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.
FIRST!
I love your posts bro. I must hit refresh about 50 times per day for a new story.
Posted by: King Troll | April 19, 2006 at 10:50 AM