<THE RULE MAKER PORTFOLIO>
By Matt Richey (TMF Verve)
ALEXANDRIA, VA (July 13, 1999) -- Let's pick up where we left off yesterday with Yahoo!'s (Nasdaq: YHOO) results from its recently completed second quarter. The company turned in a healthy set of financials that beat analysts' expectations on both the top- and bottom-line. I was impressed with the financial results as well as the business developments discussed in the conference call. But not everyone thought highly of Yahoo!'s performance.
In the latest edition of Barron's, Alan Abelson found fault with Yahoo!'s use and emphasis on pro forma income statement reporting. Speaking of Yahoo!, he writes:
"However, when you add in the merger costs and amortization of goodwill of this very busy acquirer, earnings disappear, replaced by a loss... Which neatly illustrates why Yahoo and its fans -- and so many of its Internet kith and kin -- cherish pro forma. For in earnings, like virtually everything else about these companies, illusion, not the real thing, is what counts."
I'm not sure why Abelson has such an obvious chip on his shoulder about pro forma income statements. Quite simply, pro forma results strip out one-time charges and non-cash expenses. As long as these charges are truly "one-time" or non-economic in nature, then the pro-forma results help investors in assessing a company's true results from operations. In the case of Yahoo!'s management, I don't think there's any reason to doubt the integrity of its pro forma reporting.
Let me back up for a minute. This pro forma stuff can be a bit confusing at first. Basically, a pro forma income statement allows an investor to cut through the mess of GAAP (generally accepted accounting principles) rules, so that she can get an idea of a company's true earnings power. It's this basic earnings power -- the ability to generate cash from core operations -- that makes a business valuable. With Yahoo!, we care not about this quarter's charge for relocating GeoCities employees from their Santa Monica headquarters to Yahoo!'s Santa Clara offices. We care about Yahoo!'s ability to generate cash from its advertising and e-commerce channels. And we care about the strategic initiatives that Yahoo! is taking to attract more eyeballs, which attract more advertisers, which grows revenues, which grows cash... and on and on. Investors price stocks based on a company's future cash flows, not today's exact profit or loss.
Abelson rightly calls Yahoo! a "busy acquirer," but it will not always be that way. Right now, Yahoo! is in high-growth mode, making frequent acquisitions, which result in acquisition-related charges and non-cash expenses resulting from the amortization of goodwill (a non-economic expense). As investors, we should be concerned about the impact of an acquisition five and ten years from now; not the impact on this quarter's earnings.
I only raise Abelson's point because acquisitions played a big role in Yahoo!'s Q2 results. During the quarter, the company completed three acquisitions -- Encompass, Online Anywhere, and GeoCities -- all accounted for by the pooling of interests method. Not only do these acquisitions introduce obtrusive one-time charges, but also they cause unwieldy comparison to past results. In particular, the $4 billion GeoCities acquisition makes the Q2 results not directly comparable -- at least for an apples-to-apples comparison -- with any prior quarter results. Thankfully, Yahoo!'s earnings press release includes current and past financials that have been restated to reflect the impact of these acquisitions.
Consequently, going forward, investors studying Yahoo! should be careful not to mix and match financials from multiple sources. For example, as we look at the Q2 financials, we'll focus just on the numbers included in the press release. To compare these results with the historical financials of a past 10-Q would be to compare apples to oranges. With the broadcast.com acquisition set to close in Q3 and with other acquisitions likely, investors should be prepared for some unique challenges in analyzing Yahoo!'s results in the quarters ahead.
Okay, with all of those disclaimers behind us, let's finally pick up where we left off yesterday and jump into our financial analysis.
6. Sales Growth
All of Yahoo!'s revenue metrics were positive during the quarter. Between Q1 and Q2, the number of advertisers on Yahoo! and GeoCities' combined properties increased to 2,700 from 2,350. These new advertisers included some major accounts such as Bell Atlantic, Claritin, Nabisco, Sprint, Target Stores, and Proctor & Gamble. In addition, the average contract length increased to 166 days from 145 days, and average revenue per customer increased to $43,000 from $40,000. Another positive was that no single customer accounted for more than 10% of total revenues. The Rule Maker standard for year-over-year sales growth is 10%, but Yahoo! blew past that with 156% growth. Using the pro-forma income statement, here's the calculation:
$ thousands Q2 '99 Revenue / Q2 '98 Revenue = Sales Growth $115,239 / $44,948 = 156%
Since Yahoo!'s product is digital, the cost of the inputs for delivery of Web pages is very low. The benefit of a virtual product shows up in the gross margin, where Yahoo! came in at 86.3%, versus 82.7% a year ago. Gross margins over 80% are rare, but Yahoo! is pushing this number closer and closer to 90%, which is outstanding. Using the income statement again, here's the calculation:
$ thousands (Revenues - Cost of Revenues) / Revenues = Gross Margin ($115,239 - $15,766) / $115,239 = 86.3%
8. Net Margins
As Yahoo! spreads its costs over an ever increasing amount of revenue, its net margins are on the rise as well. Since Q2 of last year, net margins have increased from 3.2% to 24.6%. Obviously, Yahoo! is in a unique stage where it is gaining critical mass and showing extraordinary gains, but this is still phenomenal expansion of profitability. We like to see net margins of at least 7%, and Yahoo! has soared over that hurdle. Here's the calculation:
$ thousands Net Income / Revenues = Net Margin $28,298 / $115,239 = 24.6%9. Cash-to-Debt Ratio
"We pay a great deal of attention to the balance sheet." -Gary Valenzuela, CFO Yahoo!
Yahoo! manages its balance sheet very conservatively, just the way we like it. On its ninth consecutive quarter of positive cash flow, Yahoo!'s cash balance continues to expand with not an iota of debt. Since there's no debt, there's really no calculation to perform, but it's instructive to see that the cash balance has increased by $60.6 million over the past six months, surpassing pro forma net income of $48.2 million over the same period of time. Maybe this company is the real thing after all, eh Alan?
10. Flow Ratio
Finally, no balance sheet analysis is complete without our friend, the Flowie. Unfortunately, Yahoo!'s press release balance sheet doesn't break out current versus long-term assets and liabilities. That leaves us with some assumptions to be made in calculating the ratio. I'm going to make two estimations. First, based on the past two quarters, Yahoo! has reported ~$9 million in prepaid current assets, which are not detailed in the press release, but which I'll assume is there. Second, Yahoo! doesn't have any major non-current liabilities, so I'll assume that total liabilities equals current liabilities. Here are the relevant numbers:
$ thousands Cash & Equivs $637,588 Accounts Receivable 34,052 Prepaid assets (estimated) 9,000 Total estimated current assets 680,640 Total liabilities 134,736And, here's the calculation:
(Current Assets - Cash & Equivs) / Current Liabilities = Flow Ratio (680,640 - 637,588 ) / 134,736 = 0.32
A Flowie of 0.32 is much better than our standard of 1.25. A Flow Ratio as low as Yahoo!'s means that customers and suppliers are footing the bill (and then some) for the costly non-cash current assets, thereby leaving cash available for more productive uses. If that last sentence was gobbledygook to you, I encourage you to click into this explanation of the Flowie.
All in all, Yahoo!'s quarter appeared to be outstanding in every respect. This business will be a delight to watch in the quarters ahead.
Last Wednesday, the Rule Maker Portfolio bought 6 shares of Microsoft (Nasdaq: MSFT) at $91 13/16, plus Suretrade's $7.95 commission for a total of $558.83. We were able to buy more than $500 worth of shares because our account had some spare cash from dividends, as well as cash received in lieu of partial shares from the 3-for-2 Gap split and General Motors' spin-off of Delphi Automotive Systems Corp. (NYSE: DPH), of which we now have 11 shares.
Many of you have asked about the whereabouts of our Delphi shares in our online accounting numbers at the bottom of this page. The reason we haven't reported these new shares, along with the change in cost basis for General Motors, and the new Microsoft shares, is because we are in the process of switching to a new form of accounting and a more sophisticated (and very sweet!) accounting tool, developed in-house by David "Dagwood" Gardner (not to be confused with "plain old" David Gardner.) By the way, the comprehensive portfolio management features of this new tool will soon be incorporated into the already pretty-darn-comprehensive My Portfolio.
Right now, the MakerPort uses normal (i.e., simplistic) portfolio accounting within an Excel spreadsheet that looks pretty much like the data you see at the bottom of this page. This method yields accurate results, except for when additional shares of the same stock are added -- as we are now doing on a monthly basis. The problem with our current accounting method relates to the time value of money. When we purchase additional shares of a stock that we already hold (such as we are now doing with Microsoft), the spreadsheet assumes that the additional shares were purchased on the same date as the original shares. To solve this problem, we'll be switching to "value per share" (a.k.a."share price") accounting, which is the same method used by the Drip Portfolio. For an excellent explanation of how this type of accounting works, check out this link: Drip Portfolio Accounting.
We'll be switching to the new accounting tool within the next month. In the meantime, rest assured that our reported returns are very close to accurate, and if anything, have slightly underrated our actual performance.
That's all for tonight. We'll spend the rest of the week on more earnings news. After market close today, Intel (Nasdaq: INTC) reported earnings that fell short of analyst estimates. We'll have more on those earnings and the company's conference call (available at www.intc.com) later. Good night!
Day Month Year History R-MAKER -0.24% 1.31% 15.23% 45.81% S&P: -0.40% 1.52% 13.95% 40.91% NASDAQ: -0.44% 3.45% 26.70% 68.08% Rule Maker Stocks Rec'd # Security In At Now Change 2/3/98 48 Microsoft 39.13 93.63 139.24% 6/23/98 68 Cisco Syst 29.21 65.25 123.42% 5/1/98 82.5 Gap Inc. 22.91 49.19 114.67% 2/13/98 44 Intel 42.34 65.38 54.42% 2/3/98 66 Pfizer 27.43 37.25 35.79% 5/26/98 18 AmExpress 104.07 133.13 27.92% 2/17/99 16 Yahoo Inc. 126.31 156.94 24.25% 8/21/98 44 Schering-P 47.99 52.75 9.91% 2/6/98 56 T. Rowe Pr 33.67 35.34 4.96% 2/27/98 27 Coca-Cola 69.11 62.44 -9.65% Foolish Four Stocks Rec'd # Security In At Value Change 3/12/98 20 Exxon 64.34 78.44 21.92% 3/12/98 15 Chevron 83.34 97.13 16.54% 3/12/98 20 Eastman Ko 63.15 72.75 15.21% 3/12/98 17 General Mo 72.41 67.75 -6.43% Rule Maker Stocks Rec'd # Security In At Value Change 2/3/98 48 Microsoft 1878.45 4494.00 $2615.55 6/23/98 68 Cisco Syst 1985.95 4437.00 $2451.05 5/1/98 82.5 Gap Inc. 1890.33 4057.97 $2167.64 2/13/98 44 Intel 1862.83 2876.50 $1013.67 2/3/98 66 Pfizer 1810.58 2458.50 $647.92 5/26/98 18 AmExpress 1873.20 2396.25 $523.05 2/17/99 16 Yahoo Inc. 2020.95 2511.00 $490.05 8/21/98 44 Schering-P 2111.7 2321.00 $209.30 2/6/98 56 T. Rowe Pr 1885.70 1979.25 $93.55 2/27/98 27 Coca-Cola 1865.89 1685.81 -$180.08 Foolish Four Stocks Rec'd # Security In At Value Change 3/12/98 20 Exxon 1286.70 1568.75 $282.05 3/12/98 15 Chevron 1250.14 1456.88 $206.74 3/12/98 20 Eastman Ko 1262.95 1455.00 $192.05 3/12/98 17 General Mo 1230.89 1151.75 -$79.14 CASH $232.29 TOTAL $35081.95
Note: The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it added $2,000 in August 1998 and February 1999. Beginning in July 1999, $500 in cash (which is soon invested in stocks) is added every month.