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Yahoo! Inc. (YHOO - Analyst Report) reported third quarter non-GAAP earnings that were up 31.2% sequentially and 81.0% year-over-year, exceeding the consensus estimate by 11 cents, or 45.8%. The average surprise in the preceding four quarters was 26.0%, so the quarter’s results were very strong in comparison. Yahoo shares responded as may be expected, jumping 4.6% in after-hours trading.

Revenue

Yahoo reported GAAP revenue of $1.20 billion, which was down 1.3% sequentially and 1.2% year over year. TAC costs were down 17.7% sequentially and 22.2% from last year. Excluding these costs in all periods, net revenue was essentially flat on a sequential basis and up 1.6% from last year, in line with the consensus.

Yahoo combines revenue from O&O and affiliate sites and presents under Display and Search.

Display revenues (ex-TAC) dropped 4.6% sequentially and 1.was consistent with the comparable quarter of 2011. The Americas (up 4%) was the only region to see some notable growth in the last quarter, which was however supported by flattish results in both the APAC and EMEA regions. The product mix helped results in the Americas, with Class 1 impressions continuing to do well, while Class 2 continued to decline. Macro conditions in Europe weakened results in the EMEA.

Yahoo’s position in display will be a key to its future growth, since most market research firms are projecting strong growth here due to underlying drivers, such as brand building on online properties. However, there is little confidence in Yahoo’s prospects, with most market research firms expecting the segment to be dominated by archrival Google and Facebook (FB - Analyst Report). The company is steadily losing market share and it remains to be seen whether the new CEO can reverse the trend.

Search (ex-TAC) was up 7.4% sequentially was 10.6% year over year. Yahoo said that guaranteed placements helped results in the last quarter, as did the positive RPS.  Yahoo is still protected by Microsoft’s (MSFT - Analyst Report) RPS guarantee.  

Other (fees, listings and leads) revenues were flat sequentially, while declining 9.9% from last year.

Display, Search and Other platforms represented 41%, 38% and 21% of Yahoo’s third quarter revenue, respectively.

Yahoo generated around 74% of revenue on an ex-TAC basis from the Americas (up 3.4% sequentially and up 6.5% from September 2011), around 7% came from the EMEA region (down 15.8% sequentially and 17.9% year over year) and the balance from the Asia/Pacific (down 1.7% sequentially and 6.4% year over year).

Margins

Yahoo generated a gross margin of 67.1% in the last quarter, up 126 bps sequentially and down 130 bps year over year. Total operating expenses of $629.9 million were up 1.9% from the previous quarter and up 7.8% from the year-ago quarter. Product development costs were up as a percentage of sales, partially offset by higher cost of sales, with both S&M and G&A staying consistent.

However, product development and S&M declined significantly on a year-over-year basis, partially offset by PTEHR costs that increased. The net result was an operating margin of 14.7% that declined 38 bps sequentially and increased 241 bps from the year-ago quarter.

Net Income

Yahoo’s pro forma net income was $421.5 million or 35.1% of sales compared to $328.4 million or 27.0% of sales in the previous quarter and $245.5 million or 20.2% of sales in the year-ago quarter. Our pro forma estimate excludes restructuring charges and Alibaba sale-related gains on a tax-adjusted basis in the last quarter.

Including these special items and the amount given out to non-controlling interests, Yahoo’s GAAP net income was $3.16 billion ($2.64 per share) compared to $226.6 million ($0.19 per share) in the June 2012 quarter and net income of $293.3 million ($0.23 per share) in the September quarter of last year.

Balance Sheet

Yahoo has a solid balance sheet, with cash and short term investments of $8.41 billion, up $6.50 billion during the quarter. The company generated $1.05 billion from operations in the last quarter and spent $139.9 million on capex.

After adjusting for this and excess tax benefits from stock awards, free cash flow came to around $920.4 million, up significantly on a sequential basis. The company also spent $190.4 million on share repurchases in the last quarter. Yahoo does not have any debt.

To conclude

Yahoo provided some encouraging commentary about product innovation, which following the better-than-expected third quarter results went down well with investors. However, a turnaround in the company’s business remains an uphill task given the company’s declining position in display and search, the monetization issues related to Microsoft’s search platform, and Yahoo’s lagging in several emerging segments, such as mobile, social and the cloud.

Cost controls and efficiencies are likely to continue. However, we expect management to continue investing in the business, which would be a pressure on operating margins.

We remain cautious about the company despite its cheap valuation because interesting management commentary could simply be history repeating itself. Further clarity regarding the game plan would make us more optimistic.

Also, while the improving ad market will continue to benefit Yahoo and a leaner cost structure will help cash flow and earnings growth, these factors will be mitigated by competitive pressures.

The shares carry a Zacks Rank of #3 (short-term Hold recommendation). We are also Neutral longer term (3-6 months).

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