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Yahoo (YHOO - Analyst Report) reported fourth quarter non-GAAP earnings that were down 12.0% sequentially and up 25.5% year-over-year, exceeding the Zacks Consensus Estimate by 5 cents, or 18.5%.

The surprise history is also positive (31.6% in the four preceding quarters). Yahoo shares responded as may be expected, jumping 3.2% in after-hours trading.

Revenue

Yahoo reported GAAP revenue of $1.35 billion, which was up 12.0% sequentially and 1.6% year over year. TAC costs were up 10.8% sequentially while declining 19.6% from last year. Excluding these costs in all periods, net revenue was up 12.1% on a sequential basis and 4.5% from last year, ahead of the Zacks Consensus Estimate.

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

Display revenues (ex-TAC) increased 15.2% sequentially while declining 4.6% from the comparable quarter of 2011. Management attributed the year-over-year decline to declining engagement on key properties, primarily webmail.  The number of non-PPC ads sold declined double-digits for the fourth straight quarter, although the price per ad continued to increase.  

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, confidence in Yahoo’s prospects remains low, given the growing success of archrival Google and Facebook (FB - Analyst Report). The company is steadily losing market share and it remains to be seen whether the latest CEO can reverse the trend.

Search (ex-TAC) was up 3.2% sequentially and 13.8% year over year. Ad quality improvements, including a Yahoo-specific click prediction model from Microsoft (MSFT - Analyst Report) and new ad products drove click-through rates.

With both the number of paid clicks and the price per click increasing for the second straight quarter, Yahoo saw another quarter of positive RPS. Microsoft’s RPS guarantee expires at the end of the current quarter, so the improvement in Yahoo’s RPS is encouraging.  

Other (fees, listings and leads) revenues were up 22.4% sequentially and 10.4% from last year.

Display, Search and Other platforms represented 43%, 35% and 22% of Yahoo’s third quarter revenue, respectively.

Yahoo generated around 74% of revenue on an ex-TAC basis from the Americas (up 13.1% sequentially and 8.1% from Dec 2011), around 8% came from the EMEA region (up 22.1% sequentially and down 12.0% year over year) and the balance from the Asia/Pacific (up 4.4% sequentially and down 1.3% year over year).

Margins

Yahoo generated a gross margin of 70.6% in the last quarter, up 343 bps sequentially and 222 bps year over year. Total operating expenses of $659.1 million were up 6.0% from the previous quarter and up 2.0% from the year-ago quarter.

The gross margin expansion from both comparable quarters was supported by lower S&M and flattish product development costs (as a percentage of sales). However, while G&A expenses were consistent with the previous quarter, the increased substantially from last year. The net result was an operating margin of 21.6% that expanded 620 bps sequentially and 205 bps from the year-ago quarter.

Net Income

Yahoo’s pro forma net income was $369.6 million or 27.5% of sales compared to $429.5 million or 35.7% of sales in the previous quarter and $312.8 million or 23.6% of sales in the year-ago quarter. Our pro forma estimate excludes restructuring charges on a tax-adjusted basis in the last quarter.

Including the special item and the amount given out to non-controlling interests, Yahoo’s GAAP net income was $280.2 million ($0.24 per share) compared to $3.17 billion ($2.65 per share) in the Sep 2012 quarter and net income of $295.6 million ($0.24 per share) in the Dec quarter of last year.

Balance Sheet

Yahoo has a solid balance sheet, with cash and short term investments of $4.2 billion, down $4.2 billion ($2.3 billion was paid for Alibaba-related taxes) during the quarter. The company used $1.90 billion in operations ($2.3 billion was paid for Alibaba-related taxes) in the last quarter and spent $130.3 million on capex, which resulted in negative net cash flow.

The company also spent $1.5 billion on share repurchases in the last quarter. Yahoo does not have any debt.

Guidance

Yahoo provided limited guidance for the first quarter of 2013 and the full year. Accordingly revenue for the current quarter is expected to be $1.07-1.1 billion, with EBITDA of $340-360 million and operating income of $155-175 million.

For the full year, Yahoo expects revenue of $4.5-4.6 billion, with EBITDA of $1.6-1.7 billion and operating income of $810-850 billion.

The guidance takes into account the closure of the Korean business and expiration of Microsoft’s RPS guarantee on Mar 31st.

To conclude

Yahoo’s search business showed signs of improvement, while the display side disappointed yet again.

The guidance was also not very exciting although management commentary about ad improvements, technology enhancements and cost control sounded good. Yahoo’s guidance indicates a 3.3% decline in operating income on a revenue decline of 8.7%, which seems to be accounting for some cost control.

We think Yahoo needs to step up investments to drive its business. Therefore the lower costs seem to indicate the lack of a crystalized strategy.

With Microsoft’s RPS guarantee disappearing and the display market remaining challenging, we think a turnaround remains a wait-and-see story.

Yahoo shares have appreciated 27.1% over the last six months, after the Alibaba issue was resolved and the company decided to retreat from unprofitable markets. However, the current valuation is no longer cheap.

Yahoo shares currently have a Zacks Rank #1 (Strong Buy) and we expect the rank to move lower in the next few weeks.

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