Heads You Win, Tailwinds Yahoo! Loses

The not-so-hip Yahoo! (Nasdaq: YHOO  ) is finally hitting the teens, but not in a Hannah Montana or Fall Out Boy kinda way. Falling to depths not seen in five years, Yahoo! shares shot downward into the high teens after last night's disappointing earnings report.

The news wasn't all bad. Revenue before traffic-acquisition costs climbed 14% higher to hit $1.4 billion during the final quarter of 2007, and the bottom-line results clocked in ahead of analyst estimates of $0.11 a share. The company also blew past Wall Street's net income targets three months ago.

So why did the stock fall in after-hours trading? Well, operating margins contracted, for one thing. Earnings came in at $0.15 a share, after the company had turned a profit of $0.19 a share a year earlier. And there's more:

  • Yahoo! sees revenue before traffic acquisition costs growing by 5% to 16% in 2008, but it says free cash flow will fall. Operating cash flow is also likely to be lower.
  • Affiliate revenue, the greenery Yahoo! generates from its presence on third-party sites, actually fell by 13% during the period.
  • Some of the bright spots aren't entirely organic. For instance, the 20% surge in display advertising was mostly the handiwork of the company's recent Right Media and Blue Lithium acquisitions.

As the wind blows
"While we will continue to face headwinds this year, we believe that the moves we are making will help us exit 2008 stronger and more competitive and return to higher levels of operating cash flow growth in 2009," CEO Jerry Yang stated during last night's report.

Those headwinds are pretty stiff, and there's a chance that they may be doubling as Google's (Nasdaq: GOOG  ) tailwinds. Google, the real bellwether of paid search, reports tomorrow night and continues to grow at Yahoo!'s expense.

Yahoo! isn't standing still, though. Forget the share buybacks and acquisitions last year that shrank the company's cash and cash-equivalents balance to $2.4 billion by year's end. Its emphasis right now is on beefing up the monetization of its landing pages. It's also willing to cut deals to get its affiliate revenue growing again.

Making good on the rumors, the company has announced it will lay off 1,000 employees.

The company's traffic acquisition costs -- essentially what it pays third party sites that distribute Yahoo! contextual marketing ads on their sites -- will go from 72% of related revenue in 2006 to a target of 80% this year. In other words, partners will be getting more of the revenue generated through their sites.

President Sue Decker explained during last night's conference call that most of that pro-publisher improvement took place through 2007, which makes it troublesome to note that third-party gross revenues are still falling.

These are the right moves to make, but they may not be aggressive enough. Keep in mind that Google's traffic-acquisition costs are higher -- 84% through the first nine months of 2007 -- and that Google is the preferred choice, given its deeper inventory of relevant ads.

I have argued that the only way for Microsoft (Nasdaq: MSFT  ) and Yahoo! to dent Google's growing market share with affiliate sites is to actively recruit small and medium publishers while temporarily paying 100% -- if not more -- to get existing Google partners to migrate to their fledgling platforms. If Yahoo! has to treat its affiliates as loss leaders to becoming relevant to advertisers again, so be it.

This is no time to be conservative. To its credit, the company is already signing up major website publishers, it keeps growing its consortium of newspaper websites, and it has relationships with the likes of Comcast (Nasdaq: CMCSA  ) and now AT&T (NYSE: T  ) . These are sound alliances. Yet Yahoo!'s presence on the Web continues to shrink outside its owned and operated sites. And that's why Yahoo! needs to act before it's too late.

Bottoming out
Value hounds will want to keep a close eye on Yahoo! over the next few trading days. As stiff as these headwinds may be, Yahoo! remains solidly profitable even as its stock ticks lower. It's also rich in assets. The company owns stakes in Yahoo! Japan, China's Alibaba.com, and South Korea's Gmarket (Nasdaq: GMKT  ) that add up to at least $14 billion in market cap -- or roughly $10 a share. I say "at least" because privately held Alibaba has taken only its Alibaba.com B2B appendage public so far. Ali Baba has yet to cash in on the value of its other sites, such as the popular Taobao.com auction presence that was strong enough to chase eBay (Nasdaq: EBAY  ) out of China.

Yet that $10-a-share floor isn't clean. Selling those stakes would create significant tax bites as realized gains. The better alternative would be to spin them off as a separate entity, although Yahoo! is unlikely to go that route.

However, Yahoo! also has nearly another $2 a share in cash on its balance sheet. In other words, as much as it stings to see Yahoo! trading in the teens, it's highly unlikely that we'll see its shares fall below the teens, unless its fundamentals crumble or its Asian investments decrease significantly in value.

Fact is, although Yahoo! is doing more things wrong than right, even a cynic like me is tempted to nibble at the shares at today's attractive price point.

Yahoo! in the teens? Be still, my high school heart.

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