Brian Bolan, research analyst at Jackson Securities, downgraded Yahoo (YHOO) following its earnings report Tuesday evening. Key excerpts from his note to clients:
Valuation and Recommendation:
We believe that investors will no longer afford a large multiple to a growth company that isn’t exhibiting all the signs that a normal growth company shows. The push back of Panama into the fourth quarter, lack of growth in registered users and the already high expectations for the second half of the year combine to make the idea of building a position Yahoo! a bad one at this time.
Project Panama, the code name for the improvement in search monetization has been delayed from the third quarter into the latter half of the fourth quarter. This is critical to the valuation of the stock, as many investors had expected this update to be available for the all important 4th quarter. As far as retail and other commerce goes, so goes the web and advertisers. Not having this product in place in the third quarter will make a positive earnings surprise in the fourth quarter a very slim possibility.
The potential for growing market share is no longer the positive catalyst we thought it could be.
Management noted on the conference call last night that “we do take comfort in is that the underlying core search product to consumers is doing so well and at least maintaining or, it looks like it was gaining slight share” relative to the industry as a whole.
We had hoped that there was a more significant share gain that could be exposed, but even mentioning the word “maintaining” decreases those chances.
First the good news
Yahoo! Answers showed strong growth and excellent momentum in its early stages. Users are asking questions ranging from mundane idiosyncrasies to some of the greatest questions of our time. Stephen Hawking and Bono have both helped stir this pot with the more active questions.
We were pleased with the expansion of the mobile efforts with the strategic partnership with Hutchison 3 Group, a global mobile broadband operator. This is a very positive development in a segment we believe will be key to Yahoo! and all internet companies in the coming 2-3 years.
Graphic advertisements seems to be gaining traction with advertisers and the volume growth in this medium is looking to grow at 20% or more in the coming quarter. Yahoo! also noted that of the top 200 advertisers in their network, graphic advertisements are likely to grown between 35%-40%. This
implies a good amount of growth from a developing business line.
Earnings met our expectations of $0.11 per share, but revenue was just slightly below our estimate of $1.13B. Following press releases that the World Cup had generated extra traffic to Yahoo!, most investors had expected the company to beat the top line.
Other areas of concern were the high level of expense in the quarter, including a sales and marketing number that grew 33% from the year ago period. With the expense of stock options, investors are getting a better picture of how companies are rewarding their employees. Yahoo! noted on their conference call that rewarding their employees with stock options was yielding positive results and efficiency gains. The company spent $100M on stock based employee compensation in the quarter, or roughly $9,500 per employee.
Click fraud continues to wreak havoc on search engines and Yahoo! is no exception. On the conference call yesterday, CEO Terry Semel stated that Yahoo! believed they had the best click fraud prevention practice in the business. This is a major claim, and likely to draw the ire of those who purport this less than legal practice.
Recent reports that we have seen are putting the number of fraudulent clicks at about 14% of all clicked advertisements. We believe that this number is very close to the true number, but it is very difficult to come to the actual number. Over time, the chances of click fraud growing seem to outweigh the chances of click fraud fading off into the sunset. We believe that this problem will persist and that even though its an industry wide issue, Yahoo! will likely bear the brunt of headline risk for the foreseeable future.
New Risks and former Catalysts
Certainly new risks include concentrated efforts by fraudulent clickers to show up the company that stated they had the best click fraud detection and prevention. This could cost the company more than just revenue, but respect and ultimately customers. We believe that brash statements like that will not be rewarded by investors, but rather find their ways into the ears of the less scrupulous.
The delay in the search monetization upgrade is one of the main reasons for the downgrade, but it also carries with it a significant future risk as well. Further delays would be met with severe multiple retraction and subsequent decline in the share price.
With search not performing as well as we hoped, there is a chance that Google might have taken even more share from Yahoo!. We will get a better grasp on that idea tomorrow when Google reports its earnings. The delay in the upgrade from Yahoo! will also serve to weaken its competitive position in the struggle of #1 vs. #2 in the search space.
The lack of growth from registered users is an ominous sign. Growth companies that aren’t exhibiting growth will undoubtedly lose growth investors. As we saw with eBay in early 2005 when the growth had stalled, shares dropped, and did so by a large amount. We note that there is a large gap between where growth investors decide to sell and value investors begin to buy.
These days, investors tend to shoot first and ask questions later. The is evidenced in the fact that the stock sold off some 14% in the after hours market following the earnings release even though the company made the consensus earnings estimate and issued inline guidance for the third and fourth quarters of this year.
At this time, we are not making any changes to our year end earnings estimate of $0.53 per share. That said, we believe that the market will no longer afford such a large multiple for share of Yahoo! and we are cutting our target price from $37 to $33, as we believe a more tempered multiple of 62x this years earnings is warranted.
We believe that investors will no longer afford a large multiple to a growth company that isn’t exhibiting all the signs that a normal growth company shows. The push back of Panama into the fourth quarter, lack of growth in registered users and the already high expectations for the second half of the year combine to make the idea of building a position Yahoo! a bad one at this time. We recommend investors HOLD shares of Yahoo!.