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Thursday, July 8, 1999

An Investment Opinion
by Dale Wettlaufer

Yahoo!'s Q2 Review

Yahoo! (Nasdaq: YHOO). That's a sentence, an exclamation of what a super- freaky colossus this company has become. The Web's premiere portal company once again blew through analysts' revenue expectations and mean pro-forma earnings results, delivering another stellar quarter for Q2 FY 1999.

To start with, revenues increased 156% year-over-year and 22% sequentially, to $115 million. Off that, gross profit was either $96.8 million or $99.5 million, depending on how you want to treat amortization of purchased technology. Either way, that's a staggering number if it truly reflects the cost of creating revenues. At the smaller gross margin number, it takes $0.16 to generate a dollar of revenues. Looked at in the inverse, you're marking up the product 6.24 times.

However, gross margin in this sort of industry isn't the best indicator of profitability, in my opinion. The costs of generating revenues are more fully reflected in the operating cost structure, not just in looking at telecom costs, depreciation of servers, and lease expenses related to the "broadcasting" costs, for lack of a better word. After all, some base portion of the sales and marketing costs plus the product development costs are certainly necessary to create revenues, though a certain additional portion past a base in the different operating expense lines is discretionary.

The bottom line on the operating cost structure is that it's still stellar. Q2 pro-forma income from operations, excluding intangibles amortization and one-time costs (made up mostly of purchased R&D) but including amortization of purchased technology found in the cost of goods sold line, was $34.3 million, yielding an operating margin of 29.8%.

An important component of the company's earnings that should be considered is the quarter-to-quarter growth in deferred revenues. That's cash that has come in but has yet to be recorded in earnings. Unless there is a significant doubt as to the ability of the company to deliver on the services promised, it's appropriate to add this cash inflow to operating profits to get closer to the company's real cash flow for the quarter.

Depending on the tax treatment of the item, which is very likely wrapped up in the level of discretion the company has over the recognition of the revenues and the obligations attached to the liability, you're either adding the entire $18.4 million quarterly increase in deferred revenues to after-tax operating income of $22 million or you're adding $11.8 million to the quarter's after-tax operating income. That's economic operating profit of anywhere from $33.8 million to $40.4 million. Until those deferred items stop growing and there's a reversal in those accounts, that's a cash inflow that should not be ignored in attempting to discount the company's cash flows.

Overall cash flow for the quarter looked extremely robust. Compared to pro-forma net income of $28.3 million, I get something in the neighborhood of operating cash flow of $62.6 million, treating cash taxes for the quarter as the pro-forma provision for taxes but without adding back the tax benefit the company will surely realize from the exercise of incentive stock options. I don't treat those as an operating cash flow for the purposes of figuring out the value of the company. (Note: figuring out the operating cash flow of a company without a detailed balance sheet and income statement necessitates my estimating some items).

For reference on some of the dynamics of a company that's generating operating cash flows at multiples to net income or straight net operating profit after tax, check out CS First Boston's Michael Mauboussin and Bob Hiler's excellent Frontiers of Finance piece titled " Cash Economics in the New Economy."

In essence, the report points out the discounted cash flow (DCF) value of a company is the product of not just the bottom line, but of free cash flows, of which working capital dynamics are a highly important component. In this case, working capital investment is not a negative cash flow. It's a positive addition to the quarter's operating cash flow to the tune of $36.6 million (again, this is my estimate), which right there is better than double pro-forma net income. A static valuation of a company such as this, looking at the market cap and comparing that to net income or revenues, is going to miss the triple-digit growth components, the margins, the cash flow characteristics, and the characteristics of marginal returns on investment.

Since I don't cover this company regularly, I haven't worked out exactly what the gross investment of this company is or what its marginal investment for the quarter works out to be. I can say this, though: poolings of interests accounting totally screws up the ability of an investor to ascertain the marginal return on capital performance of the company. In the Geocities acquisition and in the acquisition, you're not just bringing on the balance sheet the net assets of the acquired companies. You're deploying equity worth large multiples to these companies' shareholders' equity. So the cash flow characteristics of Yahoo! and the return on investment characteristics here aren't useful when looking at just the GAAP balance sheet. If you really want to look at free cash flow, cash flow return on investment (CFROI), or economic value added (EVA), you have to adjust the balance sheet of Yahoo! to reflect the heavy deployments of equity that are being made.

Overall, the company is just amazing in its size and scope. Having worked for an Internet company for almost four years, I'm truly blown away by the pageview, unique visitor, and registered user numbers: 310 million pageviews per day, 80 million unique visitors, and 65 million registered users are all just stupefying numbers. With the company priced at $685 per registered user and $556 per unique visitor, the static valuation metrics aren't off the edge of the earth here when you consider the growth of accounts. Can the company realize the value off its customers? Well, I really think the reality here is that this company is the big three networks circa 1970 or so while other portals are maybe the WB and UPN. No one else has moved as aggressively as this company in amassing properties that add as much practical utility and entertainment value as this company, as far as I can tell.

If the company retains its customers and keeps adding to the value it delivers its end-customers, then its advertising and marketing customer rolls are going to keep expanding and spending more with Yahoo! You've already got Procter & Gamble, Mars Inc., Nabisco, and Target Stores, as well as others, doing business with the company. General image advertisers such as Coca-Cola aren't far behind, in my opinion. In sum, while I can't deliver what I feel is a good estimation of the value of this company since I haven't worked on it, I don't think a market cap somewhere in the tens of billions of dollars is totally out of line. The assets are unique, the financial aerodynamics look very attractive, the growth is amazing, and the company has built a formidable moat around itself in terms of scope and scale.

The "value" people can complain about the static valuation numbers all they want in their articles and fund annual reports, but unless you've really put your nose to the grindstone on working out the value of this company, I think it's naive to claim right off the top of your head that this is definitely overvalued. In terms of getting a long-run rate of return on this equity in-line with the S&P 500, it may well be valued fairly here. It could even be undervalued. I think the "value" people should really wake up and start paying attention to what this company is doing, what its financials beyond just the bottom line look like, and how unique it is. Unless you've worked through those and gotten past the idea that anyone can do what Yahoo! is doing, you don't have a hope of figuring out if this company is undervalued, overvalued, or fairly valued.

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