We know Internet media company Yahoo! (Nasdaq: YHOO) isn't the same bird it was nine months ago. Or rather, we know that it is the same bird, we just hadn't seen it fly into a storm. The company, which once had a market value topping $100 billion, which some investors thought would buy auction leader eBay (Nasdaq: EBAY) or even media giant Disney (NYSE: DIS), now has a market value about $2 billion lower than eBay and just one-sixth of Disney's.
The Santa Clara, California company made news last week when it announced first-quarter earnings, pared back revenue and earnings estimates for 2001, and announced plans to lay off about 12% of its workforce. Its shares rallied, however, after Lehman Brothers' (NYSE: LEH) analyst Holly Becker, who had been bearish on Yahoo!, recommended purchasing the shares.
The company made news today when it named its new chairman and chief executive, appointing to that post Warner Brothers veteran Terry Semel. Effective May 1, Semel will replace Tim Koogle, who will remain on the company's board. Yahoo! was looking for an executive with experience running a big company, and they've found one in Semel. The media industry veteran has a big job ahead of him.
What should the typical Rule Maker investor think about Yahoo!?
In terms of the cash we can expect Yahoo! to generate in the coming years, and this is the basis on which we want to consider the value of Yahoo!'s stock, there are two issues to consider:
1. As the online advertising model changes, how will Yahoo! fare?
2. How successful will the company be in broadening its revenue stream?
We've seen Yahoo!'s fundamentals erode as the economy softened, and it's clear how vulnerable the company is to changes in the economic climate. Advertising rates and levels ebb and flow with the business cycle, however, and investors have always known this.
What we didn't prepare for was the hit Yahoo!'s revenues would take when easy capital dried up, leaving young advertisers in a cash crunch, and online advertising rates fell. This makes it very hard to put any kind of value on the Internet as an advertising medium. It's just too new to know what to expect. The attractiveness of banner ads on websites, for example, has fallen off a cliff over the last year as advertisers have learned how low click-through rates really are. How then, can we make any kind of judgment about Yahoo!'s future cash flows? In my opinion, we can't, and this is a serious strike against its attractiveness as an investment.
In an interview, Yahoo! President and Chief Operating Officer Jeff Mallett said customers are just beginning to understand the value of the Internet as an advertising medium, yet companies know it's an integral part of doing business. He's right, and Yahoo! is making progress in important areas. For example, even though the number of advertisers that used Yahoo! in Q1 fell sharply from Q4 -- to about 3,145 from 3,700 -- consider that 86% of Yahoo!'s top 200 advertisers contracted for two or more services in the latest quarter, up from 73% in Q4, meaning that Yahoo! continues broadening its appeal as an advertising medium.
It's clear there's value to the Yahoo! platform, and, as an online advertiser, Yahoo! tops the crowd. The problem for investors worried about preserving capital, however, is that the Web-advertising crowd is camped on shifting sands.
Second, Yahoo! is making efforts to broaden its revenue stream. In 2000, about 90% of its revenue, or $1 billion, came from advertising. About $106 million, or 10%, came from business services such as broadcasting audio and video events, offering Web hosting services, and other services.
By the end of 2001, the company expects about 20% of its revenue to come from sources other than advertising. With Yahoo! forecasting revenue in the $700 million to $775 million range this year, that means Yahoo! could generate from $140 million to $155 million in non-advertising based revenue in 2001. This aggressive target would represent 30% to about 45% growth year over year. In 2000, non-advertising revenue grew almost 90%, so the company has a track record of success boosting this revenue stream, though it's now working in a much tougher environment.
We can see the company is making progress. What investors must decide is whether Yahoo! fits into their investing framework. Last week, we wrote about the importance of finding an investment center. Yahoo! presents you with a good way to think about where you fall on the investment spectrum. Despite the fact that Yahoo!'s price has fallen sharply in the last year, I think you should regard an investment in Yahoo! as a risky move.
For starters, the fact its market value plunged from more than $100 billion to about $10 billion doesn't mean the company is suddenly cheap. The market is still heaping a great deal of success on Yahoo! A $10 billion market cap isn't chump change. It's above the median market cap of companies in the S&P 500. Consider that in its Q1 report, Yahoo! guided investors to expect 2001 earnings before interest, taxes, depreciation, and amortization (EBITDA) in the breakeven to $50 million range, down from more than $400 million in 2000. With capital expenditures rising, it's unclear how much free cash flow the company will generate this year, but it's a number that's certainly lower than last year, when Yahoo! produced a stunning $243 million. For all the talk that Yahoo! needs a new business model, the market is putting a great deal of faith in its ability to generate cash in the future, and on its option value.
An investment in Yahoo! is a bet the online advertising market will shakeout in such a way that Yahoo! will earn high returns on this revenue stream. It's also a bet Yahoo! will be able to expand its revenue stream beyond advertising, turning its user base into paying customers. The company may be able to do this, but a bet on this is much different than a bet Johnson & Johnson (NYSE: JNJ), for example, will be able to grow earnings 12% to 15% annually the next five years. Johnson & Johnson faces challenges, to be sure, but its income stream is comparatively stable and it's not necessary the company reinvent anything to grow its business.
It may seem like an obvious distinction that Yahoo! and Johnson & Johnson are in different base camps, but all investors don't necessarily see this. A great deal of money has been made in the stock market by identifying successful companies in stable industries. Tougher investing mysteries, such as which direction the online advertising arrow is pointing, were typically the province of hedge firms and venture capitalists. If you want to play that game, great, maybe you have an edge. Just understand it's not easy, it's not necessary, and it's high risk.
Have a great day.
Richard McCaffery doesn't own shares of Yahoo! or Johnson & Johnson, but he's a fan of both their products and services. The Motley Fool is investors writing for investors.
