Yahoo! -- Cash Prince

by Matt Richey (TMF Verve)

ALEXANDRIA, VA (April 23, 1999) -- Here in Rule-Maker land, our way of looking at companies is pretty simple. We love companies that generate a whole lotta cash. We also are attracted to companies with a strong consumer brand name and a bright future. One company that exemplifies all three of these qualities is Yahoo! (Nasdaq: YHOO). In fact, I believe Yahoo! is the quintessential Rule Maker. Today, I want to first explore the inner-workings of Yahoo!'s business model, and then evaluate the company's outlook.

A few weeks ago, Yahoo! reported first quarter net income of $25 million on revenue of $86 million (press release). The 29% net margins, 180% revenue growth, and 670% net income growth brought a grin to my face. But what really made my heart race was the company's balance sheet. During the quarter, the company grew its cash balance by $42 million, while profits for the quarter were only $25 million.

More cash than profits? What gives?

The cash piling up on Yahoo!'s balance sheet is evidence of the unique cash generating power of "lightweight" companies. By "lightweight," I mean companies that have a relatively small proportion of their assets tied up in bricks-and-mortar infrastructure. For Yahoo!, total property and equipment of $19.9 million is only 2.5% of total assets. As Yahoo! expands into new Web businesses such as auctions and small-business services, no additional physical investment is required. All that is needed are creative people to come up with cool ideas for products and services on the Web, and then programmers to make it happen. And once a website is in place, it scales effortlessly as users click-in. Yahoo! refers to this phenomenon as "leverage." The company builds user applications, then watches user trends and markets accordingly.

Yahoo!'s power to leverage operations is only one cylinder of this cash engine. The company generates a big chunk of cash from its successful working capital management. Working capital refers to a company's current assets less its current liabilities. Think of working capital as an investment. To increase sales, most companies have to "invest in" two primary current assets: inventory and accounts receivable. From Rule Maker Step 7, here's why we don't like inventory:

"[Inventory], in various stages of development, that hasn't been sold yet. Some of it is raw material, some of it is finished product waiting to be sold. But let us convince you that all of it is a liability. Why? Because there's a cost to storing inventory on shelves in an enormous warehouse outside of town. Wouldn't you be much happier to see that inventory in a store today, in the form of a giant, stuffed Donald Duck doll, in the hands of a parent out birthday shopping? So would we. Certainly, every company on the planet has to carry inventory. We just like those that can quickly assemble product and race it out to the door into the marketplace. Because, after all, inventory is just potential cash sitting on shelves. We'd rather have the cash, thanks."

Fortunately, Yahoo!'s intangible products and services negate the need for inventory altogether. Zero inventory is a source of considerable savings. The next current asset that we consider to be a liability is accounts receivable. Here's why we like to see accounts receivable as low as possible:

"[Accounts receivable] reflect payments that your company hasn't collected yet. Let's say that you've invested in a camera maker that has $43 million in accounts receivable. That entry reflects $43 million of cash from operations that your company is owed by its customers. Maybe $10 million of it came from camera sales into Europe -- from which payments take 8-10 weeks. That cash isn't yet in your company's coffers. It isn't going to work for the business. Its delayed arrival, Fool, is a liability to the business. Well-positioned companies are able to require up front payments from customers..."

Yahoo!'s accounts receivable grew only 8% during the first quarter, even as sales mushroomed over 180%. Altogether, Yahoo!'s "investment" in accounts receivable for the quarter was only $2 million.

The second part of working capital is current liabilities. We actually like current liabilities, and contrary to their name, look at them as an asset to the business. Yahoo!'s current liabilities generate a substantial amount of interest-free cash from suppliers, employees, and customers. During the first quarter, the company's combined increase in accounts payable, accrued expenses, and deferred revenues was over $13 million.

So, here's how we calculate Yahoo!'s "investment" in working capital for the first quarter:

   $2 million cash outflow for current assets
+ $13 million cash inflow from current liabilities
= $11 million cash inflow from net working capital

As you can see, Yahoo! doesn't "invest" in working capital, but rather makes money from its working capital. It's a strange phenomenon that may require some pondering, but this is a critical aspect in understanding the value of Yahoo!'s business model.

Luckily, our Flow Ratio captures all the moving parts of this working capital analysis. In the latest quarter, Yahoo! turned in a Flowie of only 0.276, compared to 0.294 in the December 1998 quarter. That's a 6.1% improvement on an already superb score.

Alright, Yahoo! has even more cash than its profits indicate, but how is it using all of this cash?

Glad you asked, Fool. Yahoo! is constantly offering new products and services for individuals and businesses. One such service is Yahoo! Site, which for $29.95 per month, offers businesses a fast and easy way to create Web sites, including a suite of tracking and reporting tools providing information on how the business' site is doing. Yahoo! offers several other services for businesses, ranging up to the Connected Office product that offers companies an internal communications hub and Intranet. During the first quarter, 92% of CEOs said Yahoo! was helpful in building their business. Truly, Yahoo! is offering a sites and services for everyone. From auctions to shopping to entertainment, Yahoo! offers something for everyone. This breadth of offerings gives the company awesome advertising potential.

And, that breadth will be expanding in the next two quarters as Yahoo! closes its acquisitions of GeoCities (Nasdaq: GCTY) and broadcast.com (Nasdaq: BCST). Currently, among all digital media and Web properties for users at home and work, Yahoo! sites rank fourth with 31.3 million unique visitors (UVs). But, by adding the numbers for GeoCities and broadcast.com, that number jumps to 61.2 million UVs, placing Yahoo! well ahead of current #1 AOL Networks with 47 million UVs. Already, yahoo.com is the #1 most bookmarked Web site and #1 for customer satisfaction. For February, yahoo.com was the fastest-growing top-10 website.

Yahoo! is still a very young company, but its cash-generating business model and dominant set of Internet properties make this cash prince likely to grow up very quickly.

The only question in my mind is whether Yahoo!'s current leadership is sustainable. Will the company's currently innovative products and services give way to competition? Come share your thoughts on the Rule Maker Companies board or Yahoo! board.

Also, be sure to turn in your vote on the Companies board for which company you'd like to see Phil Weiss (TMF Grape) walk through the Rule Maker paces one day next week.

Have a great weekend!

04/23/99 Close

Stock Change    Bid
AXP   -1 13/16  135.38
CHV   -2 5/8     95.88
CSCO  +4 3/16   117.38
EK    +  11/16   73.94
GM    +  7/16    89.13
GPS   -1 1/16    69.44
INTC  +  1/4     61.75
KO      ---      66.50
MSFT  +1 1/16    86.00
PFE   -1 5/16   127.00
SGP   -  3/16    53.69
TROW  -1 1/32    36.13
XON   -  5/8     78.31
YHOO  +3 11/16  187.69

                  Day     Month  Year    History
        R-MAKER  +0.13%   3.62%  15.42%  46.04%
        S&P:     -0.15%   5.48%  10.70%  36.92%
        NASDAQ:  +1.14%   5.24%  18.15%  56.74%

Rule Maker Stocks

    Rec'd    #  Security     In At       Now    Change
    2/3/98   48 Microsoft     39.13     86.00   119.76%
    5/1/98   55 Gap Inc.      34.37     69.44   102.03%
   6/23/98   34 Cisco Syst    58.41    117.38   100.95%
    2/3/98   22 Pfizer        82.30    127.00    54.32%
   2/17/99   16 Yahoo Inc.   126.31    187.69    48.59%
   2/13/98   44 Intel         42.34     61.75    45.85%
   5/26/98   18 AmExpress    104.07    135.38    30.08%
   8/21/98   44 Schering-P    47.99     53.69    11.86%
    2/6/98   56 T. Rowe Pr    33.67     36.13     7.28%
   2/27/98   27 Coca-Cola     69.11     66.50    -3.77%

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   17 General Mo    72.41     89.13    23.09%
   3/12/98   20 Exxon         64.34     78.31    21.73%
   3/12/98   20 Eastman Ko    63.15     73.94    17.09%
   3/12/98   15 Chevron       83.34     95.88    15.04%

Rule Maker Stocks

    Rec'd    #  Security     In At     Value    Change
    2/3/98   48 Microsoft   1878.45   4128.00  $2249.55
   6/23/98   34 Cisco Syst  1985.95   3990.75  $2004.80
    5/1/98   55 Gap Inc.    1890.33   3819.06  $1928.73
    2/3/98   22 Pfizer      1810.58   2794.00   $983.42
   2/17/99   16 Yahoo Inc.  2020.95   3003.00   $982.05
   2/13/98   44 Intel       1862.83   2717.00   $854.17
   5/26/98   18 AmExpress   1873.20   2436.75   $563.55
   8/21/98   44 Schering-P   2111.7   2362.25   $250.55
    2/6/98   56 T. Rowe Pr  1885.70   2023.00   $137.30
   2/27/98   27 Coca-Cola   1865.89   1795.50   -$70.39

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   17 General Mo  1230.89   1515.13   $284.24
   3/12/98   20 Exxon       1286.70   1566.25   $279.55
   3/12/98   20 Eastman Ko  1262.95   1478.75   $215.80
   3/12/98   15 Chevron     1250.14   1438.13   $187.99

                              CASH     $70.09
                             TOTAL  $35137.65

Note: The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it adds $2,000 in cash (which is soon invested in stocks) every six months.

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