Yahoo! Slides on Search Concerns

Yahoo! Inc. (YHOO) reported second quarter earnings that beat the Zacks Consensus estimate by 3 cents on revenue that beat by 38.2%.

Despite the positive earnings surprise, which continued the trend set over the preceding two quarters, investors were disappointed with the falling revenue per search (RPS). As a result, shares fell 6.12% after hours.

Yahoo recently added contextual searches, which are boxes that open up when the cursor is held over a link, even if the user does not click it. The difficulty in monetizing these searches naturally lowers the RPS. Yahoo management commented that monetization was better in the U.S. than internationally.

Additionally, although the agreement with Microsoft was supposed to increase competition for Google Inc. (GOOG), Google has in fact held its own (after adjusting for the contextual searches), while Microsoft has gained share, mostly at Yahoo’s expense. We notice that the time spent on Yahoo sites is also going down (comScore data), which would make ad sales even more difficult.

Revenue

Gross revenue of $1.60 billion was up 0.3% sequentially and 1.8% year over year. While revenue beat the Zacks consensus, it was at the low end of management’s guided range of $1.60-1.68 billion.

Marketing services (nearly 90% of total revenue), comprising revenue from Owned and Operated (O&O) and affiliate sites was up 1.1% sequentially and up 4.4% from the year-ago quarter.

Total revenue from O&O sites was up 0.7% sequentially and 2.7% year over year.

The display business was the most encouraging, growing 5.1% sequentially and 19.1% year over year. Display gained from guaranteed placements that were up 23%, as 5 of the 10 verticals addressed by Yahoo grew from the year-ago quarter. Management stated that there was particular strength in the retail, technology and CPG verticals.

The strength in display was almost totally offset by a 14% year-over-year decline in search. Non-guaranteed placements were up low single-digits. Management stated that pricing in the guaranteed business improved substantially, while non-guaranteed pricing saw less improvement. The display business in the Americas and Asia/Pac grew double-digits, while that in the EMEA region declined mid-single-digits.

The search business partially offset the increase in display, declining 3.5% sequentially and 7.8% from the year-ago quarter. However, 5 of the 10 search categories increased from the year-ago period, with telecom, CPG and health the strongest and entertainment the weakest.

Revenue from affiliate sites were up 1.9% sequentially and 7.2% year over year. Management attributed the increase to strength in the Asia/Pacific, particularly Korea.

Fees-based revenue, which accounted for the remaining 10% of total revenue, declined 6.6% sequentially and 16.4% year over year.

Management reported second quarter revenue under three geographic segments—The U.S., EMEA and Asia/Pacific. The U.S. and EMEA regions declined 1.7% and 6.5% year over year to 71% and 9% of quarterly revenue, respectively. The Asia/Pacific region was Yahoo’s strongest, growing 38.5% year over year to 20% of total revenue in the quarter.

Net Revenue

Excluding traffic acquisition cost (the portion of revenue shared with Yahoo’s partners), net revenue for the quarter was down 0.2% sequentially and 0.7% year over year. Net revenue in the U.S. segment was up 1.0% sequentially and down 1.2% year over year. EMEA net revenue declined 4.6% from year over year, while Asia/Pacific grew 24.6%.

Traffic acquisition cost (TAC) in the U.S. segment is around 24.9% of sales, while TAC in the EMEA and Asia/Pacific regions were 35.6% and 43.1% respectively. Moreover, the TAC in the U.S. continues to decline, while the international TAC continues to increase.

Margins

The gross margin for the quarter was 57.4%, up 160 bps sequentially and 266 bps year over year. The decline in gross margin may be attributed to higher traffic acquisition costs in international markets.

Operating expenses of $725.4 million were up 5.1% from the previous quarter’s $690.0 million and up around 1.0% from the year-ago quarter. The operating margin was 12.1%, down 49 bps sequentially and 302 bps year over year. Yahoo continued to prioritize its selling efforts, which led to a sequential increase in S&M expenses as a percentage of sales. G&A expenses also increased substantially, but R&D was almost flat as a percentage of sales.

Net Income

The pro forma net income was $230.6 million or 14.4% of sales compared to $229.0 million or 14.3% of sales in the previous quarter and $178.5 million or 11.3% of sales in the year-ago quarter. Our pro forma estimate excludes restructuring charges and amortization of intangible assets on a tax-adjusted basis.

Including these special items, the GAAP income was $216.1 million ($0.16 per share) compared to $310.2 million ($0.22 per share) in the Mar 2010 quarter and a net income of $141.4 million ($0.10 per share) in the Jun quarter of last year.

Balance Sheet

The company has a solid balance sheet, with cash and short term investments of $2.76 billion, down $482.0 million in the last quarter. The company generated $347.0 million from operations in the last quarter and spent $190.3 million on capex, netting a free cash flow of around $156.7 million, up substantially from $31.1 million in the first quarter. The company spent $496.1 million on share repurchases in the last quarter. Yahoo! does not have any debt.

Guidance

Management expects first quarter 2010 revenue of $1.57-1.65 billion, down 2.0% to up 3.0% sequentially. Operating income is expected to be $160-200 million, stock based compensation of around $55-60 million, depreciation and amortization of around $155-160 million and TAC of $465-485 million. The effective tax rate is expected to be 35-40%.

Management did not provide guidance for the year. However, it stated that 2010 expenses excluding TAC would range between $3.80 billion and $3.84 billion, down from the previous expectations and an 11% reduction from 2009 due to increased cost efficiencies.

In Conclusion

We are encouraged by management’s efforts at turning the company around and believe opex cuts were largely responsible for the continued expansion of operating margins compared to the margins in the Jun 2009 and Jun 2008 quarters.

At the same time, top-line numbers are also improving, with the company seeing great strength in the display business. We note that although some industries saw particular strength, there was broad-based recovery across multiple markets. Yahoo saw a temporary slowdown at customers toward the end of the quarter, or its display results would have been even better. Search remains a sore point, although the Microsoft deal is a positive. We expect continued volatility in this business going forward.

We believe that Yahoo will continue to benefit from an improving ad market, which coupled with a leaner cost structure will generate earnings growth and solid cash flows. However, near-term catalysts are limited. Hence we are reiterating our Neutral recommendation on the shares. We also do not expect much movement in the shares over the next 1-3 months and this is reflected in the Zacks #3 Rank (short-term Hold recommendation) on Yahoo shares.

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