Yahoo Soars After Q3 Earnings as Core Business Strengthens

Yahoo’s (YHOO) third-quarter revenue and adjusted earnings sailed past the Zacks Consensus Estimate and shares jumped 3.7% in response. A refocused display business, strengthening search business and success on the mobile platform supported by good cost control and a lower share count drove results.

Revenue

Yahoo reported GAAP revenue of $1.15 billion, which was up 5.9% sequentially and 0.8% year over year. Traffic acquisition cost (TAC) was up 23.6% sequentially and down 7.3% from last year. Excluding these costs in all periods, net revenue was up 5.2% sequentially and 1.2% year over year.

Yahoo combines revenue from O&O and affiliate sites and presents under Display and Search categories. All segments and regions performed better than typical seasonality.

Display revenues (ex-TAC) were up 0.7% sequentially and down 5.9% from the comparable quarter of 2013. Similar to the Jun quarter, the number of ads sold increased 24% from last year but were offset by a 24% decline in the price per ad. While the results were not exactly satisfactory, management commentary was heartening.

Yahoo’s native ad sales through its Gemini platform continue to grow triple digits, but since this business is still a small percentage of revenue, Yahoo continues to be impacted by the secular decline on the PC platform.

Management said that the traditional PC display business is a $60 million drag on segment results but would be offset by the $80 million they expect to generate from the native ad business. Pricing is expected to improve more gradually.

Search (ex-TAC) was up 5.1% sequentially and up 5.5% year over year. Paid clicks were flat year over year, with the growth in price per click remaining very strong at 15%. Management said that paid click growth of 9% in the Americas was offset by weakness in the Asia Pacific region. The price per click (PPC) is benefiting from a decision to focus on more effective ads on better user interfaces and targeting higher-quality traffic.

A lot of the ongoing strength in search is in fact attributable to improvement in click yields, due to relative strength in the Americas region and on Yahoo properties (rather than partner sites), both of which typically yield more revenue.

Other (fees, listings and leads) revenues were up 13.3% sequentially and 6.4% from last year. In the Jun quarter, Yahoo entered into a patent licensing agreement that will yield $20 million a quarter for four years and a smaller amount in the fifth year.

Display, Search and Other platforms represented 36%, 41% and 23% of Yahoo’s third-quarter revenue, respectively.

Yahoo generated around 76% of revenue on an ex-TAC basis from the Americas (up 7.2% sequentially and 2.0% from Sep 2013), around 7% came from the EMEA region (down 7.5% sequentially and up 2.3% year over year) and the balance from the Asia/Pacific (up 2.6% sequentially and down 2.5% year over year).

Margins

Yahoo generated a gross margin of 72.0% in the last quarter, up 109 bps sequentially and 104 bps year over year.

Total operating expenses of $777.8 million were up 5.2% from the previous quarter and up 8.5% from the year-ago quarter. G&A increased sequentially as a percentage of sales, but was offset by more substantial declines in product development and S&M. Product development and S&M did however increase from last year with G&A at more or less the same level (as a percentage of sales).

The net result was an operating margin of 4.3% that expanded 157 bps sequentially and shrank 380 bps from the year-ago quarter.

Net Income

Yahoo’s pro forma net income was $397.9 million or 34.6% of sales compared to $261.6 million or 24.1% of sales in the previous quarter and $298.4 million or 26.2% of sales in the year-ago quarter. Our pro forma estimate excludes restructuring charges, gain on sales of patents and gain on sale of Alibaba Group shares on a tax-adjusted basis in the last quarter.

Including the special items and the amount given out to non-controlling interests, Yahoo’s GAAP net income was $6.78 billion ($6.72 per share) compared to $269.7 million ($0.27 per share) in the Jun 2014 quarter and net income of $296.7 million ($0.28 per share) in the Sep quarter of last year.

Balance Sheet

Yahoo’s cash and short-term investments balance jumped to $11.19 billion due to the Alibaba proceeds that were received during the quarter. The company generated $289.2 million from operations in the last quarter, spending $112.3 million on capex, $292.2 million on acquisitions and $1.38 billion to repurchase 8 million shares in the last quarter. Alibaba proceeds were $9.40 billion.

Guidance

Yahoo provided limited guidance for the fourth quarter of 2014. Accordingly, revenue on a GAAP basis is expected to be $1.20-1.24 billion, revenue on an ex-TAC basis $1.14-1.18 billion, with adjusted EBITDA of $340-380 million, operating expenses roughly flat at around $800 million and non-GAAP operating income of $190-230 million. Yahoo expects to pay $3.3 billion in cash taxes in the first quarter of 2015 in lieu of the Alibaba proceeds.

Our Take

Following the Alibaba Group (BABA) and the sale of a chunk of Yahoo’s shares in it, the company finally looks like it is going somewhere. Management appears to be delivering on their promise, buying back a large number of shares during the quarter.

But what’s really driving investor sentiments is the growth in the core business. Yahoo was the leader in the traditional PC display ad market, so the secular decline here due to the advent of mobile had a rather significant impact on the company. But it now appears that the company is well on track to reinvent itself with its Gemini platform. This is basically a business wherein Yahoo makes mobile apps which are monetized through native ads.

Management said that 44% of display ads are now native, which is very encouraging because this also means a growing presence on mobile. Nonetheless, most of the traffic still comes from PCs, so there is some way to go.

The search business also continues on the road to recovery and the focus on building a more profitable business is commendable. Volumes were a bit disappointing since Google (GOOGL) saw a 17% increase in paid clicks. But the thing to highlight here is the pricing, where Yahoo’s 15% increase compares very favorably with Google’s 2% decline.

So Mayer’s people-product-traffic-revenue strategy appears to be paying off. The growth pillars now being highlighted are search, communications, digital magazines and video, where most of its future investment is likely to be focused.

Despite the solid results, Yahoo shares currently carry a Zacks Rank #3 (Hold), so investors may want to look at other options in the sector like Baidu (BIDU) or Apple (AAPL), both of which have a Zacks Rank #1 (Strong Buy).

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