, Q1 was probably one of the most exciting quarters in Yahoo!'s history in terms of delivering innovative products and services that really move the needle and make a difference for our users and customers.

And the quarter’s results underscore the fact that our strategy and investments are beginning to pay off.

We continued to make progress against our strategic objectives: being the starting point for the most consumers on the web; becoming the must buy for the most advertisers; and delivering industry leading platforms that attract the most developers.

Over the past few quarters, we have refined our strategies, reorganized and focused our people, and rationalized our products and services. We’ve also made the deliberate decision to invest so that we can capitalize on the bigger longer term opportunities in what is still a relatively young online ad market.

Our ability to execute on multiple fronts is clearly improving. Our management of expenses and resources is increasingly disciplined and balanced with our need to spend smartly to grow.

We have the free cash flow, capital, and scale we need to deliver on our plans to substantially grow revenue, and our investment in innovation is now beginning to produce tangible results.

I’ll divide my remarks today into three parts. First, the unsolicited proposal from Microsoft and the alternatives we are pursuing to maximize stockholder value; second, important highlights of our Q1 performance; and finally, our growth drivers over the next few years. Sue will then provide specifics on how we executed against our priorities and Blake will take you through the numbers. I will conclude with a few key takeaways before responding to your questions.

Let me talk about Microsoft’s unsolicited proposal. As you know, after a careful evaluation, our board of directors determined that Microsoft’s proposal substantially undervalues Yahoo! and our one-of-a-kind global franchise.

Yahoo! has a unique and valuable combination of assets that include our global brand, our large worldwide audience, our leadership in online advertising, our strategic positions in Asia, our mobile and emerging market franchises, and our scales, tools, and technology.

The board’s decision to reject the proposal was based on the strength of our business and our operating and financial plan. We have established a powerful and a profitable operating model and, in addition to accelerating our rate of innovative over the last nine months, we gained significant traction in 2007 and believe that momentum will continue.

Since then, our board and management team continue to be open to any and all alternatives, including a sale to Microsoft. We engaged with major stockholders to highlight the value of our unique assets and have been expeditiously exploring a number of strategic alternatives which we believe will help us achieve our overarching goal of maximizing stockholder value.

If you take only one thing away from this brief discussion, I hope it will be that our board and management are committed to choosing a path to maximize stockholder value and will not enter into any transaction that does not recognize the full value of this company.

Turning to Q1 results, while Sue and Blake will summarize many accomplishments, there are a few highlights in particular that stood out for me.

We saw solid growth this quarter, with display revenue on and off of our network growing more than 25% on a GAAP basis year over year. That’s a key measure of success as we focus on building out our display network.

We continued our efforts to transform the display industry, acquiring Maven Networks to become a leading video advertising solution provide and previewing our advertising management platform, AMP from Yahoo!, which we believe will fundamentally change the way ads are bought and sold.

In support of our starting point strategy, we remain the number one property in the U.S., reaching nearly 75% of all Americans online, and we closed the gap in algorithmic search relevance on a few key measures that Sue will address. These accomplishments are a direct out growth of a three year strategy that we recently laid out in detail for our stockholders.

Let me recap the key elements of that plan for you. We are fundamentally focused on four key long-term growth drivers, increasing volume and yield across both search and display.

Our volume strategy is anchored in starting points. Those properties that users return to multiple times a day to start their Internet experience. Our goal is to change the game in this area by innovating and differentiating in search, front page, mail, mobile, and other key properties, making our products and services more personal, relevant, open, and social, and doing so on a massive scale.

Our yield objective is rooted in our must buy strategy to serve our advertisers’ needs so well that they will insist on working with us. To achieve that, we are rapidly building out and differentiating our advertising network, adding to our capabilities emerging areas like video and mobile ads and offering integrated solutions that span both search and display.

The key to this strategy is closing the gap in search monetization. We estimate that last year we reduced the U.S. revenue per search gap between ourselves and the leader in search. We have an extensive road map to enhance our Panama platform and we believe revenue per search will continue to grow.

While we see strong prospects in search, our largest opportunity is in display. With our existing display leadership, increased visits to our starting points as a result of innovation, and the pending rollout of AMP, we have positioned ourselves to gain share in this huge opportunity, projected to be more than $40 billion by 2010.

While the overall economic outlook remains unclear, and we are not immune to the economic conditions, we have a very diverse advertiser base and expect that ad budgets will continue to move online. We believe targeting capabilities only become more attractive during periods of economic softness and that we will be well-positioned to take market share and perform as well as or better than the market, as we continue to execute.

We believe we can achieve significant growth over the next three years, and the results of this quarter demonstrate that we are making progress against that plan.

Now, we are well underway in the most important transformation in our history. We are making brisk progress against our strategy and are building strong momentum as we continue to differentiate and innovate in critical areas.

Against the backdrop of the circumstances of the last three months, the results we are delivering are extraordinary and I am so proud of the thousand of Yahoos whose commitment and energy are the driving force for this success.

Hard work lies ahead but we are pursuing the right strategy and it is beginning to bear fruit. We are executing well and we remain focused on building a strong foundation for long-term growth and maximizing stockholder value.

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

Susan L. Decker

Thanks, Jerry and good afternoon, everyone. This quarter’s results are a testament to the progress we are making in executing the strategy we defined last summer. To deliver on that strategy, we created specific operational objectives, aligned the company around a powerful product road map and a short list of critical priorities, and focused on building a strong foundation for Yahoo!'s long-term growth.

The result -- we are now functioning with greater speed and efficiency, rolling out higher quality products at an accelerating pace.

As you know, we are focusing our operational efforts on two long-term objectives -- to become the starting point for the most consumers and to become the must buy platform for the most advertisers. And in both of these objectives, we are executing on four key revenue drivers to grow volume and improve yield.

Let me walk you through the tangible progress we made in Q1, beginning with Starting Points and how this focus drives attractive inventory gains across our site.

Hundreds of millions of users start their Internet experience on a handful of Yahoo!'s marquee properties and return multiple times per day. These represent our most powerful connections to users. They provide the insight that allows us to personalize their user experience. Most importantly, they drive tremendous economic value for Yahoo!.

Our approach to Starting Points comes down to three key changes in strategy and emphasis. First, rather than diluting our experiences by emphasizing hundreds of properties, we are narrowing our focus to concentrate on making these key Starting Points the very best on the web.

Second, we are open Yahoo!'s Starting Points to third party content and services. When we think of ourselves as a starting point rather than as a destination, all of us become more focused on simplifying users’ lives, giving them what they want rather than solely directing traffic to Yahoo! properties.

We expect that enabling third party developers to have access to our over 500 million users will spawn innovation that is great for our users and financed by others -- a true win-win.

Third, we are facilitating social connections across key Yahoo! properties. We are not trying to be another social network; rather by linking users’ favorite destinations and content with their friends, families, and communities, we can deliver better relevance on a scale no one else has achieved. This may include anything from Yahoo! content from inherently social properties like Answers and Flickr, or even leveraging information from other social experiences across the web.

So let’s look now at how we are leveraging our already strong position in these starting points to drive volume, starting with search. In our March investor presentation, we made it clear that driving 10% compound search volume growth over the next three years is one of the four key value drivers. In the first quarter, we approached that long-term goal on a global basis and exceeded it in the U.S.

We have a strong number two position in search but our efforts until last summer largely concentrated on attaining parity with the leader in algorithmic search by scaling the index and focusing on relevancy. Having achieved this, we are now focused on delivering new game changing features that will differentiate the Yahoo! search experience from the competition. We believe this will continue to drive volume and ultimately query market share.

The first example of this was the launch of search assist in October of ’07 to help users complete their searches much faster and also integrate multimedia, including video, images, and audio, onto the search results page. Following that launch, a keynote systems user opinion study showed that we are making major gains with customers in customer satisfaction, brand impact, and on several other measures.

Our next major advance is open search, which we call search monkey. Later in Q2, we will open the search user interface to developers and give them the opportunity to innovate right on top of our search technology. As a result, users will soon enjoy search results as rich and dynamic as businesses and the community of developers can make them.

We are also innovating in mobile search. Our industry leading one search product is specifically designed for the mobile experience, providing consumers with better answers, not just static web links. This quarter we released one search 2.0, which sports one of the best mobile features ever, voice activated search.

With the push of a button on your mobile device, you can say anything into your phone and get results just as if you had typed your query. This goes above and beyond the market offerings today that feature only local listings and frankly, it’s just a lot of fun to use.

Search assist, open search, one search, and voice search all help Yahoo! search users’ complete tasks faster, more efficiently and more intuitively on any device at any time.

One sign of the progress we are making comes from ComScore report earlier this month that found Yahoo! search relevancy rate, which is the percent of searches that have at least one user click, was 72.5% of all Yahoo! searches versus 69.2% for the previous market leader in that measure.

We’ve come from behind 18 months ago and closed the relevancy gap with new products that consumers love and industry third parties have validated that we are taking the lead in key measures of relevancy and consumer satisfaction. These are the most material gains we have seen in key leading indicators since becoming a principal in algorithmic search more than five years ago.

Let me now turn to our second major value driver, growth in the inventory that supports all of our non-search properties and runs advertising in display and video. Driving non-search inventory growth at a 12% rate per year is our three-year target. In the first quarter, we exceeded that goal with contributions from some of our innovative new products.

Let me give you a couple of examples, starting with our home page. In addition to becoming more open, Yahoo! also has the unique scale, tools, and user relationships to attract users by delivering value through social connections. One way we’ll do this is with Buzz, a new beta product launched in February. With Buzz, we surface the best web content on our enormous scale. Web publishers submit their content, users vote on it, and we use their votes along with a proprietary algorithm to develop popularity indices. Our editors select from among the most popular items to include on the front page, refreshing the content many times per day.

Over 120 publishers are in the beta, with more coming in every week. Yahoo.com has already sent tens of millions of referrals to our publishers in the beta and ComScore recently estimated that we reached 4 million unique visitors in the U.S. in our first month.

This model is self-reinforcing. Users find content they want via features like Buzz so they return more and more to Yahoo! to start their web experience. With our enormous scale, this should make us the partner of choice for publishers and in turn further enhance our access to the best content for our user starting points. Most importantly, the repeat visits to our home page create greater opportunities for monetization on some of the most valuable real estate on the web.

Another important element of Starting Points is the key properties that support them by attracting high volume and high quality traffic. Take video on Flickr, launched a few weeks ago. Flickr is among the world’s fastest growing online photo sharing communities with over 40 million users. Video on Flickr has already quadrupled video uploads by users across the entire Yahoo! network. Again, we are leveraging social connections to deliver better content and experiences at a scale no other company has achieved.

And there is more to come. Soon we will begin testing our newly designed content optimization capabilities on the home page, which will ultimately allow us to customize home page content served to reflect each user’s unique interests.

Let’s shift now to our Must Buy objective. Must Buy means serving our advertisers so well that Yahoo! continues as a critical partner for their media planning and execution. Unlike our Starting Points objective, where we are narrowing our focus on the most economically valuable properties, our Must Buy objective is about broadening and extending our advertising skills, tools, and platforms to a growing network of premium publishers off Yahoo!.

Rather than working exclusively to sell our own ad inventory, we are focused on making it easier for advertisers, agencies, publishers, and ad networks to do business with Yahoo! and with one another at a scale across the entire spectrum of online advertising. We believe this will encourage ad dollars to move online at a faster rate, increasing demand for inventory and most importantly resulting in higher yields for publishers, including Yahoo!, and higher ROI for advertisers.

Our huge O&O positions and the actionable insights this enables across search and display inventory, gives us a unique position from which to do this.

I will now talk briefly about the trends we are seeing in our two remaining key drivers to revenue, search yield and display yield. Starting with search, Panama continues to make good gains, improving search relevance, click-thru rates, and the advertiser user experience. The financial gains we began to see in 2007 continued in Q1 with another quarter of improvement. In the U.S., O&O RPS was up 10% and GAAP O&O search revenue was up about 20%. In international O&O, we also saw good RPS gains of roughly 15%.

As we reach the first anniversary of our initial Panama launch and successful migration of our global advertisers to our new platform, it’s important to note that we’ve made tremendous progress on the purpose of this investment to increase the relevance of our search listings to consumers, measured by click yield rates, which is coverage times click-thru rate relative to the competition.

Thanks to our talented engineering team, we have made real competitive progress on improving click yield. Consequently, the financial and product opportunity going forward is on price per click, or PPC, where we believe there is still significant upside. We believe we can maintain improved relevance and deliver steady improvements in making the marketplace more efficient, which should attract higher bidding due to the value delivered to advertisers and the relevance delivered to consumers.

To that end, we just launched minimum bid changes, also known as marketplace reserve prices, which is value-based pricing platform that will provide an opportunity for advertisers with small budgets to market through Panama by eliminating our $0.10 minimum bid in the U.S. on selected keywords. It also rewards advertisers for quality while attracting higher pricing in selective keywords where pricing is not commensurate with the value delivered.

The launch is the most significant since the launch of Panama itself, both in terms of engineering resources and also in terms of the associated financial opportunity. This and other innovations to follow are important to achieving our three-year goal of 15% RPS gains. First quarter RPS gains were in line with that longer term goal.

Before concluding my comments on search monetization, let me directly address the question of outsourcing. We see tremendous value in being a significant player with principal positions in both search and display. We continue to innovate and differentiate in both algorithmic and paid search and both remain important elements of our business strategy.

We’ve narrowed the search monetization gap and plan to continue closing it. There may be more than one way to achieve that goal, so we are exploring options to enhance our monetization, including a test with Google, which we recently announced.

It’s premature to speculate on what options we may ultimately pursue or whether some form of arrangement with Google might result, but the goal remains the same -- to be a significant player in search and optimize near-term monetization as one important way to create stockholder value.

Now let’s move to our last value driver, display yield. In the first quarter, overall U.S. display pricing was up slightly as we continued to see demand shift from non-guaranteed inventory -- toward non-guaranteed inventory from guaranteed. Importantly, the price of non-guaranteed ads has more than doubled since early 2006, while guaranteed has risen modestly, narrowing the gap between those two price points dramatically.

Our three-year plan calls for 15% annual growth, with the expectation that we will see more significant growth than that average in 2009 and 2010. This is because the out years should benefit from the introduction of our new display ad platform.

We also expect the mix shift from guaranteed to non-guaranteed to have a more muted impact in the out-years as the price points between those two have narrowed.

In the latter part of 2007, we started to redeploy significant resources from throughout the company in order to build the display platform for the future, leveraging key talent across Yahoo! and our recent acquisitions of Right Media and Blue Lithium.

Why is a new industry platform for display so timely? Compared to search, we are buying targeted reach and frequency online as comparatively easy through two large players, it’s very difficult to get that kind of scaleable relevance in reach and display. Inventory is highly fragmented across publishers and the existing tools are dated and difficult to use. Advertisers must engage in a complex process of cobbling together inventory from multiple publishers and ad networks, each with different systems, a laborious and time consuming process.

For publishers, the inability to sell their inventory of other relevant publishers in addition to their own limits their advertiser relationships and monetization capabilities.

To seize the opportunity to simplify the market, which we believe we can -- which we believe can meaningfully increase display yield, we are fundamentally redesigning our display ad management system in a way we think will transform the industry for advertisers and publishers alike.

We recently announced AMP from Yahoo! which will be delivered in a web-based, hosted application that harnesses the power of the collaboration across the Internet. The platform will standardize the basic way transactions are handled, freeing advertisers and agencies to focus on higher value tasks.

This quarter, we previewed AMP with selected newspaper partners to excellent reviews and we will begin rolling it out in Q3 of this year.

The financial benefit of this system should be a meaningful increase in display yield across Yahoo!'s site and that of other publishers. Today, so much of the inventory is undervalued relative to the audiences that it attracts due to the structural inefficiencies in the market that I discussed earlier.

Non-premium display CPMs today are only a fraction of more targeted ads in display, search, and classifieds. By adding insights to less valuable inventory and by aggregating much more demand with easy to access -- much easier to access the right supply in a way that decrease the friction in the current buying and selling processes, we expect to help both Yahoo! and other sites realize greater value.

In fact, having just begun the process that we call We Sell, You Sell, with our publisher partners, they have already sold hundreds of ad campaigns on Yahoo! and we are seeing significant yield benefits on these campaigns at very attractive CPMs that continue rising steadily week to week. With the more efficient platform we are designing, the upside can be even greater.

In summary, we are very pleased with the quarter’s product releases and revenue and cash flow growth. I am particularly proud of our people who have really rallied to execute on a more focused set of high impact priorities at this extraordinary time for Yahoo!.

We’ve talked a lot about strategy and organizational structure on our past couple of conference calls. Those efforts to streamline and prioritize helped us exceed the midpoints of our revenue and operating cash flow ranges this quarter. We are innovating and executing more rapidly and effectively. We are delivering on our most ambitious product roadmap, expanding our partnerships and receiving positive customer reviews for the innovations we are rolling out. And we feel we are on the verge of fundamentally changing the game in what we believe will be the most important segment of online advertising display.

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

Blake J. Jorgensen

Thanks, Sue. We are very pleased that our first quarter financial results came in above the midpoints of the quarterly ranges we outlined for you in January, despite this quarter’s unique environment. Revenue ex-TAC was up 14% year over year to $1.352 billion, and we delivered $476 million of operating cash flow on a normalized basis, or $433 million including costs related to our workforce realignment and the Microsoft proposal.

As we expected and consistent with our recent conversations with the investment community, revenue ex-TAC growth in our core business was approximately 18% in Q1.

As we anticipated, our affiliate search business reduced growth rates in Q1 due to ongoing network quality initiatives and rising TAC rates. Nonetheless, our underlying marketing services business continues to grow at very healthy rates. Because of this continued strength, we are reaffirming our full year 2008 revenue outlook and increasing our operating cash flow and free cash flow outlook today.

Before turning to the details of our Q1 results, I would like to take care of a few housekeeping items.

First, during Q1 we recorded approximately $29 million of cash costs related to the strategic workforce realignment that we announced on our January call. We implemented the workforce realignment in February as planned.

Second, we also recorded approximately $14 million of costs for outside advisors related to Microsoft’s unsolicited proposal. Given that neither of these costs items were included in out outlook and do not reflect the run-rate for the business, we will discuss results normalized for these items, as well as our reported numbers.

Third, as we previewed on our January call, we are increasingly managing our business around GAAP revenue because we view it as a better measure of our overall advertising reach than revenue ex-TAC. As we also mentioned in January, we’ll be providing our revenue outlook for Q2 on a GAAP basis and we’ll give the investment community direction on our TAC expectations to aid in this transition.

Turning to the quarterly results, free cash flow was $647 million in the first quarter. As we previewed with you on our January earnings call, in Q1 we received a $350 million payment from AT&T in connection with the renewal of our broadband partnership. Excluding this one-time item, our free cash flow for the quarter was $297 million, representing 69% of operating cash flow.

Our cash and marketable securities balance was $2.8 billion at quarter end. During the quarter, we repurchased approximately $79 million of our stock and invested approximately $166 million in two acquisitions, Maven Networks and FoxyTunes.

In addition to our cash and marketable securities balance, our equity interest in several entities provide incremental value. The value of our direct and indirect interest in the publicly traded securities of Yahoo! Japan, alibaba.com, and G-market were valued at approximately $13.8 billion in the public markets, or nearly $10 per share at quarter end. These figures include the value of the shares of alibaba.com held by Alibaba Group, of which we own 40%. These figures to not include estimates of the value of Alibaba Group’s other privately held businesses, such as Talbot, Ali Pay, and China Yahoo!, which we believe provide significant additional value.

As we outlined for you on our January earnings call, Alibaba Group took public a portion of its business to business subsidiary, alibaba.com, in late 2007. Alibaba Group reported a gain related to the IPO and we in turn recognized a gain proportionate to our 40% ownership stake in Alibaba Group.

As a reminder, we account for our ownership stake in Alibaba Group using the equity method of accounting on a one quarter lag. Included in our equity earnings line is a net gain of $401 million related to the alibaba.com IPO. This is a non-cash gain and had no impact on our operating results or cash flow.

One more important item from the balance sheet is that approximately $167 million of our $750 million convertible note issuance was converted into common stock during Q1. The remaining $583 million balance was converted into common stock at the notes maturity date in early April. As a reminder, because our convertible notes have been in the money for the past several years, the shares underlying the notes have been included in our diluted share count every quarter. The conversion of the notes will not have an incremental impact on our diluted share account.

Let’s now move to the P&L -- GAAP revenue was $1.818 billion in the first quarter, up 9% over Q1 2007. Revenue ex-TAC came in at $1.352 billion, advancing 14% year over year. These results exceeded the midpoint of our January revenue outlook ranges on both a GAAP and an ex-TAC basis. Acquisitions and exchange rates each contributed approximately 2% to ex-TAC growth.

In our marketing services business, first quarter GAAP revenue was $1.572 billion, up 7% over last year’s first quarter. As a reminder, during last year’s first quarter, we recognized search affiliate revenue from Yahoo! Japan on a gross basis and we also recorded the related TAC payments. As a result of our Q3 2007 sale of Overture Japan to Yahoo! Japan, we no longer recognize revenue under this model and instead recognize the net revenue for services provided to Yahoo! Japan. While this change reduced our GAAP marketing services revenue by approximately $110 million to $130 million on a year-over-year basis, it had only a minor impact on revenue ex-TAC.

Marketing services revenue ex-TAC was $1.107 billion, up 13% versus the prior year. Owned and operated marketing services revenue was up 15% over last year on a revenue ex-TAC basis with O&O search up 16% and O&O display up 15%. Our core marketing services business continues to grow faster than our overall growth rate and we are confident about the rest of the year. We also continue to expect this year’s investments to provide a strong base for growth in 2009 and 2010.

As we expected, revenue ex-TAC from the affiliate search business declined slightly in Q1. We anticipate that this business will be flat to slightly down on a year-over-year basis for the balance of 2008.

Within our marketing services business, some of the major categories, including auto, pharmaceuticals, telecom, and consumer packaged goods continued to report strong double-digit growth in Q1. As we indicated on our January call, we saw some softening in finance, travel, and retail -- areas that have been affected by recent economic trends.

Our diverse base of advertisers and industries has produced good overall growth and helps to offset cyclical weakness in different sectors. The Internet has evolved into a mainstream advertising vehicle since the last recession and industry dynamics are much different now. Advertisers’ budgets may fall but we believe the compelling ROI of online ads compared to other media may cushion the impact on our industry.

Now let’s look at fees revenue. We generated $245 million of fees revenue in the first quarter, up 21% from the same period last year. I would like to clarify a few points about the transition of our broadband partnerships. As we have outlined for you previously, our strategic relationships with AT&T and Rogers have been renewed to reflect the market environment in which ad revenue sharing is the prevailing economic model. On our January earnings call, we noted that we expect these renewals to have a negative impact on our revenue ex-TAC of between $150 million and $200 million in 2008 compared to our prior run-rate. This impact will consist of both higher TAC payments in our marketing services business and declining portal fees in the fees revenue line.

As I mentioned earlier, we received a $350 million payment from AT&T during the quarter as part of the restructuring of our broadband relationship. We will recognize this revenue over the four-year life of the contract. We expect the fee line in our P&L to be flat for 2008 with year-over-year declines in the back half.

While these headwinds will reduce our overall revenue growth in the first few years of the renewals, we believe that these strategic partnerships with key leaders in the broadband business offer large and growing advertising opportunities on both the PC and on mobile devices.

U.S. revenue ex-TAC increased 17% year over year. International revenue ex-TAC increased 7%.

We ended the quarter with approximately 13,800 employees, down from 14,300 at year-end. This includes approximately 600 new hires, offset by the impact of our strategic workforce realignment.

Turning to profitability, as I mentioned earlier, normalized operating cash flow, or OCF, was $476 million for a normalized OCF margin of 35%. OCF including the workforce realignment and Microsoft related costs came in at $433 million, resulting in OCF margins of 32%.

Our effective tax rate for the quarter was 39%. We continue to expect our effective tax rate for the year to be approximately 44% to 46%. We expect our cash tax rate for the year to be approximately 8% to 11%.

That brings me to our business outlook. As we indicated in our January call, this quarter we are transitioning to GAAP revenue outlook for our quarterly updates as we are increasingly measuring our business on this metric. We expect full year results in the following ranges: GAAP revenue of $7.2 billion to $8.0 billion; operating cash flow of $1.775 billion to $2.025 billion; free cash flow of $900 million to $1.050 billion, reflecting $675 million to $775 million of capital expenditures.

Our full year outlook excludes the impact of the strategic workforce realignment, costs associated with the Microsoft proposal, and the positive cash flow impact of the $350 million cash payment to us by AT&T.

For the second quarter, we anticipate GAAP revenue in the range of $1.730 billion to $1.930 billion. For the balance of 2008, we expect TAC as a percentage of GAAP revenue to be in line with our annual outlook, around 26%. We expect OCF for Q2 to be in the range of $425 million to $475 million. Our Q2 outlook excludes the impact of costs associated with the Microsoft proposal.

As we outlined in the investor presentation we released in March, we believe that 2008 will provide the operational and financial basis for accelerated growth and profitability in 2009 and beyond. We are executing strongly against that plan and we believe our expected long-term growth trajectory demonstrates the value of the Yahoo! franchise.

Now I would like to turn the call back over to Jerry.

Jerry Yang

Thanks, Blake. Let me conclude by emphasizing a few key points. First, we have the right strategy in place and it is beginning to bear fruit. Second, we are executing well, delivering strongly against our strategic plan even under extraordinary conditions. Third, the proof is in our numbers. Our results this quarter demonstrate that we are on the right track. And fourth and most importantly, we are totally committed to maximizing the value of this asset.

Before we open it up to Q&A, I would just like to remind you that today’s call is about our Q1 results so please direct your questions to the quarter, if possible. We’d be happy to answer some of those questions now. Operator.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of Youssef H. Squali with Jefferies & Company. Please proceed.

Youssef H. Squali - Jefferies & Co.

Thank you very much. Blake, in the long-term guidance that you gave back in March, what kind of economic environment did you bake in there? Would you characterize it as conservative or was it closer to a base case scenario? Because you are basically guiding to growth in the mid-20s for the next couple of years and that far outstrips the growth of the online ad market today. And clearly if you look at street estimates, they are a lot lower, implying a fair amount of skepticism. Thanks.

Blake J. Jorgensen

Thanks, Youssef, appreciate the question. As we said before, the midpoint of our guidance range reflects the best estimate of where we believe the business will perform in 2008 with the economic view that we have today, and certainly the economic view we had back when we set original guidance in January.

We’ve not changed our top line guidance. We’ve changed our bottom line guidance and we believe that the plan is forecasted on market growth rates and our projections for Yahoo!'s growth relative to those growth rates, and I think we spelled out the key components and metrics of all of those growth rates in the plan we showed, the three-year plan we showed the street last month.

Jerry Yang

Next question, please.

Operator

Your next question comes from the line of Jeffrey Lindsay with Sanford Bernstein. Please proceed.

Jeffrey Lindsay - Sanford C. Bernstein

We wanted to ask basically we’ve noticed that TAC is coming down as a percentage of gross revenues, especially internationally. Does that imply that you are now doing better deals on the network, or is it a slowdown or a shift in the network business? And if it is a slowdown, does that mean a loss of network business? Could you just give us an indication as to the dynamics here? Thank you.

Blake J. Jorgensen

Sure. Appreciate the question. Overall TAC rates decreased slightly around 4%. Our average TAC is still around 78% globally. We believe there is continued upward pressure on TAC rates and the rates that we will continue to pay our partners as the competitive dynamics continue to get more difficult.

As we build out our network display business, competitors are also building out a network display business and we expect that we will need to share some of those revenues. That said, we I think internally are very disciplined on the TAC rates that we are willing to pay and the partners that we are willing to go after, and so I think probably what you are seeing is more discipline in the system over time and focusing on really partners that can help drive the strategic alternatives that we are after.

Operator

Your next question comes from the line of Brian Pitz with Bank of America. Please proceed.

Brian Pitz - Bank of America

Could you provide any color on Right Media and the type of lift you are seeing in yield on your remnant? And also just second, unrelated, would you provide any additional color on the weakness you were seeing in the few categories that you mentioned. Is it regional in travel, et cetera? Thanks.

Susan L. Decker

I’ll take the first part of the question. We call our -- what you are referring to remnant inventory as non-guaranteed, or class two, as compared with our guaranteed inventory, or class one. Recall that last fall we talked about moving our on-network class two into Right Media and we’ve had a very successful migration of what runs on Yahoo! that is class two into Right Media.

We are seeing significant growth in revenue in class two, which includes the Yahoo! inventory and the Right Media exchange -- very strong growth in CPMs and impressions with revenues close to doubling in that category.

Blake J. Jorgensen

And on the second part of the question, we don’t break out the components by region. I do think we are seeing continued differences between search and display. Some of the stronger categories in search are also strong categories in display but I think also telecom and technology remain very strong on the display side where health and autos are shared both in terms of search, the pharmaceutical side of the equation.

Operator

Your next question comes from the line of Ross Sandler with RBC Capital Markets. Please proceed.

Ross Sandler - RBC Capital Markets

Sue, so you mentioned that the U.S. O&O yield improvement on search was up about 10% and you talked about just recently launching some new minimum bid features. Did those features have an impact in the 1Q number? And why -- I think on previous quarters, that O&O number was up closer to 20%. Any reason to be concerned there on the slowdown? Thanks.

Susan L. Decker

Sure. Just to restate the past versus the current, you have the numbers right. In our first few quarters of launching Panama, it was roughly 20%-ish. This quarter it was 10%. Remember we have now anniversaried the launch of Panama with this quarter, so we had tougher comparisons on the click yield improvements that we’ve seen in the past.

As I said in my comments, we are very pleased with where we stand competitively on click yield -- that is coverage times click-thru rate, and feel we’ve seen some nice gains and we continue to see some carry-on gains as implied in RPS this quarter, notwithstanding the anniversary.

Looking forward, the most important drivers will be a variety of different launches around building a more robust marketplace and driving PPC. And the MRP launch just happened last week, so there was no impact on the quarter. At this stage, it’s a limited number of keywords are being affected and just in the U.S., but we’ll be rolling it out to our other larger markets outside the U.S. later this year and to emerging markets most likely early next year.

So that is -- that is the most significant pricing related launch we’ve had. We have more to come but that is where you will see future growth in that variable coming from.

And on a global basis, the RPS gains were roughly 15%, which is consistent with what we had in the investor presentation as our long-term compound growth rate goal.

Operator

Your next question comes from the line of Mark Mahaney with Citigroup. Please proceed.

Mark S. Mahaney - Citigroup

I actually just wanted to ask a strategic question, and it had to do with the Asian assets. And during the call, you talked about the value of those. They have always consistently been a very large part of the value of Yahoo!. They may or may not have been part of the undervaluing of Yahoo!. Jerry, as you think more aggressively about strategic options, which you talked about earlier on, what are the hypothetical things you could do with those assets, particularly Alibaba and Yahoo! Japan?

Jerry Yang

Mark, we’re probably not going to be able to talk too much about all the different alternatives that we are thinking about, but suffice it to say that as we think about the strategic value of Yahoo! and what it means in a number of different transaction -- potential transactions, we certainly think the position that we’ve been able to achieve in China and in Japan are second to none and probably so unique that it won’t be able to be recreated in any other form.

So we think of that as a scarcity value. We also obviously continue to think about ways in which we can provide more transparency and visibility to what is going on in those assets, particularly in China there is a mix of public and private assets that probably isn’t as well understood as we would like it to be, so we’ll continue talking about those to our investors.

Operator

Your next question comes from the line of Christa Quarles with Thomas Weisel Partners. Please proceed.

Christa S. Quarles - Thomas Weisel Partners

Just a question on AMP; I was just wondering, how flexible is the architecture, such that you’d be able to embed with other ad networks easily, either in the case of partnering with other ad networks or even buying addition ad networks yourself? And then, how important is search going to be a component of the information derivation from AMP? So to the extent that -- you know, again I’m not going to ask about a Google partnership but to the extent that you would partner with somebody on search, how important would being able to sub-syndicate search into that publisher network be in terms of being able to be competitive on that front? Thanks.

Susan L. Decker

On the flexibility of AMP, a critical foundational tenant of AMP is that it is built on incorporating and integrating in the exchange, so any ad network that is fully open that connects to the exchange would have open participation with any of the inventory in that exchange, and we also have offered a number of publishers We Sell, You Sell over time. We can partner Yahoo! inventory as well, and certainly our class two is already in the exchange. So we certainly intend to be very open. That’s a critical strategic tenant and as long as other ad networks are opening, they connect to the exchange.

On the second question, in terms of the search component, AMP today is primarily a display platform. The roadmap includes integrating various forms of advertising sometimes considered search but really that runs on the same kind of inventory that display runs on we call content match today. We have an integration plan for that late this year, early next year and then over time plan to integrate. We see the worlds very much converging, which is why we recently integrated our sales force and channel effort as well.

So AMP is the first launch of a number of different launches that will be built on that same platform and over time, search will be integrated fully into that.

Operator

Your next question comes from the line of Imran Khan with JP Morgan. Please proceed.

Imran Khan - JP Morgan

Thank you for taking my questions. I’m trying to understand this quarter growth rate. International revenue growth was up 7%. Can you please remind us what are the one-time event and what would be the revenue growth excluding this one-time event?

And secondly, with regard to the Microsoft distraction, could you help us to understand how, what percentage your growth rate might have impacted because of the distraction, if customers are holding back their budget because of this uncertainty? Thank you.

Blake J. Jorgensen

Let me take the first part of the question and then Sue or Jerry might be able to address the second part. There was not a one-time event in international. You may be referring to the shift from Japan and moving the search business over there. Really what’s impacting the international growth is the continued pressure of affiliates. We had the same movement that we’ve seen in the U.S. occurring internationally where we are moving off of low quality affiliates and that drives down the overall GAAP revenue growth.

And we are just continuing to see strong, very strong growth on the display side internationally. That’s obviously been masked by the affiliate growth overall but I think you will see over time greater growth on the display side.

Jerry Yang

Imran, I don’t -- I think as we’ve said in our comments, I think our business continued to perform pretty robustly. We obviously are watching the economy a lot more than the Microsoft uncertainty. I would say we are pretty much keeping the eye on the ball and running the business and it’s hard to say if any impact, at all, from Microsoft. We think we had a really good quarter, both from a top line standpoint and certainly as you look at the growth rates in our core businesses of marketing services, we certainly ended up ahead of where we thought we would be.

Operator

Our next question comes from the line of James Mitchell with Goldman Sachs. Please proceed.

James Mitchell - Goldman Sachs

Thank you. This is a follow-up on a prior question; given your position straddling the display and search advertising markets, do you view the current U.S. economic weakness is only affecting the display business and not the search business, or is impacting the display and search business in different ways? And if the search business is completely immune, I’m just curious how you intend to sustain your search revenue growth rates once you lap Panama implementation in the international markets. Thank you.

Susan L. Decker

I would say that the categories that Blake talked about in his prepared comments, specifically financial, travel, and retail, are seeing the same weakness in search as in display. And when I say weakness, there are slower growth rates than they were, in some cases modest declines but we are seeing very strong growth in other categories, which has caused our overall growth rates to be double-digits in both forms of marketing services and very consistent with what we thought a few months ago.

So where we are seeing weakness in certain categories, we are seeing it across both industries. But as we’ve talked about in the past, we think that the Internet is evolving into a mainstream advertising vehicle and there are strong ROI components that are very measurable in both search and in display when you think about the tonnage buys in display, which are increasingly being sought after.

So moving to your second question, how do we sustain search revenue once Panama is launched internationally, we have a very significant opportunity in pricing, I think I mentioned that, and that’s on a global basis. And so we just launched MRP, this new -- which reduces and removes the minimum bid in certain keywords. We’ll be rolling that out internationally later this year, so every single launch we’ve had for Panama is global and so the timing isn’t always exactly coincident with the U.S. launch but the whole roadmap, which has a number of more initiatives on it is very much attributable to our international markets as well as the U.S.

And we’re seeing I think I said in my comments, 15%-plus RPS growth internationally as well.

Operator

Your next question comes from the line of Justin Post with Merrill Lynch. Please proceed.

Justin Post - Merrill Lynch

A question about search, which I think is pretty interesting on improving your cash flow situation -- where did you get that 60% to 70% estimate that was in your plan about the improvement factor there? And as you look at the quarter results, I don’t know if you guys look across the industry but do you think you are again gaining ground on a monetization front, or do you think you might have actually lost some ground this quarter?

And then Blake, maybe real quick, on the guidance raise for the year, was that due to some cost savings versus where you were at the beginning of the year or are there some other operational things going on that maybe helped you raise the bottom line for the year?

Susan L. Decker

Justin, I am not sure I know what you mean by the 60% to 70% improvement. I think if you are talking about -- I cited some stats about relevancy in my script from ComScore that I thought you might be speaking about. You may be talking about the RPS gap. If it’s that, we do a lot of crawling and testing of our competitors in search across each of the major variables. We also have information that comes back from bidding on deals and have a sense for what partner might be monetizing from one alternative versus another.

So there’s quite a number of inputs that go into that. We had measured that we thought the gap was close to 100% when we launched about 90% when we launched Panama. And based on both those instrumentation tests that we do and the results that are then reported, we feel pretty comfortable that in U.S. sponsored search, we have narrowed the gap by about 30% and there is about 60% to 70% remaining.

In Q1, I think it’s early to tell. We are just going through that process now. It’s a fairly involved process to understand all the components there. But we did see we think very strong growth in paid clicks in the U.S. versus the market and we also saw strong RPS gains.

Blake J. Jorgensen

Justin, on the cost side, we are indeed seeing cost savings, some of those based around activities we started last summer. As well, we had put together, I think as we made it clear in the January call, a very healthy investment plan to drive the growth of our three-year forecast. As we start to roll out that plan, we continue to readjust it and that in some cases is driving our cost down below what we originally forecast.

Jerry Yang

Could we get the last question, please?

Operator

Your last question comes from the line of Heath Terry with Credit Suisse. Please proceed.

Heath Terry - Credit Suisse

Thank you. Between AMP, the Google test, and the acquisitions that you’ve done, the focus really seems to be on monetization and price growth and getting more out of the inventory that you have. I was wondering if you could tell us what kind of ad inventory growth you are seeing, particularly in key verticals like finance, entertainment, auto, et cetera. And what’s being done to drive inventory growth on the display side?

Jerry Yang

I’ll start real quick and then Sue can jump in. I think it really is a -- as we describe it here, an ecosystem strategy. We need both great inventory and great monetization. I think there is a higher focus around monetization because it is -- we think it’s still very early, as Sue described it in the display market, a very nascent stage of efficiency, transparency, and I think our ability to buy across publishers and buy across mediums and certainly buy across formats.

But we have seen and continue to invest in inventory, both on our network and off our network. We have seen some robust growth in our own page views this quarter, especially in our Starting Points strategy but also in some key anchors, as we continue to be number one in some of the very key, like finance.

And we also see new categories, whether it’s in the -- some of our new launches around Shine and other sites to try to target our inventory for that more desirable demographics. That’s continuing.

So we do see both of those things as being important. Our long-term goal is, as we said in our three-year plan, has been to really drive 12% CAGR over the next three years, but all of our initiatives, a lot of them described by Sue, whether it’s Buzz or Flickr video, are all surrounding this inventory goal.

Okay, with that, I want to thank everybody for joining us and we’ll be talking to you all soon. Thank you.

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