1Q Results to Support Shares; Reiterate Buy
• We continue to rate shares of YHOO Buy with a $42 target price. Our target price equates to a market capitalization of $55 billion after netting out the value of Yahoo! Japan. Also, on an EV/ unlevered FCF basis our target valuation equates to 40x our 2007 estimate.
• Yahoo!'s 1Q06 revenue was mostly in line with our expectation at $1,088 million ex-TAC. Cash EPS of $0.15 was in line with our estimate of $0.15.
• Active registers users advanced to 208 million users, up from 193 million last quarter, with 3.8 billion average daily page views. Unique users increased to 402 million up 27% YOY, while total fee paying customers now number 13.3 million, up from roughly 12.6 million in 4Q05.
• Management's 2006 free cash flow guidance is for a range of $1.4 billion to $1.55 billion. We expect free cash flow of above $1.5 billion in 2006.
• For 2Q06, we estimate revenues of $1.2 billion, with EBITDA of $486 million and GAAP EPS of $0.13. Our full year 2006 EPS estimate is unchanged at $0.55.
Yahoo! reported a solid, inline quarter that we believe will provide support for the shares as the company builds toward a very strong calendar 2007. In our view, Yahoo! shares are a core holding for investors in the media category (online or traditional) and we would be opportunistic buyers of the shares with a focus on operating outperformance occurring with the changed search tools, online video, classifieds/local, and general improvements in monetization of the content platform. Along those lines, year-over-year metrics which we found to be particularly relevant to a long-term owner of Yahoo! shares include unique users of 402 million up by 27%, registered users of 208 million up by 23%, 13.3 million unique paying relationships up 49%, page views of 3.8 billion per day up by 24%, U.S search query growth up between 15%-20%, revenue per page view up by 10%.
The case for ownership in Yahoo! from our standpoint has been focused around a very strong management team confronting a huge market opportunity, with recent entry points available to investors of 30% off peak valuations. We believe Yahoo! has the capacity to exceed the market value afforded the largest traditional media companies over the next several years (3-to-5). Today, still less than 4% of advertising dollars are spent on the Internet while 15% of discretionary time is spent on the Internet. The global advertising market is estimated to range between $600 billion and $800 billion. We believe Yahoo! (and Google) are uniquely positioned to benefit from the transition of advertising budgets toward the Internet. The question for us has always been about the timing of the transition and how quickly Internet media companies could monetize their respective platforms. While we try to be conservative with our own guess, we do believe both the 4% and the 15% will increase over time. One metric that we track to monitor the general monetization improvements of Yahoo! model is revenue per average unique user per month which was reported at $0.95 in 1Q06, up by 8% from 1Q05. We believe the search monetization improvements will be a driver of revenue-to-user metrics beginning early in 2007.
We expect Yahoo! shares to settle in the mid-$30s following a quarter in which expectations were low from investors. For the shares to trade above the mid-$30s in the near term, we believe investors need to become more comfortable with the next phases of monetization – search, video, and local. We note that the company will discuss search improvements in detail at the analyst day of May 17, a possible catalyst for the shares dependent on the takeaways.
Yahoo! reported first quarter 2006 revenue of $1,567 million, or $1,088 million (excluding normalized TAC) and $0.11 per diluted share (including stock comp expense). This compares to our estimates of $1,067 million in revenue and $0.11 EPS for the quarter. Total revenue for the quarter was up by 34% year-over-year. Gross profit was $909 million with DSO of 44.
Revenue (excluding TAC) per unique user per month was $0.95 during 1Q06, up 8% from the year-ago period, and down 5% over last quarter. U.S. revenue ex-TAC improved to $826.7 million for the quarter, growth of 34% over last year with gross profit of $682.4 million. International revenues ex-TAC grew to $261 million for the quarter and jumped 29% year/year, and contributed approximately 24% of revenue ex-TAC. Active registers users, the most revenue productive segment, advanced to 208 million users, up from 193 million last quarter, with 3.8 billion average daily page views. Yahoo! ended the quarter with approximately 402 million unique users, up from approximately 365 million this quarter last year. Starting in 2Q06, Yahoo! will begin to report user numbers that reflect Yahoo!'s global reach including users of Yahoo! China and Yahoo! Japan. Total fee paying customers now number 13.3 million, up from roughly 12.6 million in 4Q05. Management expects to grow paid relationships to 16 million by year end and believe they are on track to exceed that target. Further management expects to produce ARPU of $3 to $4 per month.
Free cash flow for 1Q06 was $343 million with trailing 12-months free cash flow of roughly $1.32 billion. Operating income for the quarter was $201 million with operating cash flow of $445 million. In addition, Yahoo! generated $88 million from the issuance of common stock as a result of the exercise of employee stock options, and a net $22 million from structured stock repurchase transactions. These increases were offset by $639 million used for direct stock repurchases. Cash, cash equivalents and marketable debt securities were $3,833 million at March 31 2006, down about $167 million from last quarter. Stock repurchases in aggregate totaled almost $750 million in the quarter representing 22 million shares at an average price of under $34. Management noted that the company's interest in Yahoo! Japan is currently valued at $12.4 billion.
Marketing Services revenues totaled $1.38 billion during 1Q06, or $902 million ex-TAC, a 34% increase from the same period last year and a 2% increase over last quarter, due to strong contributions from advertising. U.S. search queries grew about 15% to 20% year-over-year.
Fees revenue for the quarter was $186.2 million, a 25% increase compared to the same period last year, and below our estimate of $193.6 million. The primary growth driver was the number of paying relationships for Yahoo!'s premium services, which were approximately 13.3 million through 1Q06, compared to approximately 8.9 million at 1Q05 and 12.6 million at the end of last quarter. Management continues to expect these relationships to produce an average revenue per user per month of $3 to $4.
For 2Q06, we estimate revenues of $1.117 billion, with EBITDA of $486 million and EPS of $0.13. Our full year 2006 EPS estimate is unchanged at $0.55. We project EBITDA margins of 43.5% and 42.3% and gross profit margins of 87.6% and 87.6% for 2Q06 and full year 2006, respectively.
Management gave guidance for 2Q06 revenue excluding traffic acquisition costs (TAC) of $1,080 million - $1,160 million, and gross profit is expected to range between $895 million and $965 million with operating income before D&A between $415 million and $455 million. Yahoo!s full year 2006 revenue ex-TAC expectations are $4.6 billion to $4.85 billion (unchanged from previous guidance), with operating income before D&A in the range of $1.915 billion to $2.06 billion. These projections incorporate the termination of the MSN deal, expected to end in mid 2006. Management anticipates generating free cash flow in the range of $1.4 billion to $1.55 billion in 2006. This outlook contemplates capital spending of approximately $525 million to $625 million, representing 27% to 30% of OCF.
Valuation & Conclusion
We rate YHOO shares Buy. We believe Yahoo! should generate more than $1.9 billion in free cash flow in 2007. On a tax-adjusted basis, the multiple of unlevered free cash at our target price equates to 40x. On an EV/EBITDA basis, our target price equates to 18x our 2007 EBITDA estimate of approximately $2.6 billion.