Behind Yahoo's numbers by Ryan Tate July 13, 2001

It wasn't the executive's words that threw them -- Semel, after all, promised "real progress" in "transforming" Yahoo -- but rather the numbers. Headline-worthy figures for Yahoo's second quarter were slightly encouraging, as earnings and sales both edged past analysts' low expectations and the company stuck to its full-year guidance on those metrics. What's more, earnings before interest, taxes, depreciation and amortization blew through Yahoo's targets.

But many other company gauges are signaling trouble, including third-quarter earnings and revenue targets, preliminary third-quarter ad sales figures, gross margins, revenue diversification, ad sales, sales to large, traditional corporations, ad rates and -- almost unthinkable for Yahoo -- Web traffic in the U.S. In fact, it is hard to come up with numbers other than second-quarter earnings and revenue that give reason for optimism in Yahoo.

But Yahoo rallies

Strange, then, that Yahoo shares had above-average gains during Thursday's raging tech rally, rising 7 percent, better than the Upside 150's 6 percent gain and well beyond the 5 percent gain for the Nasdaq.

Strange, too, that in light of the trouble signs in the second quarter, Merrill Lynch analyst Henry Blodget upgraded Yahoo's stock to near-term "accumulate" from "neutral."

"The stock will likely remain highly volatile, but we think we have seen the bottom," Blodget wrote in a pre-bell research note Thursday, stoking a Yahoo mini-mania that had been brewing in Wednesday's after-hours trading, when at one point the company's share price was up 12 percent. "We believe the company is stabilizing: management turnover has slowed, revenue [d]uality has improved and costs are under control."

All true. The recent spate of executive departures came just before former CEO Tim Koogle left, so Semel would be hard-pressed to do worse. Non-advertising revenues are up, just not nearly as much as many analysts had hoped.

And Yahoo did cut costs, shaving $25 million off capital expenditure plans despite opening a new headquarters. But costs had better come down, because sales are falling fast. Even if Yahoo hits its financial targets, 2001 revenues will be off between 30 percent and 37 percent from last year and earnings will be off between 88 percent and 96 percent.

Safa Rashtchy at U.S. Bancorp Piper Jaffray also upgraded Yahoo, to "buy" from "neutral," writing that "Yahoo has largely reached its bottom" (sound familiar?) and predicting "coming improvements in ad sales, innovative new products [and] better effectiveness."

He cited Yahoo's higher than expected second-quarter earnings and revenue numbers, which compared favorably with deepening losses reported by ad agency DoubleClick (DCLK) the previous day; growth in spending by traditional, non-dotcom advertisers; higher spending per advertiser; a large user base; and comments by Semel that Yahoo would focus on developing premium services in a handful of key verticals, including music and financial services.

Year-over-year decline disappoints

When Rashtchy said spending by traditional advertisers and spending per advertiser went up, what he means is that they went up sequentially: quarter over quarter. But, as a sharp-eyed Derek Brown at W.R. Hambrecht points out, Yahoo's second quarter is generally better than the first due to seasonality in the online ad market, which drives 82 percent of revenue. That's why quarterly metrics are usually compared with results from the same quarter in the prior year.

When revenue from traditional advertisers and per-advertiser sales are backed out this way, it is clear that Yahoo is experiencing a significant year-over-year decline in these line items. Revenue from traditional advertisers, for instance, is off 7 percent from last year's Q2.

"There's no question that there's an element of the macro environment playing a role in that decline," said Brown. "On the other hand, if we are led to believe that a year ago, traditional clients were much less important to Yahoo, and that in the last 6 to 9 months they've revamped their sales staff and really focused on that market" -- a point Semel made at length in the post-earnings conference call on Wednesday evening -- "it seems they are not doing a very good job of penetrating that market."

So when Yahoo bragged that dotcom clients in Q2 accounted for just 26 percent of business, down from 30 percent in the previous quarter, and when stock analysts parroted that bragging, they were observing the result of the dotcom massacre rather than growth by non-dotcoms.

That is, traditional advertisers are a bigger part of Yahoo's revenue base because spending by online startups is shrinking faster than spending by the traditionals, not because spending by traditional advertisers is growing in a meaningful sense.

In fact, advertising spending seems to be falling faster than ever if one keeps the comparisons year-over-year rather than quarter-over-quarter. Year over year, ad sales were down 41 percent in the second quarter and down 32 percent in the first quarter.

Spending per advertiser, which was also touted by Rashtchy, is down year over year by some 31 percent, compared with a decline of 25 percent in the first quarter.

Ad rates are also on the decline, along with gross margins, which fell to 78 percent from 86 percent in the year-ago quarter and 79 percent in the prior quarter.

Bad news for full year

In the wake of its second-quarter performance, Yahoo itself isn't counting on much for the third quarter. Deferred revenue, a measure of pre-sold ad inventory for the following quarter, declined to $119 million in Q2 from $127 million in Q1.

Yahoo's break-even earnings guidance and revenue target of $160 million to $180 million for the third quarter were below the average estimates of analysts polled by Thomson Financial/First Call. Analysts had previously expected Q3 earnings of 1 cent per share on revenue of $185 million and many, including Blodget and Rashtchy, raced to slash their numbers after the earnings conference call.

With a weaker than expected Q3, how will Yahoo meet the full-year earnings and sales targets it reiterated Wednesday? Well, the company gave a fairly wide range of numbers -- earnings of 2 cents to 6 cents per share on sales of $700 million to $774 million -- and can always come in at the low end.

"It would surprise me a great deal if the company was able to come out at the high end of its year-end guidance," said W.R. Hambrecht's Brown.

The company has made slow progress in diversifying its revenue base beyond the beleaguered advertising sector, and some analysts are getting impatient despite Semel's pledges Wednesday to grow sales of things like music subscriptions, online storefronts, real-time stock quotes and corporate portals. After all, sales of business and premium services grew just 10 percent, to $33 million.

Analysts like Anthony Noto at one-time Yahoo underwriter Goldman Sachs and Arthur Newman at ABN AMRO had hoped Yahoo's so-called "B and P" line item would grow twice that fast.

"They didn't grow their corporate portal business much in Q1 or Q2," said John Corcoran of CIBC World Markets.

Mass market elusive

Corcoran is also not yet convinced that Yahoo can squeeze much more money out of its existing premium services or that it can create new, mass-market services like music subscriptions in the face of intense competition.

"It's one thing to come up with extra mail storage, or photos online. Those are interesting, but those are niche markets. It's not mass-market penetration," Corcoran said.

"What's mass-market penetration? Go back to Napster before it shut down. Twenty million people. That's mass market. But stock trackers, fantasy sports -- do we expect 20 million people to play fantasy sports? Come on now."

Brown agrees. "I think premium services are going to be very difficult to sell," he said. "To start out with, [Yahoo] doesn't have a credit-card relationship with its customers. Secondarily, many of the services for which they plan to charge a fee are services consumer can find elsewhere on the Web for free."

And what of music? Terry Semel is a Tinseltown veteran, and the hope is he can assemble a winning music subscription site. Yahoo already has a marketing deal with Pressplay, the online music alliance of Sony (SNE) and Vivendi's (V) Universal Music Group. But MSN on Thursday announced a virtually identical pact with Pressplay -- "that's not good for Yahoo," Corcoran said -- and Yahoo has yet to produce a popular music site, even though it began to discuss its for-pay music plans in November of last year. (See " Yahoo eyes for-pay music, movie services.")

"The music thing, there has been a lot of talk about it, but not much has been rolled out thus far, and it's not at all clear what Yahoo's role will be," said Brown.

A non-growth growth stock

Based on all this uncertainty, many analysts think the worse may be yet to come for Yahoo. Newman at ABN AMRO writes, in almost precise rebuke to the likes of Blodget and Rashtchy, that "the online ad market has not yet hit bottom" and "we see significant downside potential in the stock price."

Even Noto at the often exuberant Goldman writes, "the environment remains difficult and visibility remains very low."

Those conclusions can be pretty scary for a company trading at around 350 times projected 2001 earnings and 175 times projected 2002 earnings, depending on whose projections one uses. High P/E ratios like those belong to a growth stock -- and yet Yahoo isn't growing.

"Are these issues the symptoms of a healthy, high-growth company?" asks Corcoran. "No. These are symptoms of an older, more mature company." Or, as he wrote in a research note: "Yahoo is a growth story that has stopped growing."

That's true in more than a monetary sense. While Yahoo trotted out a string of impressive-sounding Web traffic numbers in its conference call, it declined to mention that, for the first time in its history, U.S. page views declined sequentially.

Traffic fell to 708 million page views from 735 million in the previous quarter, according to Goldman Sachs.