Yahoo!: Built to Last[Fool on the Hill] April 6, 2000

An Investment Opinion

Yahoo!: Built to Last

By Matt Richey (TMF Verve)
April 6, 2000

Yahoo!'s (Nasdaq: YHOO) first quarter earnings last night weren't good enough to lift the shares today. The stock ended down nearly 7% at $154. Ho-hum. The market's knee-jerk disdain for the company's results is just the latest piece of evidence supporting the well-documented truism that the stock market is a popularity contest in the short term, and only becomes a gauge of business value over the long haul.

Among today's littany of stories on Yahoo!'s earnings, not a single one drilled down on Yahoo!'s business progress during Q1. Although you may not have heard it amidst all the rabble about the stock's moment-by-moment wanderings, Yahoo!'s business continues to be tremendous -- and I don't use that word, nor the italics, lightly. Let's take a look at the major operating metrics, revenue growth, profitability, balance sheet quality, cash flow generation, future opportunities, and management strength to get a feel for Yahoo!'s long-term business prospects.

Starting with usage metrics, Yahoo!'s unique users increased to 145 million versus 120 million in December. Even more impressive, the company's database of registered users grew to 125 million, up from 100 million in December and only 47 million a year ago. The personal information in Yahoo!'s user database allows it to offer highly targeted online advertising. Next, daily page views soared to 625 million -- a 36% sequential improvement, representing the strongest sequential gain in a year and sure evidence that Yahoo!'s users are making Yahoo! an ever-increasing habit in their lives.

Moving to the business side of operating metrics, Yahoo! served 3,565 advertisers and merchants during the first quarter, up only slightly from 3,550 in Q4, but still up strongly from the 2,125 a year ago. Other positive indications abound: Average contract length increased to 230 days, up from 192 days in Q4 and 145 days a year ago; average revenue per client reached $64K, up from $59K in Q4; and, Yahoo! now serves 27 of the Fortune 50. Overall, 96% of the top-100 customers renewed in Q1, which represents very good retention, although it's down slightly from the 97% renewal rate in Q4.

Among the commerce metrics, Yahoo! Shopping now features 10,500 merchants, up 16.7% from 9,000 merchants in Q4. During March, Yahoo! Auctions, which now reaches 17 countries in 11 languages, enabled an average of $5 million in daily transactions, up from only $180,000 a year ago. To farther facilitate auction convenience, Yahoo! acquired during the quarter to provide buyers and sellers with a personal payment service to more easily complete transactions.

All told, revenue growth was strong during the quarter, rising 13% sequentially and 120% year-over-year to $228.4 million. According to management, advertising seasonality was not as pronounced as expected. CEO Tim Koogle made it clear that the market for Yahoo!'s integrated marketing services is "really strong." Marketers increasingly look to Yahoo!'s network as the place where they can reach the largest audience possible on the Web. In addition, Yahoo! continues to increase its pricing on advertising space. This type of pricing power is exceedingly rare in our low-inflation economy.

Moving down the income statement, Yahoo!'s profitability continues to climb. The pro forma gross margin reached 85.8% versus 81.9% a year ago. Yahoo!'s low material costs make possible its extraordinary level of pro forma pre-tax operating margins, which hit 38.4% during the quarter, up from 19.2% last year. The expanding margins prompted Yahoo! to increase it long-term operating margin guidance to 32-38%, up from 30-36%. Management emphasized that profitability is being held down due to the many opportunities for investment. Even so, it's clear that Yahoo!'s model is quite scalable, allowing revenues to grow significantly faster than expenses and capital expenditures. Expect profit margins to continue their climb upward in coming years.

The income statement's profitability was confirmed by the balance sheet. Cash increased $214.1 million during the quarter to a total of $1.18 billion. It's important to note that the sequential increase in cash is substantially higher than the $77.9 million in reported net income. Although not all of the cash increase can be attributed to operating cash flow, a significant portion of it can. Yahoo! is increasing its cash flow through tight working capital management. This quarter marked the 16th consecutive improvement in days of sales outstanding (DSO), which dropped to 24 days from 25 days in Q4 '99. That, by the way, compares to 68 days when the company came public. The declining level of DSO indicates that Yahoo! is collecting its revenue faster and faster. This directly -- and beneficially -- impacts Yahoo!'s ability to generate free cash flow.

A simple study of Yahoo!'s free cash flow in 1999 reveals that Yahoo! is growing its cash generation ability with each passing quarter. As of Q4 '99, Yahoo! earned 37.1 cents of free cash on each dollar of sales. This is a phenomenal level of cash profitability. (In the Rule Maker Portfolio, we refer to the ratio of free cash to sales as the Cash King Margin.) Yahoo!'s scalability makes an increasing Cash King Margin a strong likelihood. One of the primary justifications for Yahoo!'s $98 billion market capitalization is its proven ability to grow free cash at a rate faster than sales.

Yahoo! also deserves a high valuation based on the wide scope of its future opportunities, the first of which is the international arena. As stated by CFO, Gary Valenzuela, "International is a huge, huge opportunity for Yahoo!" Yahoo!'s international presence expanded during the first quarter with the launch of Yahoo! Argentina, the company's 22nd local business operation outside the United States. Having created 22 international properties, Yahoo! has achieved excellent speed and efficiency in these roll-outs. Much of that efficiency is based on the company's platform approach, which includes worldwide standardized technology and processes.

Already, more than 1,250 of Yahoo!'s 3,565 total clients are based outside the United States. Further, non-U.S. Yahoo! users represent 40% of the total audience. Even so, revenue from international is still playing catch-up, as it currently makes up only 14% of total revenues, up from 13% in Q4 '99. Management expects international revenue might catch up on a percentage basis of usage by three years from now.

Expanding future opportunities also will come from the secular growth in online advertising. According to a recent study by The Myers Group, global Web ad spending will balloon from this year's $5.25 billion to $45.5 billion by 2005 -- that represents 54% annualized growth. The potential to target advertisements to a particular demographic is making the Web the preferred medium for marketers. In the U.S. market, The Myers Group expects online ad spending to overtake both network TV and cable advertising spending in 2005.

The third main area of future opportunity is commerce. Yahoo!'s oft-stated goal is to be the world's largest enabler of transactions. With $40 billion in B2C e-commerce expected for this year -- up from $16.2 billion in 1999 -- Yahoo! is targeting an enormous market. During the Q&A session of the conference call, Yahoo! revealed that all of the merchants in Yahoo! Shopping have recently restructured their contracts to include a variable revenue component. It's too early to guess what percentage cut Yahoo! might be able to garner, but needless to say, the opportunity is large and the profit margins would be very high. As a wild guess, more or less, let's say Yahoo! enabled $5 billion during all of 2000, and took a 0.5% cut of each sale. That would amount to $25 million in high margin revenue.

Finally, Yahoo! is unique for its management strength. Under the leadership of Tim Koogle and COO Jeff Mallet, the company has maintained a consistent vision: "To be the only place anyone in the world needs to go to find information, get connected with anyone or to buy anything." Yahoo! pursues this goal with an unrelenting focus on the customer, including excellent products and services. If you're reading this column, chances are you use and love Yahoo! -- 'nuf said.

In the modern-day gold rush to build a dot-com business and then flip it to the public markets for a fat gain, it's rare -- exceedingly rare -- to see a company that is very intentionally growing its business for long-term strength, prosperity, and shareholder wealth creation. Yahoo!'s stock is not cheap, but its business is exceedingly strong and worthy of investment consideration, especially during the frequent pull-backs such as we've seen lately.

For the full scoop on Yahoo!'s investment potential, Zeke Ashton has written an outstanding in-depth analysis of the company as part of our new premium research offering -- Yahoo! Stock Research. In case you're wondering, the report costs $12, but I guarantee the value of the investable knowledge will more than outweigh the purchase price. If it doesn't, quite simply we'll give you your money back with no questions asked. That's the policy on all of The Motley Fool's research products.

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