"Take what the market gives you." It's a maxim that the Rule Maker managers regularly recite as we bat stock ideas around the pool table here at Fool HQ. Right now, the market is giving us Yahoo! (Nasdaq: YHOO). Rising concerns about the near-term outlook for the dominant portal's advertising business have sent the stock falling -- down 20% over the last three weeks alone.
Various reports have been swirling about the ineffectiveness of online advertising. Ten days ago, The Wall Street Journal ran an article (subscription required) raising a number of questions about the health of Yahoo!'s advertising business, including the following snippet from Yahoo!'s Chief Operating Officer, Jeff Mallett:
"'Is this a branding medium? Is it? No, not really,' he says. 'The traditional building of a brand, which is to create an image, create a feeling' -- he sighs loudly -- 'not there yet.'"And even if Web advertising is effective, the predictably neurotic Wall Street analysts are doing a good bit of hand-wringing over fears of slack demand in Yahoo!'s third and fourth quarters. The worry is that cash-starved dot-coms will be less-able to pony up as much dough for online marketing as they could a year ago.
Fear is in the air.
Fear of this type reminds me of a favorite dollop of Foolishness from Warren Buffett:
"A great investment opportunity occurs when a marvelous business encounters a onetime huge but solvable problem."(For other pithy Buffett quotes and the best-ever 20-minute investing read, check out Thoughts of Chairman Buffett.)
Applying the Buffett truism to the situation facing Yahoo!, three questions emerge:
- Is Yahoo! a marvelous business?
- Is the current state of online advertising a one-time problem?
- What is the future of online advertising?
1) Is Yahoo! a marvelous business?
Chances are Yahoo! is your personal "information cockpit" -- you and 156 million other global users. Yahoo! has the global reach and consumer penetration that few other companies can match. Even fewer can match Yahoo!'s profit-rich business design.
Back in July, in Yahoo!'s Big Picture, I walked through the calculation for Yahoo!'s cash-on-cash returns, and discovered that one dollar invested in Yahoo!'s operations produces a bit over two dollars in return over the course of a year. In other words, Yahoo!'s annualized cash-on-cash profitability is in excess of 100%. It's a rare business with such cash generating aerodynamics.
So much can be said of Yahoo!'s business, but I think the company's performance across our six Rule Maker financial metrics paints the picture most succinctly (trailing twelve months):
- Sales growth of 119.1%
- Gross margins of 85.1%
- Net margins of 23.7%
- Cash and marketable securities of $1.6 billion -- and no debt
- Foolish Flow Ratio of 0.34
- Cash King Margin of 44.2%
About Yahoo!'s future opportunity, Rule Maker co-manager Zeke Ashton offered this analysis in his most recent quarterly Motley Fool Research report on the company:
"Yahoo! finds itself in the wonderful position of having too many possibilities to mention, and investors need to be cognizant that part of the rich price tag of Yahoo!'s stock is attributable to this 'option premium.' This premium represents the potential of Yahoo! to create new business opportunities for itself. The combination of Yahoo!'s unmatched ability to scale globally, the ever-growing value of the Yahoo! brand, and the close relationship the company builds with its customers may give Yahoo! the highest option value of any company in the world today."So, is Yahoo! a marvelous business? Absolutely. (That's why I own shares in the company.)
2) Is the current state of online advertising a one-time problem?
This question has two components: the impact of cash-starved dot-coms and the effectiveness of online advertising.
Regarding the first component, you'll remember that dot-coms discovered the virtue of frugality earlier this year, around February -- eight months ago. Since Yahoo!'s average advertising contract runs about 8-9 months, only in the next two quarters will the first signs of dot-com penny-penching come to light in Yahoo!'s financial results.
That's why Yahoo! may face a hiccup in its third and fourth quarters. For Yahoo!, a "hiccup" probably means that Q3 and Q4 revenue and earnings will be in line with Wall Street expectations, rather than the customary blow-out.
To put this all into perspective, in last quarter's earnings conference call, Yahoo! said that only 10% of its revenues came from "financially questionable" clients. Also, remember that 29 of the Fortune 50 are Yahoo! clients, and all of Yahoo!'s top 50 clients renewed their contracts last quarter. My conclusion is that any slowdown in demand from dot-com clients will have little material impact.
As for online advertising's effectiveness, I think the "problem" is more of perception than reality. Which leads us to the last question.
3) What is the future of online advertising?
Dollars always follow eyeballs. Yahoo! CEO Tim Koogle has said it a thousand times, and I've probably quoted him on it nearly as often. Worldwide, people are flocking to the Internet, and per-user time spent online is steadily increasing. This extra time spent online comes at the expense of television and newspapers. (Doesn't your personal experience confirm this?) Guess what? The advertisers are going to follow the people.
Jupiter Communications recently published an outstanding report (free registration required) on Internet advertising. In comparing the Internet to other advertising mediums, they concluded that the Internet is a superior medium for the following reasons:
- "ROI [return on investment] analysis. The Internet is a highly efficient medium if advertisers adopt a stringent analysis of their ROI.
- "Cost. Lower production costs and lower audience reach means lower up-front costs when compared to those of TV.
- "Real-time optimization. The Internet allows marketers greater targeting capabilities and higher accountability. These two factors give advertisers the opportunity to optimize their campaigns in real time.
- "Off-line influence. The Internet has the ability to influence not only online purchases but also off-line purchases. Jupiter predicts that consumers will spend $632 billion by 2005 off-line as a direct result of research they conduct on the Web.
With each drop in Yahoo!'s stock price, the market is offering an even greater bargain on the Internet's leading Rule Maker. Take what the market gives you.