Yahoo's Fundamentals Are Deteriorating

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Includes: AABA, GOOG
by: Jonathan Liss

JPMorgan analysts Imran Khan, Joseph Okleberry, Dana Maynard Gray and Vasily Karasyov sent a note to clients breaking down Yahoo's (YHOO) recent quarterly earnings report. They maintain a 'neutral' rating for Yahoo based on what they believe are deteriorating core business fundamentals at the company. Excerpts follow:

Weak Graphical Segment Drives Miss

Aside from the promise of Project Panama, we believe Yahoo!’s core business fundamentals are deteriorating. As such, we are reducing our estimates and reiterating our Neutral rating.

Graphical Ad Weakness to Continue. Yahoo’s graphical ad business grew ~30% in 3Q (from ~39% in 2Q). Consistent with our thesis, we believe newly addressable page view inventory may lead to CPM pressure and in-line industry growth. Consequently, we are lowering our F’07 growth assumption to 24% from 27%.

RPS Declines May Suggest Poor Traffic Quality. 3Q gross search revenues grew ~15% due to RPS declines and the loss of MSN. Yahoo! guided for 4Q growth of only ~5% and suggested further RPS weakness. We are concerned by RPS declines as they may indicate that advertisers’ ROIs are deteriorating.

Project Panama on Track. Yahoo! launched phase I of Panama yesterday and remains committed to on-schedule launch of Phase II. However, we believe financial upside is still 2+ quarters away.

Int’l TAC growth augurs well for Google. Google’s (NASDAQ:GOOG) greater exposure to the int’l market, combined with our belief Yahoo!’s US TAC weakness was company-specific means we remain bullish on Google going into its 3Q announcement Thursday. On an EV/EBITDA basis, Yahoo! trades at 11.4x our F’07 estimate of $2.2B vs. its peers at 15.0x F’07 estimates. Given our concerns about the graphical segment, we reiterate our Neutral rating.

Graphical Advertising Growth Continues To Slow

Growth in graphical advertising slowed, with Yahoo! reporting 30-35% growth (we estimate 31%) in branded advertising in 3Q from their top 200 advertisers, a decrease from past quarters when this segment grew at a 35-40% clip. Beyond the weakness in the automotive and financial services verticals reported earlier, executives suggested they were seeing advertisers spend “less than ... initially expected” in several verticals, particularly among advertisers and industries in economically sensitive categories. More broadly, the company spoke of an evolving marketplace for online advertising. As we have previously noted, we believe an increase in addressable available inventory may pressure CPM pricing growth as advertisers are now in a more advantageous negotiating position, and we expect this trend to continue.

Search Fundamentals Deteriorating

According to our estimates, Yahoo! grew its gross search revenues by 15% in 3Q, down from 25% last quarter and 53% a year ago. Further, the company guided for 4Q gross search revenue growth of ~5%, suggesting continued deceleration is expected. Although a portion of the Y/Y deceleration is due to the loss of MSN, we believe Yahoo!’s underlying search fundamentals are deteriorating. We believe the fundamentals are deteriorating because: 1) Yahoo! has begun to anniversary a number of the coverage-expanding initiatives, 2) Yahoo! continues to lose some search market share in the domestic market and considerable share in Europe, 3) Some advertisers are lowering their max-CPC bids due to dissatisfaction with the ROI dynamics at Yahoo! when compared to Google and MSN, 4) Yahoo! is seeing rising TAC rates as it bids aggressively to maintain its existing affiliate relationships in light of fierce competition and a monetization advantage from Google, and 5) Yahoo! may be losing affiliate partners due to a scrubbing of its traffic as well as competitive pressures from Google. Overall, we are more concerned with Yahoo!’s search business given the 3Q results and 4Q outlook.

Project Panama Debuts

Yahoo! announced that Project Panama, the overhaul of its paid search platform interface, went live on a limited basis today on the front end. Yahoo! says the platform will be fully operational in 1Q’07 for the US market. Customers will have the option of not adopting Panama until after the busy 4Q season. Yahoo! expects the financial impact from Project Panama to lag the full release by a quarter, meaning the first results should begin making an impact no earlier 2Q’07, assuming the release continues as scheduled. The firm also announced that a global rollout would follow one quarter after the US; if current plans hold that would imply that, on a worldwide basis, the effects of Panama would begin to be seen in the second half of ’07. Yahoo! counseled not to expect any improvements in RPS (revenue per search) until Panama is fully rolled out. We continue to maintain that Panama could see further delays and that any monetization upside could be gradual rather than immediate.

Implications for Google

Despite Yahoo! reporting global TAC growth of only 1.2% in 3Q, we believe a deeper inspection of the numbers suggests Google is poised to report strong results this week. First, Yahoo!’s international TAC grew nicely at 9.9% Q/Q, suggesting Google may report similarly strong international results (int’l represents ~40% of Google’s revenues vs. ~25% for Yahoo!). Second, Yahoo!’s unimpressive results in the US (TAC down 6.9% Q/Q) were driven by a weaker RPS. We believe this issue was company-specific and likely due to declining CPC (costs-per-click) resulting from lower conversion rates relative to the competition (Google, MSN). Third, Yahoo!’s US business was negatively impacted by the loss of MSN traffic. Finally, we believe Yahoo! may be losing affiliate partners at the hands of Google and also due to the company’s own traffic-scrubbing initiatives. In conclusion, despite Yahoo! reporting weaker than expected search results, we remain bullish on Google and expect the company to report 3Q results in-line or ahead of consensus estimates.

Stock Repurchase Program

Yahoo!’s board approved the repurchase of up to $3B of its common stock over the next five years. In 3Q’06 Yahoo! invested $1.091B in direct stock repurchase transactions, acquiring 41M shares. Yahoo! repurchased approximately 49M shares in 3Q, which includes two earlier stock repurchases that matured and resulted in a buyback of approximately 8M shares.

Updating Estimates

Yahoo! Introduces Lower F’06 Guidance, Reducing Est.’s

Yahoo! reduced its F’06 guidance on the back of weaker 3Q results. The company now expects net revenues to fall within a range of $4.477B-$4.597B, down from previous full-year guidance of $4.6B-$4.85B. The company guided for operating income $866M-$906M for the year, below the bottom end of the previous guidance of $935M-$1.025B. Guidance for free cash flow was given as $1.295M-$1.415M, within the previous $1,270M-$1,415M range on the strength of an extra $75M in excess tax benefits from stock-based compensation, up from $400M-$450M to a current guidance of $475M-$525M. Cash flow from operating activities is expected to hit $1.503B-$1.623B, trimming the upper end of the previous $1.538B-$1.738B range.

Given Yahoo!’s lackluster 3Q results and lowered F’06 guidance, we are reducing our 4Q net revenue estimates. We are now modeling for 4Q net revenues of $1.219B (suggesting 9% sequential growth), down from our prior estimate of $1.305B. We are also reducing our 4Q EBITDA estimate to $532M from $580M. For F’07, we are reducing our net revenue, EBITDA, and EPS estimates to $5.410B, $2.238B, and $0.58 from $5.623B, $2.449B, and $0.65.

Summary of the Quarter

Yahoo! reported 3Q’06 financial results with net revenue levels below our and street expectations, and EPS below our estimates. The company announced that Project Panama had gone live on a limited basis, and Yahoo! has begun inviting advertisers in the US to use it.

Yahoo!’s 3Q’06 net revenues were $1.121B, below consensus estimates of $1.143B and below our estimates of $1.15B, driven by weaker growth in graphical advertising. GAAP EPS was $0.11, in-line with consensus but slightly below our estimate of $0.12. We estimate Yahoo! paid search revenues (ex-TAC) were $498M, representing 14% Y/Y growth. Yahoo!’s TAC grew by 1.2% sequentially, while TAC in the US declined 6.9% sequentially. Graphical advertising revenues were $336M, up 31% Y/Y, according to our estimates. Fees revenues were $210M, up 5% sequentially after excluding a one-time $10M license accounting benefit.

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