Rule Maker To Buy YHOO
Part 2

February 16, 1999

<< Back to Part 1

Yahoo!, the Company

There is more to Yahoo! than just the baseline growth potential of the Internet. If there weren't, we would have directed our $2,000 toward buying more shares of Cisco Systems (an option we considered quite seriously). That way we could have participated in the Internet's outstanding growth, yet with much less risk.

Instead, we've chosen to take the extra risk with Yahoo! Why? Because the company's business model and its financials represent the very best of what the Communications Age has in store for its commercial leaders. These include, but are not limited to: very high margins; the stock piling of cash; worldwide name recognition; a living room brandname; repeated visiting and purchasing by hundreds of millions of people; deflated costs for customers; the near elimination of "physical space" as a restraint on commercial growth; and life in a market where the greatest competition will be nothing more nor less than a lack of imagination.

To show how Yahoo! demonstrates many of these qualities, we'll now rank the company under the Rule Maker criteria laid out in The Motley Fool's new book Rule Breakers, Rule Makers: 1) Brand, 2) Financial Location, 3) Financial Direction, and 4) Monopoly. If you have not read this book yet, you should. It lays out in plain detail the structure of all of the analysis that follows.

So let us rank and score Yahoo!, on our Rule Making scale of 1-60 points:

Brand (0-1 points)

  1. Familiarity

  2. Yahoo! has established itself as number one among search engines. It just partnered with Fox on a major advertising and cross-promotional campaign. 1 point

  3. Openness

  4. Yahoo! is constantly striving to make its service easier for members around the world -- regardless of age, nationality, economic status or any other supposed boundary -- to use and customize Yahoo! to their heart's content. 1 point

  5. Optimism

  6. The name says it all. The branding campaign has confirmed it. Yahoo! helping to build for the future, for a world where individuals can determine what information they want and how they'd like to receive it. That's forward-thinking optimism. 1 point

  7. Legitimacy

  8. Yahoo! is number one in its category and considerably larger than most media companies today. With tens of millions of monthly customers, Yahoo! has arrived. 1 point

  9. Inevitability

  10. The whole idea behind Yahoo!'s customization is to make it the core of your Internet experience, to make it your home page to the universe. 1 point

  11. Solitariness

  12. No, Yahoo! has not yet claimed the throne here. Other competitors are starting to advertise on TV. Yahoo! has yet to assert its dominance, locking down its status as the only portal worth using. 0 points

  13. Humor

  14. Great name. 'Nuff said. 1 point

After the branding segment of the exam, Yahoo! has raked in six out of seven points.

Financial Location (0-2 points)

  1. Repeat Purchase Business

  2. Millions of people use Yahoo! every day. The company has the potential to be serving hundreds of millions of customers each day over the next two decades. This is a repeat-visit/repeat-purchase model. 2 points

  3. Gross Margins

  4. Yahoo!'s gross margins clock in at 89.7%. This marks an extremely inexpensive business, with plenty of room to pound away at marketing its name and experience. Yahoo!'s gross margins resemble Microsoft's. 2 points

  5. Net Margins

  6. In its most recent quarter, Yahoo! posted 32.8% net margins. This means that, after taxes, the company is netting 32.8 cents in pure profit off of every dollar of sales. Again, this has the look and feel of Microsoft. 2 points

  7. Sales Growth

  8. In weak businesses, the cost of high and rising gross and net margins can be a slowdown in sales growth. As the company extends its profits, it risks alienating its customers. Not so here. Yahoo! has only gained power over its advertisers as its sales grew 188% this year. 2 points

  9. Cash-to-Debt Ratio

  10. With over $400 million in cold cash and not a dollar of long-term debt, we now have to start asking if Bill Gates has a hand in running this business. Yahoo! has exceeded -- by a longshot -- our goals of fat margins, strong growth, and now loads of cash without a lick of debt. 2 points

  11. Foolish Flow Ratio

  12. As if that weren't enough, in terms of asset management, Yahoo! pitches another perfect game. This past quarter, the company dropped its Flow Ratio all the way down to 0.29. With no inventory and few receivables, the company's sales and earnings are as pure as the driven snow. 2 points

  13. Familiarity and Interest

  14. All of the managers of this portfolio are familiar with and interested by Yahoo!'s service and business. 2 points

You guessed it. Yahoo! stormed the castle with a perfect score of 14 on our classic Rule Maker criteria. Its financial location is extremely enviable and one of the primary reasons that Yahoo! is now a $30 billion business. Add fourteen points on financial location to the six points on brand, and Yahoo!'s cumulative score is up to 20.

Financial Direction (0-3 points)

  1. Rising Gross Margins

  2. Yahoo!'s sky-high gross margins actually rose to 90% in the 4th quarter from 87% in the same period last year. 3 points

  3. Rising Net Margins

  4. Yahoo!'s net margins also leapt higher to 33%, up from 7% last year. 3 points

  5. Share Buy backs

  6. Yahoo!'s shares outstanding rose by 10% over the past year, indicating to us that the company is still in expansion mode. It will be some time before share buybacks start kicking in. 0 points

  7. Cash Outgrowing Debt

  8. Yahoo! has no debt and its cash holdings continued to expand. 3 points

  9. Lowering Flow Ratio

  10. Yahoo!'s Flow Ratio dropped down to 0.29 from 0.46 last year, an extraordinarily fine showing. 3 points

  11. Expanding possibilities

  12. Today, Yahoo! is the number one portal in an industry that doubles in size every 100 days. It's running high margins alongside a growing pile of cash and no debt in a world hungering for more interactive services. 3 points

Yahoo! scores a solid 15 points in financial direction, bringing its cumulative total up to 35 points. Its stellar showing in the direction of its business is a primary reason that companies like Yahoo! are storming past the valuations of traditional-media entities. Today, Yahoo! is valued more richly than CBS. Compare the financial direction of both businesses and you'll understand why that is.

Monopoly Status (0-4 points)

Finally, it's time to test Yahoo! on the Monopoly Board of business. The company's competition is swirling. Its lead competitor, Excite (Nasdaq: XCIT), was recently bought out by @Home (Nasdaq: ATHM), so this test will get more complex with time. For now, though, we'll stack Yahoo! up against Excite:

  1. Gross Margins

  2. Again, Yahoo!'s gross margins for 4th quarter 1998 were 90%. Excite's were 83%. Since Yahoo's were more than five percentage points higher, it earns a monopoly chip. 4 points

  3. Net Margins

  4. Yahoo!'s net margins for the 4th quarter were 33%. Excite's were just 5%. Yahoo! again meets that five-percentage-point standard (and then some!). 4 points

  5. Cash

  6. Yahoo! had $482 million in cash and securities on December 31, 1998. Excite had just $61 million. Neither had any debt. Because Yahoo! has more than five times more cash than Excite, it gets another chip. 4 points

  7. Foolish Flow Ratio

  8. Yahoo! has a flow ratio of 0.29. Excite's is 1.47. Yahoo!'s is more than 0.25 points less, earning it more monopoly rewards 4 points

  9. Victory through convenience

  10. Not yet. Yahoo! doesn't yet have enough sales to be a Rule Maker, to kick out the competition repeatedly and expect victory. We'll grant them equal status with Excite here. 2 points

Under the Monopoly heading, Yahoo! adds another 18 points to its total. And that brings its final score to 53 -- a simply phenomenal total. Ranked alongside the companies scored in Rule Breakers, Rule Makers, Yahoo! falls in behind Microsoft and Cisco... and ahead of America Online. Its financials, its brand, its market opportunity, and its management all lead us to believe that we'll hold a prince here heading toward the throne.

A prince who could lead us to market-beating profits.

Concluding Points

By every measurement except one, Yahoo! is a classic Rule Maker. The company's score of 53 is enough to make Yahoo! a "Tier 1" Rule Maker, the cream of the crop, the sort of businesses that we like to own for the next decade. We have an opportunity to buy this business at the beginning of its career, and -- daggone it -- we're taking advantage of that now.

But let us be very clear. The one variable Yahoo! falls short on is an important one. Yahoo! doesn't yet have the $1 billion in sales to plant it in regal territory. The company is just too new to be a Rule Maker. Period. Recognize, then, that a lot can happen between now and any extension of its market dominance. The technology marketplace could shift. Or old competition could gain ground. Or new competition could appear.

What if, for example, the Department of Justice decides to lay off Microsoft? Couldn't the Redmond giant buy out the Alta Vista search engine, neatly embed it into all those Microsoft applications neatly embedded into each other, and seriously threaten Yahoo!'s future? Absolutely, yes. And this development would spell d-a-n-g-e-r for Yahoo! (though we believe Yahoo! is a much stronger company than Netscape was when it waved its wooden sword at the software dragon).

Thankfully, we'll be owning both Microsoft and Yahoo!, as the world adopts digital information and communication at a frenzied pace. And we'll feel comfortable holding the smaller of these two applications businesses because our portfolio is already swollen with pure Rule Making companies. If something were to go wrong with Yahoo!, we could weather the storm without much harm (if any).

We, of course, are expecting things to go very right for this company in the future. There may well be room enough for both Yahoo! and Mr. Softy here.

To talk more about this report, drop by the following Fool boards:

Fool on!

Al Levit and Tom Gardner