Analyzing Yahoo's First Quarter Results - Conference Call 101

The best way to approach an analysis of conference calls and accompanying financial slides is to think like a magician. Remember the TV show where the magician gave away all the secrets to the illusions? It wasn’t what you saw that was important; it was what you didn’t see.

Therefore, it’s not important what they say on the call or what’s on the slides. It’s what they didn’t say. It’s what’s not on the slides.

YAHOO 1Q08 CONFERENCE CALL – Jerry Yang

The call starts off in the proper format. Jerry explains some general points about the business and the quarter. I will talk about a couple of them.

We are raising cash flow guidance for the year. That’s great, but the company is not raising revenue guidance, so that means it is cutting some expenses, about $50 million. Increase in cash flow guidance is roughly 2.5%.

Have scale we need for our plans to substantially grow revenue. However, the company is not raising guidance on revenue, and Q1 revenue fell from the previous quarter. Q2 projection is flat with Q1 (Q2 midpoint estimate of $1,830B vs. Q1 result of $1,817B). To hit midpoint of annual projections, it needs to grow to $4.6B for the year, which means it needs about an 18% increase in revenue in the third quarter followed by another additional 18% quarter over quarter increase in revenue in the fourth quarter. The company did not discuss how that growth will be achieved in those quarters.

Microsoft (MSFT) offer – Board determined that offer under-valued Yahoo. The Board decided to reject the offer. Open to all alternatives including sale to Microsoft to maximize stockholder value.

Going to lead and differentiate products… differentiating offerings… close the gap in search (assumedly against Google (GOOG)), making progress against 3 year plan, continue to innovate and differentiate.

Results remarkable because of economic environment and uncertainties from the Microsoft unsolicited proposal.

CONFERENCE CALL – Sue Decker

Sue talked a lot about the various business platforms and applications and some growth projections. Again, I will only mention a few items.

Progress in Q1 – narrowing starting points to make them the best on the web, opening starting points to third party services/developers, facilitating social connections over Yahoo properties. The company is limiting the focus ,which saves it money. It will then be allowing third parties to take advantage of Yahoo’s customer base, presumably on some revenue sharing basis. We don’t know how this will affect the financials because we don’t know how much cost will be saved and/or how much revenue will be produced.

Goal is to increase search revenues by 10% compounded growth per year over the next three years. That’s about a little over 2% growth per quarter.

In the first quarter we approached that long term goal on a global basis and exceeded it in the US. Interesting, there are no projections in the slides related to search growth either in the US or abroad. I would have liked to see some projections for the next few quarters. There was no breakdown for last quarter.

Search Assist, Open Search (“Search Monkey”), and Mobile Search will help customers search better and faster. Poll says making gains in customer satisfaction, brand impact and several other measures. Tells you nothing of how it estimates these new tools will increase revenues.

Targeting 12% per year of growth inventory in non-search, such as advertising display and video. In the first quarter it exceeded that goal. This would be a 3% increase for that quarter.

Trying to attract new users through social connections. For example through BUZZ, launched in February. Sounds pretty labor intensive because she said that editors review the articles that come from various publishers and choose articles that have the most BUZZ.

FlickR now offers video uploads and has grown 400%. Sounds like a competitor to YouTube, but she didn’t give me any numbers. Was that 400% increase from 100 to 400 or 10 million to 40 million?

We will soon allow customers to customize their home page, content optimization. To tell you the truth, didn’t Yahoo do that a couple of times already? There is an ongoing debate on whether the home page should be simple and clean like Google’s home page with drop down menus or customizable like Yahoo’s. You decide, but they better make it easy. I know a lot of people who complained last time it was changed.

Trying to grow search yield- grew ONO RPS by 10% last quarter and ONO GAAP revenue by 20% last quarter. She later admits that this rate of growth will slow on a year over year basis. Because of the roll out of Panama last year, the comparisons will be more difficult.

Targeting 15% growth per year on RPS. First quarter consistent with that goal. That would be a 3.75% growth for the quarter. Compare that with Google’s growth rates to see how good that rate of growth is. A couple of the analysts thought this growth rate was not sustainable.

Outsourcing – value in search and display, narrowed the monetization gap, but may outsource to Google, but wants to still be a significant player in search. Translation – the company doesn't know what it is going to do.

AMP should help us increase revenue. That is probably a good strategy, but won’t roll out until third quarter, so results from AMP are probably only going to show significant impact next year. Maybe the company believes it will get those 18% revenue gains in the third and fourth quarter from AMP. That’s possible.

Pleased with revenue and cash flow growth. That’s funny, the slides show that revenue declined quarter to quarter by 1%, and operating cash flow declined 18% quarter to quarter. Revenue grew 9% year over year for the first quarter and operating cash flow declined 6% year over year.

CONFERENCE CALL – Blake Jorgensen

To understand his presentation or the slides, you need to understand the difference between revenue and revenue ex-TAC. Revenue includes all the revenue that comes into Yahoo. Revenue ex-TAC is all the revenue less amounts Yahoo pays others for traffic acquisition costs [“TAC”]. Think of it as revenue sharing. An independent site drives its traffic to Yahoo. Yahoo receives revenue from that traffic, but also must pay the site for that traffic.

So the accounting question is which revenue figure is more relevant? The answer is – it depends. Overall revenue growth would be an important number to gauge how the whole market is doing for Yahoo branded services. On the other hand, one could argue that these deals are more like revenue sharing deals and the partners’ share of revenue should not be reported by Yahoo – making revenue ex-TAC the most important.

If you use revenue ex-TAC, you need to monitor whether and to what extent your traffic acquisition costs are increasing. Why? Well, as you grow through affiliates or partnerships, you can count on your partners wanting a bigger and bigger piece of the pie, especially if they are very successful driving your revenues. You also need to monitor TAC rates if you are going to rely on additional affiliates/partnerships for growth. You see, increasing TAC rates (or the percentage of revenue you have to share with the affiliates/partners) affect new business, but they also affect your old business. The older business may want a better deal too.

In addition, TAC rates can increase because of competition. If you have a competitor that is more efficient or more automated, or just has a lower cost model, then that competitor may offer a higher share to the affiliate/partner (i.e., a higher TAC) for that traffic. So you can’t just look at revenue-exTAC in a vacuum. You need to keep an eye on how TAC is increasing.

You also must be careful in year to year or quarter to quarter comparisons. You need to compare apples to apple and oranges to oranges. You need to compare revenue to revenue; TAC to TAC; and revenue ex-TAC to revenue ex-TAC.

Now to Blake’s comments.

Revenue ex-TAC was up 14% year over year for the quarter and operating cash flow was at a normalized $476 million. Hold on! Read that again. Did you catch that one? Revenue ex-TAC, which is revenue after deducting traffic acquisition costs, was up 14%. Actual overall revenue was up less than 9% (8.73%). But that’s not my point.

He compares a percentage increase in Revenue ex-TAC with an absolute dollar amount of operating cash flow, interesting. Why did he do it that way? Let’s switch that around. Revenue ex-TAC was up $169 million and operating cash flow increased by 3.5% on a normalized basis year over year for the quarter. Doesn’t sound near as good, does it? Oh, and actual operating cash flow actually dropped from $460 to $433 million, for a decline of 5.8% year over year for the quarter and a decline of 18% from last quarter. Geez, that sounds even worse. But the company added back $43 million of cash expenses paid for outside advisors related to the Microsoft proposal and workforce realignment because these cash expenses were not “normal”. Ok, well it will probably be more “normal” in Q2 and maybe Q3 now.

Now, none of these numbers are wrong. He wasn’t wrong, but it gives the wrong impression of how the company is doing, at least to someone who is listening to the conference call and not forensically examining the financials.

As we expected and consistent with our discussions with the investment community, Revenue ex-TAC in our core business grew approximately 18% in Q1. That is actually shown on slide #4, but it is labeled revenue not revenue ex-TAC. Maybe he just made a mistake and wanted to say revenue. He already said revenue ex-TAC grew by 14%. The 18% growth rate relates to revenue for the core business year over year for the quarter. However, it decreased 7% from Q4 to Q1. Remember what I said earlier about comparing apples to apples and how it gets confusing.

Our affiliate search business reduced growth rates in Q1 because of ongoing network quality initiatives and rising TAC rates. Wait, did you miss that? 18% growth is pretty good, but the affiliate search business reduced that growth. Let’s look at that closer. Revenue from the core business grew at 18% for the quarter, but overall Revenue increased 9% on a year over year basis. What is he trying to tell us? Tell me more about the quality issues and the TAC rates. How did that negatively affect affiliate search? Sure, the affiliate revenue fell on a year over year basis from $649 million to $606 million, but it increased on a quarter to quarter basis from $554 million last quarter.

How about putting some numbers on that loss related to revenue groups? What’s the real problem? Is it quality initiatives? How high did TAC increase? If your traffic acquisition costs are increasing that rapidly, why not discuss the causes and solutions. Isn’t that a concept that your shareholders want to know?

The top half of the slide shows the revenue by revenue group and the bottom half shows revenue ex-TAC by geographical location. Not the apples to apples comparison I would like to see. It makes it difficult to compare revenue and revenue ex-TAC. If you look at the Reconciliation in Table 1, you will find the revenue, TAC and revenue ex-TAC calculations by geographic location. TAC has increased substantially from about 19.5 % (pretty consistent over the past four quarters) to 21.3% of GAAP revenue in the US for Q1. For International, TAC has fallen from the mid 40% range to the mid 30% range over the past year. As the TAC rate has fallen, so has the International GAAP revenue.

What don’t we see? We don’t see a schedule reconciling revenue, TAC and revenue ex-TAC by revenue groups. That is what I think may be even more interesting. You can calculate it from all the information; it’s about 77% and going higher.

So at this point in the call, what are the conclusions? Contrary to the optimism on the call, it appears that revenue is falling at the same time that affiliates are demanding a much greater share of the revenue. It’s not good when a business runs into decreasing revenue and declining margins, especially if it has a high cost structure.

Our underlying marketing services business continues to grow at very healthy rates. On a revenue basis? On a revenue ex-TAC basis? On a net basis? How would we know, you did not provide a reconciliation based on group volume other than revenue. And on a revenue basis, it grew about 7% from Q1 of the prior year, but has declined from the prior quarter by about 1%.

We are reaffirming our 2008 revenue outlook and increasing our operating cash flow and free cash flow outlook today. That sounds nice. The company is increasing both operating cash flow and free cash flow projections for 2008 by about $50 million. In 2007, it had approximately $1,927 million in operating cash flow. It is projecting $1,900 million for 2008 (the midpoint of their projection range). That is basically a flat projection for the year. So that is two years of stagnant operating cash flow. It fell substantially from last quarter.

But more importantly, operating cash flow as a percent of revenue ex-TAC fell from 39% in Q3 2007 to 38% in Q4 2007 to 32% in Q1 2008 (a 15.7% decline quarter to quarter). So not only are TAC rates squeezing margins on the revenue side, but operating cash flow is falling as a percentage of revenue ex-TAC, which means that other costs are increasing also.

In 2007, the company had free cash flow of $1,337, and is projecting fee cash flow of $975 million for 2008. WHAT? You just reported fee cash flow of $647 million for Q1. That included a payment of $350 million from AT&T (T) (see discussion later). Does that mean that it will only have free cash flow of approximately $328 million, or does it intend to exclude the $350 million?

If the company excludes it, it is projecting about $678 million for the last three quarters of 2008 or about $226 million a quarter. This would, at a minimum, imply an average decline in free cash flow of 27%-31% for the last three quarters of 2008.

If it doesn't exclude it, it is looking at declines of free cash flow exceeding 60%.

The company did not discuss why it projects such a sharp drop off in free cash flow. Does it plan large property or equipment purchases or other acquisitions? Yes, see slide 10 and Table 3, it is projecting $725 million in capital expenditures. It spent $139.8 million in the first quarter and projects another $585.2 million for the rest of the year. That would be an increase in capital expenditures of $123 million or about 20% over its 2007 expenditures.

That still doesn’t account for the$362 million drop off of free cash flow, especially considering that it is projecting flat operating cash flow for the year.

We are increasingly managing our business around GAAP revenue because we view it as a better measure of our advertising reach than revenue ex-TAC. We will be providing our revenue outlook for Q2 on a GAAP basis and will give the investment community direction on our TAC expectations to aid in this transition. A better measure of your advertising reach? That is the reason? Sorry, not buying that one. You should be managing all aspects of your revenue and expenses, and providing data on revenue, TAC, revenue ex-TAC on an ongoing basis. Also, how about sharing your TAC expectations with your shareholders rather than just the investment community.

I am wondering if the company really can’t control or project its TAC rates because of its competitive environment, changing TAC rate trends, and changing business model.

Equity interests in several entities – Yahoo (Japan), Alibaba, Gmarket with an approximate value (direct and indirect interests) of 13.8 billion or $10 a share at the end of Q1. This includes the value of alibaba.com held by Alibaba Group which is 40% owned by Yahoo, but it does not include the value of other “privately held” businesses owned by Alibaba Group, such as China Yahoo, Taobao and Alipay. Yahoo recognized a gain from the IPO of alibaba.com of $400 million under the equity method. BINGO – and here is the reason people are really interested in Yahoo. So let’s assume that these other interests are illiquid but probably worth another 6 billion. So together, Yahoo’s interests in Asia are worth roughly $19.8 billion or about $14 a share, and probably more valuable because of the size of the potential markets. How does Yahoo unlock this value for shareholders? That is a difficult thing to do if you are trying to build a worldwide organization, rather than simply selling off the parts.

Discusses specific amounts related to the P&L which we already discussed and were included in the slides. He also discussed some of the amounts for items not on the slides, such as some of the revenue ex-TAC amounts by revenue group. He generally only compares the financial results of Q1 2008 with the results for Q1 2007. For the most part, all the various categories showed increased performance on that basis. He did not, however, explain why the same categories declined from Q4 2007 to Q1 2008 or why it’s going to turn around.

Revenue from affiliate business will be flat or down for the year. Yes, we already figured that one out.

In marketing services, auto, pharmaceuticals, telecom and consumer packaged goods have double digit growth in Q1, but there is softening in finance travel and retail. Here again, what is the base for that double digit percentage growth. These seem to be a lot less significant than the finance, travel and retail platforms. I am betting the absolute dollar losses in finance, travel and retail dwarf the gains in the other categories. Give me consistent numbers, not percentages to compare.

Ad budgets may fall this year but we believe the compelling ROI on online ads compared to other media may cushion the impact on Yahoo. What is this conclusion based on? Do the results in Q2 bear this out thus far? Give me something more than just generic unsupported theories.

AT&T and Rogers Communications (RCI) relationships renewed, based on ad revenue sharing as the prevailing model. We expect these renewals to have a negative impact on revenue ex-TAC of about 150-200 million in 2008 from higher TAC payments and declining portal fees. We received $350 million form AT&T as part of the restructuring of our relationship and will recognize it over the four years of the contract. Fees will be flat with year over year declines in second half of year. So the AT&T deal adds about $87.5 million of fees each year, but is offset by increased TAC and lower affiliate payments by about $150-$175 million (I am assuming that the Rogers deal is similar and accounts for the other $25-$50 million). This is what I discussed earlier – the more successful your relationships with partners become, the more money they want. Yahoo believes that it can make up the deficit by increased ad opportunities on the desktop and mobile. Ok, I hope it can.

US revenue ex-TAC increased 17% year over year and International revenue ex-TAC increased 7%. He then actually repeats a summary of some of the financial results he had already discussed earlier. He keeps emphasizing year over year gains but doesn’t give any explanation of why the various categories have declined from the previous quarter.

CONFERENCE CALL - Jerry Yang Conclusion

Right strategy. Executing well. On the right track. Committed to maximizing assets.

CONFERENCE CALL - QUESTIONS (not all of them, just some significant ones)

Question from Jefferies – how can you project 20% growth rates for online ads when that’s not what we are seeing in the industry? --- Answer – basically that is our estimate.

Question from Sanford Bernstein – TAC coming down as percentage of gross revenue internationally? Answer – average TAC 78%, continued upward pressure on TAC rates as competition intensifies. Seeing more discipline overseas in selecting partners and fixing TAC rates.

Question by RBC Capital Markets – US owned and operated sites search revenues were up 10%, but were up about 20% in prior quarters – does this show a slowdown?

Answer – In the earlier quarters, we had just launched Panama and they were being compared with other quarters when we had not rolled out Panama. This quarter it is a tougher comparison because we were using Panama in the prior year. Long term growth rate goal is 15% for RPS (rate per search).

Question by Citigroup - Asian assets have large value – what could you do with those assets, particularly Alibaba and Yahoo (Japan)? Answer – Our Asian positions are unique and can’t be recreated. We want to provide more visibility on those assets with the investment community so they can understand the value...

Question by Thomas Weisal Partners - – How easy is it to use AMP with other ad networks? How important would it be to include search into AMP? Answer - Flexibility of AMP – any ad network connected with the exchange can be included in the exchange. AMP is primarily a display ad platform. We will integrate some types of search (those with inventory) sooner, but over time search will be included.

Question by JP Morgan – Are Microsoft distractions affecting ad sales – are customers holding back ad budgets because of uncertainty? Answer – Jerry – We are watching the economy more. It’s hard to say if there was any impact from Microsoft. We ended up ahead of where we thought we would be.

Question by Goldman Sachs – Given your position straddling the search and display ad business, do you think the current economic weakness is only negatively affecting the display business and not the search business? If the search business is completely immune, I am curious how you intend to maintain your search revenue growth rates once you have implemented Panama in the International markets? Answer – We are seeing weakness in financial, travel and retail categories in both search and display, but we are seeing growth in other categories. But we see the Internet as evolving into a mainstream advertising vehicle. On your second question, we have significant opportunity in pricing, we are removing minimum pricing. We are seeing 15% growth internationally as well.

Ok, this was the best question asked. Kudos to Goldman. It’s also the worst answer by management.

My Conclusions

Yahoo faces a tough year ahead. It is basically predicting a flat year for revenue growth and operating cash flow. It is predicting a substantial decline in free cash flow from the prior year, partly because of increased capital investments.

Yahoo is still behind Google in search but is making efforts to catch them. It has some bright spots – Panama will increase search revenue in the near term and the roll out of AMP in the third quarter, although too late to really affect this years results, all a step in the right direction. It may be very difficult for the company to maintain its goal of 15% growth in search in a market dripping with competition. It is not the low cost producer and it will need to become more automated and efficient to continue to vie for any type of long term leadership in search.

The company faces very difficult obstacles. First, its affiliates and other partners are demanding a greater percentage of revenues from their revenue sharing agreements, driving up traffic acquisition costs substantially and driving down fee revenue. AT&T, for example, restructured their relationship with Yahoo, costing Yahoo about $150 million a year. Yahoo received a payment of $350 million for the restructuring, but it amounts to only $87.5 million a year.

Yahoo's SGA expenses are way too high. It is competing more and more in a declining margin business, and can’t hope to be successful with SGA expenses that look out of control. It needs to review and reduce those expenses substantially.

The economic weakness will begin to affect its business, and it has not accounted for that in future projections or plans. This could prove to be a big misstep. There are not unlimited ad budgets. You can’t assume that advertising will grow and grow without being negatively affected by economic conditions. There are not unlimited ad funds. Furthermore, to hit its financial targets, the company is counting on substantial growth in the third and fourth quarters.

Yahoo is competing in many categories on the Internet - owned and operated sites, affiliate sites, broadband partnerships and is now encouraging developers to develop applications on top of their sites. It is competing in display ads, search and now mobile too. It doesn’t appear to me that the company has an overall integrated strategy. Rather, it acquires businesses and develops applications that look tempting, but can’t maximize their separate value, let alone maximize their value in an integrated offering.

Much of this is caused by the fast moving pace of the ad search business and the more concentrated focus of competitors like Google. Yahoo needs to develop a well thought out integrated strategy and communicate it to the investors. It needs to start developing some of its own ideas, rather than only trying to duplicate the success of others.

It should be more open with the investment community. When the company only emphasizes its year over year results without explaining its quarter over quarter declining performance, it appears that it is either trying to hide something that is weighing on their business or the company doesn’t know what is weighing on their business. In either case, it does not give investors confidence in your projections or your management abilities.

Now, some good points. The Asian assets have a substantial value that should increase substantially. It wants to provide better visibility regarding the value of the assets to the company. That’s great, but your main business may run into substantial issues before that occurs. In addition, those assets could also fall in value, so it may be wise to start thinking about how to monetize some of those assets now.

Panama and AMP may make you more competitive in search, and Yahoo should focus on implementing them as soon as possible. I think it needs to hold off on more acquisitions. It needs to focus on making existing applications better. You can’t own the entire Internet!

You own the best brand on the web. You were here before Google. Act like it. Act like an innovator, not a follower.

Disclosure: No Position

Comments

[Talk is Cheap:]

This is very interesting analysis. I am in an MBA program and am learning Earnings Management in my Financial Statement Analysis class but this is Earnings Call Management.
Looks like the stock is holding up merely on speculation.

2008 May 14 01:05 PM

[John from C...:]

thanks for the info. pretty interesting

2008 May 14 04:33 PM