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This post was largely inspired by several recent Fool articles strongly suggesting that the Rule Maker portfolio managers are preparing to dump Yahoo! shares. Since it was Rule Maker articles that originally drew my attention to Yahoo! and helped to inspire my (too large, in retrospect) investment in it, I wanted to express my own contrary thoughts on the matter. (To date, Yahoo! ranks as my single biggest investing mistake.) I'm posting here, rather than on the Rule Maker discussion board, because I suppose an argument could be made that Rule Maker is a narrowly criteria-driven approach, and since Yahoo! no longer meets many of its criteria, it should be sold. Personally, I don't want to be bound by that kind of strait-jacket.

By way of background, I've only been investing in individual stocks since 1999. (Yes, my timing, as always, was impeccable.) I bought four shares of Yahoo! that year purely as an experiment. Subsequently, after Yahoo! peaked in 2000 (all-time high: $250) and began its long downhill slide, I began adding shares, starting at $117. My big mistake was buying too many shares at too high prices all the way down to my last few shares at $26. In brief, I bought way too much way too soon as I averaged down. My basis is substantially higher than the Rule Maker's. The major mistake in both cases, to my mind, was one of valuation: paying too much. I have serious doubts that I will ever profit from these shares, although that remains a remote possibility. Still, I don't want to compound my initial mistake by selling at the very bottom, either. (I might add that, despite the market's current consensus, I would not feel at all bad if I was buying Yahoo! for the first time at prevailing prices; such purchases, while perhaps aggressive, do not strike me as speculative.)

Andrew Bary, a writer for Barron's who possesses a sharp eye for value, has pointed out twice this year (4/9/01 and 9/10/01, relying upon Lehman Brothers Internet analyst Holly Becker) that Yahoo! has "nearly $3 a share in cash, another $2.63 a share in stock in Yahoo! Japan, and tax-loss carryforwards valued at over $1 a share." Thus, at the prevailing price of $13, the Yahoo! Internet franchise--the main operating business--is effectively valued at $7 per share.

Of course, like everyone else I'm unhappy about many things.

The firing of Tim Koogle still rankles me. Koogle was widely recognized as one of the best executives in America. As far as one could see, he was doing a fine job when he was suddenly and unexpectedly cashiered. (Remember, despite similar circumstances at their own companies, neither John Chambers nor Jeff Bezos was dumped.) Reportedly, board member Michael Moritz was responsible for this ill-considered move, as well as for the selection of Terry Semel as Koogle's successor. At the very least, shareholders were entitled to an explanation as to why such a drastic move was necessary--an explanation that was never forthcoming. As one journalist perceptively joked at the time, "Short of cloning Bill Gates or resurrecting the DNA of Henry Ford, who are they going to get to replace Koogle?" I have to say that Koogle's firing was a big learning experience for me; in evaluating Yahoo! as a possible investment, I never once considered the possibility that the key man might be fired without apparent cause. Uggghhh!

Like Highlighter99, I have serious doubts about Semel. That said, I breathed a sigh of relief when Semel emphasized that he was intent upon "evolution, not revolution." As far as I am concerned, that is the best thing one could have hoped for once Koogle was dumped, and Semel has thus far proceeded with commendable caution and restraint. For the time being, too, the huge turnover of top executives--always a bad sign that something big is wrong internally--has stabilized.

More worrisome is the possibility that group pressure from analysts and the media might prompt executives prone to groupthink into doing something rash, thereby diminishing or irreperably harming a great business franchise. Happily, a recent Forbes article by David Simons brought a healthy dose of thoughtful skepticism to bear on the usual Wall Street cliches that Yahoo! should sell itself to a large media concern, enter the ISP business, or otherwise do something hasty and foolish to jack its stock price up a few notches. Simons even points out that "There's plenty of opportunity left in developing the Internet's marketing potential. The best way for Yahoo! to blow it would be to divert effort to a major quest for 'subscription' revenue." Read his entire article here:

(I would say that Semel's attempt to generate subscription revenue from music strikes me as very worthwhile, though.)

I would like to remind everyone what a great business model Yahoo! appeared to have when ad revenue was abundant. We are too prone to linear thinking, forgetting that business in real life is a speculative, risky, and bumpy affair at best. After 10 years, returns (whether sales, earnings, or capital gains) may have compounded at a nice, healthy annual rate. But they rarely move from Point A to Point B in a straight line. More often they plunge deeply and rise sharply in the interim.

When things were going well, Yahoo! possessed an extremely "light" business model. Despite being a new, young company in a completely new industry, it generated enormous free cash flow--often in excess of reported earnings. This is very atypical; most young, fast-growing companies require net cash infusions in the form of either debt or equity. I think it was one of the Fool's own writers who observed that Wal-Mart was cash flow negative throughout its decades of greatest growth.

Yahoo! is a company that generates roughly 80% of its revenue from ads. The advertising business is cyclical--that's its nature. If you invest in an ad-related business you have to take that in stride. And we are currently experiencing a cyclical downturn. But even more than that is at work.

I recently read an Internet interview in which an advertising expert stated that the current ad market (he was referring to the entire ad market, not just Internet advertising) was experiencing the greatest downturn it has ever experienced since reliable data has been available to measure such things. In other words, we are in the midst of a particularly nasty ad recession, and we should recognize it as such.

Secondly, Internet advertising is still in its infancy. It was only in the spring of 2001--this very year, in the midst of an economic recession--that innovative ads far, far superior to the simple banner ads of the past finally began to appear. These have yet to be tested in a robust advertising environment. Moreover, the entire Internet advertising scene has to settle out: buyers and sellers have to agree upon uniform standards of effectiveness. This has not yet happened. But when it does, the advertising environment will be radically altered. Personally, I have no doubt that Internet ads will ultimately prove to be at least as valuable and effective as TV, radio, newspaper and magazine ads. Nor should we forget their unique interactive capability.

There is one other big issue I would like to address. David Forrest and many others think that Yahoo! possesses no sustainable competitive advantage. I disagree. Dozens of competitors--major and minor--have already been shaken out of the "portal" business. We are now down to three major Internet "channels" that can boast mass audiences. As David Simons phrased it in his Forbes article, "Only Yahoo!, AOL and MSN have built audience and usage to the relative scale of mass-market broadcasting. In comparison, everything else on the Net is like cable programming." Netscape, LookSmart, AltaVista and Excite are all gone. Lycos is marginalized. And even the very deep pockets of Walt Disney and GE were unable to make a success of or

I don't know what you call that kind of competitive advantage, but it is real. A 10/2/00 article by Elliot Zaret entitled "Are Portals Passe?" first brought this point home to me in a big way. Zaret wrote: "Because Yahoo!, Infoseek, Netscape, Excite and Lycos were all big and powerful, everyone else wanted to be [a portal] too. So the other companies tried. Except they overlooked one detail: the portal as we knew it takes vast resources to build the necessary scale for survival. No matter how big or well-funded--and Disney's ABC and General Electric's NBC certainly qualify in that regard--most entrants found they couldn't make it as a general interest portal."

He describes in detail an expensive, focused attempt by AltaVista to leap this barrier--an attempt which ultimately failed: "'There's no question that we've grown really well. But we also recognized and acknowledged that level of growth is still not sufficient to be successful as a media portal,' said AltaVista CEO Ron Schrock. 'The conclusion we came to is only when you're at the enormous scale like Yahoo! do you have the scale economics to at least break even in a realistic way. . . .' Schrock still believes AltaVista could have gained the scale to be profitable as a portal, but it would have taken two or three more years of spending hundreds of millions of dollars every year until it achieved the necessary scale, he said." (Emphasis added.)

Zaret writes that "the U.S. market leaders [are] growing increasingly solidified and the ranks of the top three [Internet portals] increasingly impenetrable. . . Which is why it would be all but impossible for a new entrant to compete as a general-interest portal. That's what Disney and GE found out: no matter how big the company and how much television air time they give themselves, the scale needed to be a general portal is a huge barrier [to entry]."

Zaret also points out that one of Yahoo!'s main competitors, MSN, may actually be taking a divergent route: " is just one part of Microsoft's broader strategy to offer e-commerce services and Web-based software applications. . . . The MSN portal will likely become a platform for Office on the Web and other software more than it will be a general portal."

Finally, Zaret emphasizes that the word "portal" itself is misleading. Yahoo! and others do not want to be "portals" to other sites on the Web so much as they want to be destinations themselves: "Once upon a time there were search sites and directories . . . But the companies realized that the real money was in keeping you around."

Read Zaret's entire article here:

If the Rule Maker port dumps Yahoo! now, I think it will miss out on the fairly predictable convergence of several major developments in the near future: The economy will turn up. Ad spending will revive at a time when Yahoo! can offer ad packages and ad types that are light years beyond the simple banner ads that dominated the last healthy ad market, and tools for evaluating advertising effectiveness will have become increasingly standardized. Finally, broadband will continue moving relentlessly beyond its present 10% penetration of the home--another benefit for Yahoo!. So dropping out now is bad timing, if you ask me.

Am I sure that Yahoo! will once again become a great cash machine and wealth generator? No. Am I sure that I will profit from my shareholdings? By no means. (Remember: I paid too much.) And, of course, I do not expect a return of Internet euphoria among investors, so any share price expansion that does occur will probably be comparatively sedate.

What I do feel certain about is that--assuming the company's management and directors can avoid shooting themselves in the foot by making some drastically wrong move in the interim--I will not be able to intelligently judge Yahoo!'s business model and capabilities until the market for Internet advertising revives. The company has the balance sheet strength to survive until that happens.

That's why I'm still holding onto Yahoo!.

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