Yahoo!'s Big Picture

Last Tuesday's blowout quarter from Yahoo! (Nasdaq: YHOO) lifted the entire Internet sector, as the company performed admirably on the metrics I set forth in last Monday's earnings preview. There remains, however, a bearish buzz about Yahoo!'s slower growth in page views and unique users. Detractors point to these slowing metrics as sure signs that Yahoo!'s engine of growth is beginning to run low on gas. Slowing growth and a P/E ratio of 333 have the bears licking their chops.

Such negative sentiment, however, is actually quite a good thing. Pessimism in the stock market can be thought of as pent-up buying power. As Yahoo!'s economic success unfolds in the years to come, today's bears will slowly but surely defect to the bull camp and lift Yahoo!'s stock price along the way. In looking at Yahoo!'s big picture, I see three factors that will propel Yahoo!'s long-term success.

1. Strong Free Cash Flow

During the just completed quarter, Yahoo! generated approximately $120 million in free cash flow -- a fact revealed during the earnings conference call. Compare Yahoo!'s $120 million in free cash flow generation to its $74 million in pro forma earnings, and you can see how the income statement dramatically understates Yahoo!'s true economic prosperity.

Yahoo!'s ability to grow free cash flow faster than earnings stems from four factors. First, Yahoo! benefits from up-front cash payment for its long-term client contracts, which now average 225 days. That's Rule Making, my friends, when you get paid in advance. Not only that, but the long-term contracts give Yahoo! greater visibility into the future, which helps in planning and strategizing for the business. The second way Yahoo! generates superb free cash flow is through increasingly efficient working capital management. This quarter, Yahoo! once again reduced the amount of time it takes to collect cash on its sales, as measured by days of sales outstanding (DSOs), which dropped from 24 to 23 days. Translation: less uncollected sales and more cash.

The third additive to Yahoo!'s free cash flow is the tax shield on exercised employee stock options. The debate on how to account for stock options is ongoing, but their advantages as a tax shield and employee retention tool make them a compelling form of compensation in my book. Fourth and finally, Yahoo!'s free cash flow benefits from low capital expenditure (cap ex) needs. It just doesn't take a lot of equipment to run and scale Yahoo!'s virtual network. In recent quarters, Yahoo!'s capital expenditures have come in at $10-20 million per quarter, and they're not increasing in any noticeable fashion. Keep in mind that free cash flow is defined as operating cash flow less capital expenditures. So, by keeping the cap ex low and stable, Yahoo!'s free cash flow can ramp up faster than overall sales growth.

These four factors -- up-front cash payment, lean cash management, tax-efficient employee compensation, and low cap ex needs -- add up to a business model that generates a lot of cash. From a Rule Maker perspective, this is the holy grail.

2. High Cash-on-Cash Returns

Related to point number one, Yahoo!'s second big picture factor is its high-return business model. By that, I mean dollars invested in the Yahoo! network are spitting out well over a dollar in return. Yahoo! is creating value by spending money to roll out new global properties (23 total now) and create new services such as its corporate My Yahoo! portal. But how much value is created? One way of measuring Yahoo!'s value creation ability is through its cash-on-cash returns. In other words, we're interested in finding out how much cash is produced per each dollar invested directly in Yahoo!'s operating business, not counting any investment-related income. We want to isolate the cash-on-cash profitability of Yahoo!'s core operations.

To do this, we need two numbers: 1) free cash flow less any interest income (this is our numerator), and 2) non-cash assets (our denominator). First the numerator: free cash flow for the quarter, as mentioned earlier, was approximately $120 million; interest income was $18.4 million; thus, pure operating free cash flow was $101.6 million. Next, the denominator: total assets at the end of Q2 were $2,038 million; cash and securities equaled $1,355.4 million and long-term investments equaled $292.5 million; thus, subtracting the cash and investments from total assets gives us a non-cash assets total of $390.1 million. Finally, by dividing $101.6 million by $390.1 million, we see that Yahoo!'s quarterly cash-on-cash profitability is 26%. To annualize this number, we must multiply 26% by four, and thus we find that Yahoo!'s annual cash-on-cash profitability is in excess of 100%. Extraordinary.

3. Vast Market Opportunity

Final among our trio of big picture factors, Yahoo!'s market opportunity is expanding rapidly. The revenue pool for Web advertising will soon be measured not just in the billions of dollars, but the tens of billions of dollars. On the conference call, CEO Tim Koogle said that in 1999, Web-based advertising spending totaled $4.6 billion. By 2002, that number is projected to be $19 billion, and by 2003, $26 billion. Yahoo! is so conservatively managed that I don't think Tim Koogle would have referenced these numbers if he didn't honestly believe they are realistic. So, the question is, then, what percentage of the pie can Yahoo! expect to get?

In 1999, Yahoo! earned revenues of $588.7 million. Out of the $4.6 billion total pie in 1999, Yahoo!'s portion was 12.8%. If Yahoo! can just maintain its current market share, then a 12.8% piece of projected 2003 revenues would be $3.3 billion. That would translate to an outstanding 54% annual sales growth between 1999 and 2003. And who's to say Yahoo! won't capture a larger market share in the coming years? Typically, the strong grow stronger.


In sum, I think Yahoo! continues to make excellent progress in building the largest global audience of Web users, which can then be monetized through advertising. The model has already shown immense cash profitability and operational scalability, even though the company is only five years old. While the stock's valuation relies on immense growth in the years ahead, I expect the growth will indeed manifest itself because of Yahoo!'s steadfast commitment to serving its Web-using consumers and advertising customers. I encourage you to listen to the conference call (well worth the hour) and see if you don't agree.

I imagine my bullish stance on this company is somewhat controversial, so let's take a poll: Will Yahoo! beat the market (as measured by the S&P 500) over the next five years?

1. Yep, Yahoo! is a great and underrated company; it'll crush the S&P.
   
   
2. Yep, it's a great company but it will only slightly edge out the S&P.
   
   
3. Nope, it's a good company but the stock is overvalued -- market wins.
   
   
4. Nope, not a chance. The S&P wins by a long shot.