Yesterday, Tom confessed to liking Yahoo! (Nasdaq: YHOO) at $60! Ouch! He's a much braver man than I am. I have a hard time 'fessing up to paying top dollar for Tickle Me Elmos at Christmastime a few years back, or to loading up on bottled water just before the clock struck midnight on January 1, 2001. That's the power of groupthink, I guess. It's understandable. It's human nature. It's also human nature to be defensive about decisions that haven't panned out, but the time has come for the Rule Maker managers to stop being defensive about buying Yahoo! It was a lapse in discipline and it's time we righted the ship and got back to basics.
I can understand how the Rule Maker team was seduced by the dark side of momentum investing, or the Internet craze, or whatever it was. I watched a few stocks shoot up double-digit percentages daily during the market's irrational exuberance and considered getting in. OK, so maybe I bought one or two myself. The Force of the dark side was strong with those dot-coms. But, looking back at the Rule Maker investment team's writing during that fateful February in 1999 when we splurged for those 32 original shares of Yahoo!, I noticed two flaws in the rationale.
First, it lacked a valuation argument. All right, I know it wasn't in the cards back then, but we've learned our lesson. Valuation matters. In fact, we recently revamped the Maker investing criteria during our last seminar to include a valuation-based criterion. A reasonable purchase price that allows for the clear possibility of 2x/5y. (2x/5y requires a doubling of share price in five years.)
Applying this to even today's relatively paltry market cap of $10 billion (Yahoo! was once valued at $128 billion), we need a valuation greater than $20 billion for our double. Yahoo! needs to grow its free cash flow 21% annually -- based on trailing 12-month free cash flow of $327 million and a future price to free cash flow of 25x -- to give us that double.
Here's where the fun ends. Right now, Yahoo!'s financials are worsening, not improving, and the dark clouds are forming on the foreseeable future horizon. During the first quarter, its earnings slipped back into the red and its free cash flow dropped to one third of last year's average. Hiccups in financials are to be expected, but the larger issue is when, if ever, those bloated numbers will return.
Even if Yahoo! can increase its 12% chunk of the $8 billion online advertising market, alternate sources of revenue are needed to support a double. Yahoo! must grow faster than the online advertising market, expand its multiple, and get its net margins back above 20%, just to have a shot. As many of us here at The Motley Fool know, it's extremely tough to monetize those unique users, especially when they're used to receiving the goodies for free!
Can Terry Semel, Yahoo!'s newly appointed chief, lead this expedition? Maybe, but Rule Makers shouldn't have this much financial uncertainty. Until we see a clear path to monetizing those 185 million unique visitors, Yahoo! should be sent back to Breakerland.
Now that the bubble has burst and we've all returned from La La Land, it's easier to see that Yahoo!'s financial prospects are iffy at best. Rule Makers are not companies with highly skeptical financial futures. They are companies like Intel (Nasdaq: INTC) that can weather tough times because they have an ace in the hole -- a profitable ace in the hole -- to fall back on. Intel has microprocessors, Microsoft (Nasdaq: MSFT) has the operating system, and Johnson & Johnson (NYSE: JNJ) has an armada of consumer goods and pharmaceuticals. Yahoo! has hope, but that's not enough to hang a Maker jester cap on.
An untested business model
Second, our purchase of Yahoo! skirted the Rule Maker rules. I'm not talking about forgoing a few percentage points in gross margin or accepting a Foolish Flow Ratio of 1.30. That's to be expected. In fact, very few of our current Makers stand up to all our criteria. The Maker team made that perfectly clear at the time of the original purchase in 1999. We labeled it a "tweener" -- in between a Rule Breaker and Rule Maker.
With each of the seven additional times we plopped down cash for more shares -- some under my watch, and as recently as December 2000 -- the portfolio increased its risk and fed the monster. A monster that should never have been given the secret password to Makerland. That password is proof.
Rule Makers are proven companies, or at least in my eyes they are. We need business models that have been tested. Yahoo! is one of the shiniest speed demons to show up in a long time, but let's see how she handles herself on a crowded track before we put the Rule Maker logo on her. Johnson & Johnson and Coke (NYSE: KO) have earned their stripes with more than a century of operation. I'm not suggesting that all Makers be graduates of the century club, but a proven track record should be part of their heritage. I propose one business cycle at a minimum.
To quote The Motley Fool's Rule Breakers, Rule Makers, "As the business evolves from breaking all the rules toward making all the rules, it gradually transforms from being a mostly artistic venture with many non-monetary ideals into an operation driven by scientific artistry and the methodical pursuit of profit." Yahoo! showed us it could make money. It turned a mostly artistic venture into money. Unfortunately, the drivers of that economy are no longer with us. The cash rich dot-coms have gone the way of the dodo and so has Yahoo's return to profitability. Advertisers and consumers are no longer willing to pay through the nose for Yahoo!'s art, and the financial rewards to investors remain uncertain.
Some of you may be cringing, and others may be looking down that list of Rule Makers questioning whether Cisco (Nasdaq: CSCO) has really seen a complete business cycle or whether Nokia (NYSE: NOK) has been through ups-and-downs as a wireless company. Good. Question it. Stock investing is not a static thing. Index investing can be, but investing in individual companies requires an objective mind. One that is willing to reconsider prior thinking and move on.
Yahoo! is not a "classic Rule Maker," we wrote in the buy report. We called it a "crownable prince" and stated that we would keep a close watch over our Yahoo! shares. That watch is over, and it's time to send Yahoo! back to the minors. Maybe someday, we will meet again.