Rule Maker Portfolio Yahoo! Should Go

Yahoo! fails to meet most of the criteria for being a Rule Maker and it's questionable whether it ever was one. The valuation is no bargain and the company's options are shrinking. David Forrest thinks it's time for Yahoo! to go.

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By David Forrest (TMF Bogey)
November 7, 2001

In last week's installment of As the Rule Maker Turns, we discussed Benjamin Graham's simplistic equation for valuing a stock. On our Rule Maker Strategies discussion board, a vigorous debate ensued about the validity of Graham's equation and the potential alternatives one can employ to value stocks. I encourage you to read all of it when you have a moment. My promise to you was that we'd spend the next few weeks looking at each of the stocks in the Rule Maker portfolio, evaluating their status as Rule Makers, and trying to wrap our arms around the whole valuation/when to sell "thing."

To get us started today, let me share with you the quick results of the Ben Graham equation on each of the Rule Maker holdings.

As you can see below, most of the stocks fall in a range between 20% undervalued to 20% overvalued. There are three that fall outside those ranges fairly significantly. Using Graham's equation, Yahoo! (Nasdaq: YHOO) and Intel (Nasdaq: INTC) appear the most overvalued, especially Yahoo! at 294% above what Graham would consider fair value.

Symbol   Price    Est.  5-yr  Projected   % over-
                        Goal      Value    valued
AXP    $30.56   $1.97  13.00     $47.85     -36%
TROW   $29.69   $1.55  12.80     $37.21     -20%
PFE    $42.31   $1.59  19.00     $52.05     -19%
SGP    $37.19   $1.89  12.00     $43.24     -14%
NOK    $23.06   $0.72  18.00     $22.56       2%
JNJ    $59.00   $2.20  13.00     $53.43      10%
MSFT   $64.78   $2.10  15.00     $56.92      14%
CSCO   $18.47   $0.39  25.00     $16.06      15%
KO     $49.85   $1.78  12.00     $40.73      22%
INTC   $28.25   $0.57  18.00     $17.86      58%
YHOO   $12.99   $0.08  25.00     $ 3.29     294%

As a kick off to our exercise of going through each company, I'll start today with Yahoo! and work my way through the rest, with Intel next and then American Express (NYSE: AXP). After the initial three, I'll dig in to the others. Because this is only a once-a-week column, it's going to be tough to hit all of them in a timely fashion. My intent, therefore, is to use the Rule Maker Strategies discussion board to post my thoughts on each company over the coming weeks. You should watch the board regularly to catch the updates. [Make the board one of your favorites by clicking the little heart.]

Is Yahoo! a Rule Maker?
Without getting into a debate about whether Yahoo! ever was a Rule Maker, let's simply look at the company objectively right now and see how it stacks up. Here are each of the characteristics and some thoughts about them:

1. At least one sustainable competitive advantage -- and the more, the better.

"A company with a sustainable competitive advantage has differentiated itself in such a way that it's sheltered from competition." Clearly this is not the case with Yahoo! While I recognize that Yahoo! has the advantages of a massive installed base of users, as well as a very recognizable brand name, it is by no means sheltered from competition on any front. I also don't believe that it has a sustained competitive advantage. To me, Yahoo! is no longer a specialized search engine, especially since it farmed that out to Google. It's a media/content company in the same space as AOL. No.

2. Great management of unquestionable integrity and with a track record of excellence.

The real test of whether Yahoo! has great management is currently in progress. We've seen a number of management changes over the past few years, most notably the standing down of CEO Tim Koogle. I think it's a bit premature to call the company's management "great" or to claim that it has a "track record of excellence" until after this business cycle is done. If it is still in the game as one of the industry's dominant players, we can re-evaluate. Until then, the jury is out. At the very least, I am comfortable saying that the company doesn't currently meet this criterion. No.

3. Expanding possibilities that will allow the company to have a future that's sweeter than the present.

Otherwise known as "real options." I do think Yahoo! has some opportunities that can make its future brighter than its present. The company focus lately has been on getting people to pay for services. It is trying to diversify its revenue away from advertising and into the repeat-revenue consumer space. If it can succeed at generating a large amount of service revenue, things will at the very least be more stable for it, and we'll be able to assess the company's future with a higher degree of probability. The one thing I get caught up on is the word "expanding." I don't think Yahoo!'s possibilities are expanding. If anything, there are fewer options than seven years ago, and five years ago, etc. The possibilities are contracting, in my opinion, at least relative to where they were a few years back. Maybe.

4. Annual sales growth of at least 10%.

In the strictest sense of the criteria, yes, Yahoo! has grown revenue at a remarkable rate these past five years. However, revenue growth has been negative for the last two quarters, and likely for the next few as well. I'm more interested in the future than the past when evaluating whether the business is expanding because of "rising consumer demand or pricing power." As I mentioned above, the challenge will be to see how they emerge from this trough in the cycle. Yes, but quickly turning into a No.

5. Gross margins greater than 50%.

Even during the past two quarters, when operating profits have been negative, Yahoo! has managed gross margins in the high 70% range. Unfortunately, I think this is one of the more misguided Maker criteria. While it makes a statement about the cost of selling the goods and services, it doesn't do anything to identify actual profitability. Still... Yes.

6. Net profit margin of at least 10%.

Hit or miss. Yahoo! has three straight quarters of net losses. The expectation for the next two quarters will keep them in the sub-10% net margin range. Who knows after that? And, of the last eight quarters, only four of them have achieved the goal of 10% net margins. So, with the past eight quarters in the can, and the next two looking weak, we have Yahoo! missing the net margin number in six out of ten quarters. No.

7. Cash King Margin greater than 10%.

In the last four quarters, Yahoo!'s free cash flow to sales margin has been about 19.2%. There was no free cash flow last quarter and the March quarter came in at 16.4%, so earlier quarters are carrying them here. Overall, this passes in the strictest sense, but looking at current conditions there is serious reason to be concerned. Maybe.

8. Cash no less than 1.5 times total debt.

Yahoo! has no short or long-term debt, so it easily passes this one. Yes.

9. Efficient working capital management, as measured by a Foolish Flow Ratio no greater than 1.25.

The Flow Ratio, defined as (current assets � cash) / (current liabilities � short-term debt) was 2.29 during the last quarter and 2.30 the prior quarter. No.

10. A reasonable purchase price that allows for the clear possibility of 2x/5y.

At $13, is Yahoo! at a reasonable purchase price? If you look at Graham's equation, the answer is no. But, that's too simplistic. At the height of its economic success, April-Sept. of 2000, Yahoo! averaged around $120 million in free cash flow, on a run rate for about $500 million. If the stock doubles in 5 years, the market cap will be about $15 billion. This would put the company at 30 times free cash flow. Is that insane? No. But, given the uncertainty and lack of predictability in the business, I wouldn't place any heavy bets on a return to the hey day. No.

My conclusion
Yahoo! isn't an industry-dominating giant anymore, even if you believe it once was. It falls short on most of the criteria and isn't cheap by any standard of valuation. The company has no sustainable advantage and its opportunities are shrinking relatively speaking. If everything goes Yahoo!'s way, it might be possible to achieve the kind of return we're looking for in a Rule Maker, but my feeling is that this company isn't now, nor ever was a Rule Maker. I think Yahoo! needs to go.

Let me know what you think by posting your thoughts on the Rule Maker discussion board.  Keep watching during the coming weeks as we look at the rest of the Maker stocks like we did Yahoo!


Rule Maker Portfolio

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 Ticker Company Price
 Daily Price
 % Change
 MSFT MICROSOFT CORPORATION (0.53) (0.82%) 64.25 
 NOK NOKIA (0.86) (3.73%) 22.20 
 YHOO YAHOO! INC. 0.44 3.39% 13.43 
 INTC INTEL CORPORATION 0.04 0.14% 28.29 
 PFE PFIZER INC (0.17) (0.4%) 42.14 
 CSCO CISCO SYSTEMS, INC. 0.46 2.49% 18.93 
 TROW PRICE T ROWE GROUP INC 0.56 1.89% 30.25 
 KO THE COCA-COLA COMPANY (0.45) (0.9%) 49.40 
 JNJ JOHNSON & JOHNSON (0.25) (0.42%) 58.75 
 Trade Date # Shares Ticker Cost/Share Price  Total % Ret  
02/03/98 59 MSFT 49.35 64.25  47.09%
02/15/00 132 NOK 40.21 22.20  -42.72%
02/17/99 106 YHOO 57.60 13.43  -70.10%
05/26/98 95 AXP 35.38 31.68  -9.36%
08/21/98 44 SGP 47.99 36.55  -23.56%
02/13/98 147 INTC 27.44 28.29  11.78%
02/03/98 66 PFE 27.43 42.14  54.29%
06/23/98 182 CSCO 24.72 18.93  8.01%
02/03/98 75 TROW 34.12 30.25  -11.02%
02/27/98 27 KO 69.11 49.40  -28.21%
04/03/01 10 JNJ 43.65 58.75  34.59%
 Trade Date # Shares Ticker Total Cost Current Value  Total Gain  
02/03/98 59 MSFT 2,911.79 3,790.75  878.96 
02/15/00 132 NOK 5,307.79 2,930.40  -2,377.39 
02/17/99 106 YHOO 6,105.74 1,423.58  -4,682.16 
05/26/98 95 AXP 3,360.87 3,009.60  -351.27 
08/21/98 44 SGP 2,111.70 1,608.20  -503.50 
02/13/98 147 INTC 4,033.23 4,158.63  125.40 
02/03/98 66 PFE 1,810.57 2,781.24  970.67 
06/23/98 182 CSCO 4,498.76 3,445.26  -1,053.50 
02/03/98 75 TROW 2,559.06 2,268.75  -290.31 
02/27/98 27 KO 1,865.89 1,333.80  -532.09 
04/03/01 10 JNJ 436.50 587.50  151.00 

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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.