Yahoo! Inc. (YHOO) reported first quarter earnings that beat the Zacks Consensus Estimate by 7 cents. Revenue beat by 36.7%. Google’s (GOOG) results also thrashed estimates last week, as both companies see continued ad market recovery and several large spenders coming back.

Revenue

Gross revenue of $1.60 billion was down 7.8% sequentially and up 1.1% year over year. While revenue beat the Zacks consensus, it was just short of the midpoint of management’s guided range of $1.57-1.67 billion.

Marketing services (89% of total revenue), comprising revenue from Owned and Operated (O&O) and affiliate sites was down 7.3% sequentially and up 2.8% from the year-ago quarter.

Total revenue from O&O sites was down 9.9% sequentially and up 0.4% year over year. The display business picked up strongly in the last quarter, growing 20% year over year. Guaranteed placements were up 24%, as recovery spread across multiple verticals, with particular strength in retail, travel, auto and CPG. The strength in display was almost totally offset by a 14% year-over-year decline in search.

Revenue from affiliate sites declined sequentially on seasonality, but increased by over 7% from the year-ago period.

Fees-based revenue, which accounted for the remaining 11% of total revenue, declined 11.3% sequentially and 11.4% year over year.

The U.S. and International segments generated 70% and 30% of revenue, respectively, with the U.S. declining 9.0% sequentially and 5.7% year over year. The International segment declined 4.9% sequentially and increased 21.5% year over year.

Net Revenue

Excluding traffic acquisition cost (the portion of revenue shared with Yahoo’s partners), net revenue for the quarter was down 10.2% sequentially and 2.2% year over year. Net revenue in the U.S. segment was down 9.1% sequentially and 6.1% year over year. Net revenue in the International segment was down 13.2% sequentially and up 11.3% year over year.

Traffic acquisition cost (TAC) in the U.S. segment is around 24.8% of sales, while TAC in the International segment is around 16.8%. However, while U.S. segment TAC is on a decline, International segment TAC is increasing rapidly. In the last quarter, U.S. TAC was down 8.6% sequentially and 4.2% year over year, while International TAC was up 11.3% sequentially and 41.2% year over year. Additionally, TAC as a percentage of total revenue increased 10 bps in the U.S. and 306 bps internationally.

Margins

The gross margin for the quarter was 55.8%, down 95 bps sequentially from 56.7%. The decline in gross margin may be attributed to higher traffic acquisition costs, especially in international markets.

Operating expenses of $690.0 million was down 11.6% from the previous quarter’s $780.8 million. The operating margin was 12.6%, up 92 bps from the 11.6% recorded in the previous quarter. Both general & administrative and product development expenses were down as a percentage of sales, partially offset by higher COGS and sales & marketing expenses as a percentage of sales.

Net Income

The pro forma net income was $229.0 million or 14.3% of sales compared to $140.6 million or 8.1% of sales in the previous quarter and $88.2 million or 5.6% of sales in the year-ago quarter. Our pro forma estimate excludes restructuring charges, amortization of intangible assets, a $66.1 million gain on the sale of Zimbra and a $43.3 million receipt from Microsoft Corp (MSFT) in lieu of transaction cost reimbursement for 2009 under the search agreement on a tax-adjusted basis.

Including these special items, the GAAP income was $310.2 million ($0.22 per share) compared to $153.0 million ($0.11 per share) in the Dec 2009 quarter and a net income of $117.6 million ($0.08 per share) in the Mar quarter of last year.

Balance Sheet

The company has a solid balance sheet, with cash and short-term investments of $3.24 billion ($2.32 a share), down $49.0 million in the last quarter. The company generated $143.6 million from operations in the last quarter and spent $112.5 million on capex, netting a free cash flow of around $31.1 million. The company spent $385.2 million on share repurchases in the last quarter. Yahoo! does not have any debt.

Guidance

Management expects first quarter 2010 revenue of $1.60-1.68 billion, up 0.2% to 5.2% sequentially. Operating income is expected to be $155-195 million including $75-85 million to be received from Microsoft under the search agreement, stock-based compensation of around $60-65 million, depreciation and amortization of around $160-165 million and TAC of $475-495 million. The tax rate is expected to be 35-40%.

Management did not provide guidance for the year. However, it stated that 2010 expenses, excluding tax, would range between $3.85 billion and $3.93 billion, including $880-$900 million of depreciation & amortization and stock compensation charges. Taxes are expected to be 25-30% in 2010.  

In Conclusion

We are encouraged by management’s efforts at turning the company around and believe opex cuts were largely responsible for the significant expansion in first quarter operating margins compared to the margins in the Mar 2009 and Mar 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, with several big spenders returning.

We believe that the company 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, Yahoo! shares are up 24.2% since Feb 10, indicating that most of the growth story and the favorable impact of the Microsoft deal are already factored into the price.

We therefore have a Neutral rating on Yahoo! shares.
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