Internet Outsider

MSN: Another Quarter Closer To Irrelevant

As shown by yesterday's numbers, MSN’s financial performance continues to deteriorate.  With each passing quarter, in my opinion, the chance that the division will ever mount a serious challenge to Google and Yahoo in search (or any web business) gets slimmer and slimmer.

• MSN advertising revenue rose only 7% y/y, a deceleration from December’s mediocre 12% and September’s 20%.  This compares to Yahoo’s 34% and Google’s 79%.
• Search revenue actually declined y/y.  Microsoft blames this on the transition to adCenter, but shrinking revenue in a market growing this fast is a terrible sign.  All else being equal, shifting to adCenter modestly increases revenue-per-click because MSN goes from booking net revenue to gross revenue.  This illustrates just how much revenue is being lost due to lower keyword prices on adCenter than Yahoo.
• Operating income also declined, from positive $102 million to negative $26 million.  The division is now detracting from the performance of Microsoft as a whole.
• The plunge into the red resulted from declining revenue and a headcount increase of a whopping 35%.  Whatever the new folks are doing, they aren’t selling ads.

MSN’s heavy investment in headcount and R&D, combined with a renewed willingness to run the division at a loss, shows how seriously Microsoft is taking MSN and the Google threat.  Despite this, however, the division’s performance shows no signs of a turnaround (on the contrary, it just gets worse).   Analysts and commentators conditioned by years of Microsoft’s come-from-behind victories in software continue to act as though MSN’s ascendancy is only a matter of time.  The numbers (and general business history) suggest otherwise.

Microsoft has been at the web business for 11 years now--and it is still running a distant third.  How long Microsoft will continue to believe that gaining real traction online is just a matter of hiring the right people, developing the right algorithms, or spending the right amount of money remains a mystery.  Unless the MSN division soon shows signs of first stabilizing and then regaining share, however, even the Microsoft faithful may eventually have to throw in the towel. 

The hirings of Steve Berkowitz, Ray Ozzie, etc. are positive, but, for MSN, they are probably too little too late.  I continue to believe that the best solution to a tough problem is a spin-off.  It worked for Expedia, Slate, and other Microsoft web businesses, and it still has a chance of working for MSN.  Also, why any one company wants to have $50 billion in revenue and compete with IBM and Oracle on one end and Google, Time Warner, and Sony on the other is beyond me. With each successive re-org, however, it becomes clearer that Microsoft is deadset on doing just that.

Click Fraud Update: Arkansas, Armageddon, etc.

We've had much debate about click fraud on these pages, so I wanted to share some of the recent work we've done on the topic over at Cherry Hill Research.  I'll try not to bore you with updates on CHR, but when we publish something that is free to all and might be of interest, I'll post a link here.

Here are some of our current conclusions regarding click fraud:  (The full write-up at CHR is here.)

• The click-fraud concern is real, and the search engines must do a better job of addressing it.  This said, the problem is manageable and will not cripple the PPC industry.
• Increased awareness of click fraud (or, more accurately, the "invalid click" problem) will likely lead to increased spending on click-stream auditing by both search engines and advertisers.  This will modestly reduce ROIs for advertisers (and thus weigh on keyword prices) and modestly reduce profit margins for search engines.
• Google's settlement in Arkansas (if approved) will be a much bigger win for the company than we initially thought.  It will preclude all future class actions based on historical click-fraud claims, including a large one that has already been filed in California.
• The plaintiffs attorneys on the California class action, in fact, called the Arkansas settlement "the worst class action settlement in history" [from the perspective of the plaintiffs.]  From Google's perspective, therefore, the settlement might be described as the best in history.
• The settlement payouts are such that plaintiffs will receive not 'pennies on the dollar' but fractions of pennies, and they will receive them as rebates on future ad spending, not cash.  As far as legal exposure goes, therefore, Google CEO Eric Schmidt might have understated the case when he dismissed the click-fraud issue as "not material."  A more accurate assessment might have been "non-existent."
• The Arkansas settlement does not preclude future legal action for claims after the settlement date.
• Because Yahoo has not settled the Arkansas class action, the California case against Yahoo will continue.  Given the terms Google got, as well as the opportunity to settle all historical claims, Yahoo might be well-advised to settle in Arkansas immediately.

Our write-up at CHR includes links to several interviews on the topic, including Ben Edelman (Harvard spyware expert), Andrew Goodman (CEO of SEM firm), and a pissed-off advertiser.  We will be posting more interviews in the next few days. 

Hope you find the work interesting and/or helpful.  Look forward to hearing your thoughts.

Clever Google Invades My PC

So maybe there is something to the Google-Sun alliance after all.  After weeks of fending off an annoying pop-up demanding that I update my "Java Run-Time" capabilities (or some such under-the-hood detail that I shouldn't ever have to think about), I finally relented yesterday, mainly because a similarly annoying update from Microsoft had just crippled the "save" function on my Word program, and I was hoping that if I just accepted all updates I would get a patch. 

The "Java" update didn't say word one about Google, but after I'd downloaded everything, it asked if I wanted to install a Google Toolbar in my browser and Google search on my PC.  I checked "yes" to the former and "no" to the latter.  Now, for all with no further involvement from me, my browser looks as though it was made by Google.

Evil?  No.  My Java-update bot (in a startling non-sequitur) asked me whether I wanted the toolbar and, for whatever reason, I said yes.  A hundred-percent upright full-disclosure?  No.  In fact, it feels similar to an electrician arriving at the door to fix the panel in the basement and then, the moment he's inside, asking if I want some free life insurance.  Would I take it?  Maybe.  Would I have let him in the door if that's what he told me he was really there for?  No. 

Google Toolbar is freely available to me anytime I want it on the Google web site.  I don't object to having it, and, who knows, one of these days, I might even use it.  For what it's worth, though, even though I "opted in" to it, I don't feel as good about it (or the company) as I would if the Toolbar salesman hadn't barged into my front hall wearing a "Java update" disguise.

Great Quarter, But...

I am occasionally perceived as a Google basher, so I have to be careful here.  Let me first say that the company's revenue and operating margin were, once again, tremendous.  Google surely has all (or at least most) of the opportunity that its fanatics say it does, and the team appears to be executing superbly.  So please take the following observations in that context.

And now for some nits:

• Revenue growth continues to decelerate modestly year-over-year.  This is not a sign of a problem, but simple inevitable.  Just as inevitable, however, is that deceleration will lead to stock-multiple compression (which it already has).  The company's profit margins are also peaking (EBITDA margin was down y/y).  This means that profit and cash flow will lose a major growth driver--margin expansion.

• The company's exclusion of stock-based compensation (specifically, GSUs) from non-GAAP earnings is ridiculous.  Yes, everyone who owns the stock wants the numbers to look as good as possible, and, yes, so many people own the stock that George probably gets nothing but hosannahs for excluding such expenses.  But they are expenses.  And, unlike options, which are also expenses, they will cost shareholders money even if the stock permanently tanks.  The end result of such exclusions is that the pro forma numbers (and multiples applied to them) aren't meaningful.  If anyone wants to offer a defense of this practice other than "The numbers look better that way," please do so.  Because I've never heard one.

• The company's CAPEX spending is more than twice that of its closest competitor and is not to be believed.  This spending will presumably increase the company's competitive advantage, which is positive.  But it will also continue to eat cash flow.  The company says CAPEX growth will exceed revenue growth for this year.  Assuming revenue growth is in the 65% range, that could put full-year CAPEX in the $1.5 billion range (one Street estimates is now $1.7 billion).  This spending has a direct impact on Free Cash Flow.  Contrary to early predictions, moreover, it is showing no signs of declining now that the company has had a chance to catch up with its early growth. 

• Because of the massive CAPEX, combined with a reclassification of some tax benefits for stock options, reported free cash flow was $480 million, up only modestly from Q4.  Unless everyone ignores the reclassification (which they may),  2006 Free Cash Flow will likely be in the neighborhood of $2.5 billion, not the $3 billion-plus many are looking for.   This makes the stock more expensive than meets the eye. 

Because of the exclusion of GSUs, et al, as well as the hyper-fluctuating tax rate, I don't find the company's EPS numbers (either of them) particularly meaningful as valuation measures.  Because of the massive CAPEX, I don't find EBITDA particularly meaningful either.  And that leaves Free Cash Flow.

At $450/share on $2.5 billion of FCF, we're back up to about 55 times Free Cash Flow.  Is it possible that the stock is worth this much?  Yes.  But in the face of ongoing deceleration and a march toward an eventual margin peak, it certainly doesn't leave a lot of room for error.

And the Earnings Sweepstakes Winner Is...

First, I need to correct last night's post, in which I initially said that Google's net revenue had come in slightly above the IO Reader consensus.  In fact, it came in exactly at the IO Reader consensus: $1.53 billion.  So, hats off once again to the collective thinking of IO readers.

Of course, we collectively underestimated the market's reaction to this number--in part because there are many other factors that drive the stock in addition to net revenue, one of them being the bottom line.

So Google reported net revenue of $1.53 billion, and the stock opened at about $445.  Several contestants we're very close this quarter, so congratulations to all. 

The 2nd Google Quarterly Earnings Sweepstakes Award goes to...

Jay

Who estimated $1.52 billion and $440.

Congratulations, Jay!

Aaa-GOOOOGLE-ga!

Well, there you go.  Smokin' top line--exactly in line with our consensus estimate.  Seemingly strong bottom line (have to check operating margins--seems like some upside came from low tax rate).  And humongous CAPEX.  Someday, perhaps, we'll figure out exactly what the company's spending all that money on.

Thanks again to all who participated.  Back with detailed thoughts (and Sweepstakes winner) in the morning.

UPDATE:  In the first version of this post, I erred.  I initially thought Net Revenue was $1.55 billion, and therefore said it was slightly above our estimate.  In fact, it was $1.53 billion, spot on.

Google's Q1: IO Reader Consensus

Three hours before the big event, here's where things stand.  After tallying up approximately 30 estimates and tossing out two high outliers (calling for 1.9 billion and 2.0 billion in net revenue), the IO reader consensus for Google's Q1 is:

Q1 Net Revenue: $1.53 billion

Friday's Opening Price: $411

For perspective, this compares to a Street consensus for Q1 Net Revenue of $1.44 billion, which has declined slightly since we began the Quarterly Earnings Sweepstakes last week.  In other words, for some reason, after digesting Yahoo!'s relatively strong report, the Street revised its collective estimate downward, while IO readers (sensibly, I think) revised theirs upward.

The Street tends to aim low in its printed estimates, and, last quarter, the IO reader consensus proved much closer than the Street numbers to the market's actual expectations.  As I write this, Google is trading at exactly $411 (the IO reader consensus for tomorrow's opening price).  This suggests that, all else being equal, any revenue number above $1.53 billion will drive the stock up, and any number below $1.53 billion will drive it down.

May the best (or luckiest) soothsayer win!

eBay's New Pony: Skype

Sub-Head: Wall Street Misses Forest for Trees

A typical eBay quarter: solid numbers, sandbagged guidance, unavoidable deceleration leading to gradual multiple compression, marketplace and payment businesses that are changing the world.  And then there's that new business, Skype, the acquisition that made everyone think Whitman & Co. had finally gone nuts.

I still think the wrong company bought Skype--in my opinion, Yahoo! should have ponied up, and, because it didn't, now runs the risk of being as much a force in VOIP as it is in auctions.  This said, it's time to forget about lost opportunities and jerry-rigged "synergy" stories and focus on the fact that, as a stand-alone business, Skype is kicking ass.

Since September, average concurrent users have doubled, from 3 million to 6 million.  Average daily sign-ups have increased to 220,000 per day (closing in on 2 million a week--2 million a week!).  The company is rapidly rolling out new products, getting closer to the point where using it will become not only less expensive but more convenient (Skype is now my primary business phone number; a real back-end business voicemail system, I hope, won't be too many quarters away).  Revenue--yes, revenue--grew more than 40% sequentially, from $25 million to $35 million. 

Assuming a reasonable rate of deceleration (which isn't a given), Skype could do close to $200 million in revenue this year and $500 million next.  $500 million is meaningful, even in this league.  And assuming, say, $150 million of that revenue drops to the bottom line, eBay would have picked up the company for 15x-30x earnings--not a fire sale,  but still a bargain.  And remember that we're not talking about some niche market here.  We're talking about the global market for voice.  If Skype's Google- and eBay-like growth trajectory held, $150 million of profit would be only the beginning.   

So, while the Street obsesses about the horror of a minor interface goof (a switchover from auctions to stores, which apparently temporarily whacked revenue), and forgets that, thanks to the re-sandbagged guidance, expectations for the rest of the year are now so low that the company could fall over them, think about this: eBay is now ideally positioned to benefit from decades-long generational trends in not just two massive global markets (retailing and payments) but a third (voice).  Could they screw this up?  Of course.  But for about 30x free cash flow, this risk would seem to be priced in.

Reminder: I own a small chunk of eBay (which, despite my anti-trading philosophy, I am thinking of increasing), and this isn't investment advice.

What Yahoo's Q1 Means For Google

Goldman analyst Anthony Noto includes a handy Yahoo-Google comparison-tool in his Yahoo quarterly write-ups.  According to Mr. Noto, Google has grown approximately 800-1100 basis points faster (sequentially) than Yahoo over the last several quarters.  Mr. Noto estimates a 9%-10% sequential growth rate for Yahoo search in the quarter, which suggests a growth rate for Google in the high teens.

The current Google Street consensus of $1.45 billion in revenue represents 12% sequential growth.  As I mentioned while explaining my own $1.5 billion entry in the Google Quarterly Earnings Sweepstakes, I think this is low for a number of reasons.  Mr. Noto's handy tool would seem to confirm this.  My $1.5 billion represents 16% sequential growth--which, again, based on Mr. Noto's tool, this seems a tad light.  But I'll stick with it.

Lots of entries so far in the Google Quarterly Earnings Sweepstakes.  Feel free to tweak your estimates based on Yahoo!'s numbers (but if you do, please indicate that you are revising an earlier entry).  Later today, I'll calculate the IO reader consensus expectations for revenue and post-report stock price.  Last quarter, you may remember, we were collectively spot on.   

Yahoo: Watch Those Margin Declines

Yahoo's revenue was solid, especially after adjusting for the impact of FOREX and the deconsolidation of China (which pushes the international growth rate from 32% to 41%).  User growth was strong.  Cash management was excellent.  The big story in the quarter that no one seems to be focusing on, however, is the year-over-year margin decline.

For the last five years, Yahoo!'s extraordinary free cash flow growth has been driven by two sources: revenue growth and margin expansion.  The combination of these two drivers has allowed FCF and EBITDA to grow far faster than revenue.  Now, thanks to a year-over-year decline in margins, FCF and EBITDA are lagging revenue.  No matter how jazzed you are about users, engagement, revenue, search algorithms, etc., this will have a major impact on the future of the stock price.

The margin decline was not just the result of a new accounting treatment for stock-based compensation.  According to a Morgan Stanley model, the operating margin declined by 3 points year over year even after excluding stock-based comp.  Gross margin declined 4 points.  The EBITDA margin declined 2 points.  Etc.  Importantly, this is the first time in many years that Yahoo's margins have declined year-over-year.  That this was expected does not change the fact that it is a material change to the company's long-term FCF growth trajectory.

CFO Sue Decker did not go into detail about why the company is no longer gaining operating leverage, except to say, as she has in the past, that the company is now striking the right balance between investing for the future and capturing free cash flow.  A more detailed explanation is probably that broadband-intensive content like audio, video, music, and full motion ads, plus more sophisticated search algorithms, plus the need to keep up with a competitor (Google) that is now spending twice as much in CAPEX (and far more in R&D) is expensive.  Combine that with the fact that Yahoo!'s free cash flow margin is already reasonably high, and the prospects for future operating leverage don't look promising.

All of which means that FCF growth will likely now, at best, track revenue growth--and, over the long term, so will the stock price.  Given the revenue growth rate, this is hardly bad news.  But it's also nowhere near as good as the news has been for the last five years.

Reminder:  I own a boatload of Yahoo and have for years.  Unless Terry makes the mistake of turning the company into a Hollywood production studio, I plan to hold it for at least the next decade.