Project Network Hunt Report: Yahoo! (YHOO), Part III
How To Make Money From Network Effects
In this section, actual and potential sources of revenues are identified for Y! as it seeks to monetize its large base of users.
Interactive Marketing Services. Yahoo served more than 3,675 advertisers and merchants in Q2, including 1,500 clients outside the U.S. Major accounts and brands served in Q2 included Air France, Coach Leather, DaimlerChrysler, Heineken, Johnson & Johnson, Lancome, McKinsey & Co., Merrill Lynch, State Farm, Pharmacia & Upjohn, and the DOD. In Q3, Y! served 3,450 advertisers and merchants, including more than 1,400 clients outside the U.S. Major accounts and brands served in Q3 included Bank One, Barnes & Noble, Costco, Home & Garden Television, Instinet, Neiman Marcus, Polaroid, Publishers ClearingHouse, Replay TV, 7-Eleven, 3M, T. J. Maxx, TWA, UA, and Xerox. In Q3, average contract length increased to 235 days.
Note that in the seasonally slow Q3 the number of advertisers declined by 6.1% from June. According to President and COO Jeff Mallet, this decline represented Internet companies "that either went out of business or completely stopped spending on the web." This means that the ads lost were banner ads, whose purpose is to drive traffic to their advertisers' websites. These struggling companies must preserve cash rather than indirectly acquiring traffic from Y!, which is the most trafficked site.
Without a doubt, Y! is embroiled in a controversy over its quarterly advertising revenues. Net revenues rose a better than expected 90% in Q3. Non-U. S. revenues were 16% of total revenues. What do we know? First, Y! derives 80 to 90% of its revenues from advertising. Second, analysts raised questions about the ability of financially stressed dot-com companies to maintain advertising. Third, these questions occurred in spite of the fact that 60% of its revenues came from traditional companies, up 23% from Q2, and only 40% of its advertising revenues came from dot.com companies, down from 47% in Q2. Fourth, in spite of Koogle's declaration that no more than 10% of its revenues came from companies whose finances were at risk, the Street remained scared, expecting that two to three more quarters to be effected by the dot.com meltdown. Thus, although Y! recorded better than expected revenues, and marvelous cash flow, up 415% in the last year, it still sold off.
Is this surprising? No. As TMF Bill Mann pointed out in June, this plunge in dot-com value is the inevitable fall out of Ben Graham's maxim that in the short-run the stock market is a voting machine, but in the long-run it is a weighing machine. As a voting machine that was influenced initially by greed and currently by fear, Y! may have risen too high and may fall too low, given that its intrinsic value as a company can only be weighed by its results over the long-run. When the strategy above all else is to gain critical mass by aggregating an enormous market, successful performance drives optimism. However, that same strategic choice necessarily delays the search for either maximizing profits or diversifying sources of revenues. According to Mann, "In essence these companies [Yahoo!, Amazon.com, eBay, AOL, and CMGI] are having to make the transition from being granted huge multiples for the hazy notion of 'potential' to being knocked downward for the uncertainty of the same."
If it can distinguish a pearl from an oyster, what the market should notice, however, is that Y! is not only very profitable but also an even better cash generating machine with no debt. Moreover, Y!'s web metrics are genuine drivers of future value. If it does not recognize these virtues, the Street's blindness creates an exploitable gap in expectations that can profit insightful long-term investors with an eye for beauty bare.
What is the potential advertising market? According to market research company, Jupiter Communications, total ad spending on the Internet will grow from 3.5 BB to 16.5BB in 2005. In 1999, Y! captured about 1/6th of that advertising revenue stream. Fool poster "1000" argued that if Y! captured 1/6th of the 2005's 16.5 BB, Y! would earn 2.75BB in revenues. Richey used somewhat different estimated figures, stating that Y!'s share of a 4.6 BB pie was 12.8% in 1999, arguing that if it retained its market share that this translates into 3.3 BB in projected 2003 revenues, yielding an outstanding 54% annual sales growth between 1999 and 2003. And, he believes the strong must grow stronger.
In the long run, dollars always follow eyeballs. In the long run advertising dollars have always concentrated on just a few large audiences. In the long run, the principle of increasing returns, of he who hath gets, ensures that the best companies advertise in media possessing the best audiences.
Who are these companies? Currently, 6% of Y!'s advertising customers account for 60% of Y!'s advertising revenues. Y!'s top 200 customers include 30 of the Fortune 50 and 60 of Advertising Age's Top 100. Moreover, an "Advertising Age" survey found that advertising/marketing decision-makers voted Y! the "Best Advertising Value" and "Best Advertising Environment" online by more that a 2-to-1 margin over the nearest competitor. Y!'s outstanding advertising value produces a 90% renewal rate.
Is online advertising attractive? Online advertising continues to grow, doubling in 1999 from 1998, totaling $1.6 billion dollars in the first six months of 1999. Its rate of growth, at 80% or better, far exceeds that of all other major forms of advertising. Not only are users increasing exponentially, but so is spending on the web. U. S. e-commerce revenues are projected to grow from around $80 billion dollars in 1999 to $726 billion dollars in 2003. Worldwide e-commerce revenue is expected to increase from $131 billion dollars in 1999 to $1.6 trillion dollars in 2003.
Why does Y! have the best audience? First, it is already very large at 166 million users, and IDC projects the Internet to grow from 97.7 million U. S. users at the end of 1999 to 177 million users by 2002; whereas worldwide Web users are expected to grow from 97.3 million in 1998 to 319 million by 2002. Second, 34% of Y!'s audience has made a purchase in the last 30 days; this percentage is 36% higher than the average of the general online population. Third, Y!'s reach of 48.1 million adults age 18+ compares favorable to many television markets (CNN, 37.7 MM; MTV 26.5 MM) and major magazines (People, 34.1 MM; TV Guide, 30.7 MM; Sports Illustrated, 19.3 MM).
What is Y!'s strategy for growing and diversifying ad revenues? Y! welcomes being held to a higher standard of demonstrating its return on advertising dollars because the company believes that it can and will demonstrate that its market segmentation, targeting, and returns will prove to be superior to other media. How can it demonstrate this? First, its advertising model is called "Fusion Marketing." With Fusion Marketing, Y! has created the one place any company needs to go to find any audience, connect with anyone, and sell anything. Second, Y! has developed an advertising panel with Neilsen/NetRatings to track results. Y!'s custom Internet Marketing Panel will provide in-depth outcome data for advertisers and commerce companies. Third, this feedback on effectiveness will enhance future sales of its integrated Fusion Marketing (FM) service. It is build, test, and re-build at work, another example of how the principle of duplication with feedback guides Y!'s execution.
FM provides audience solutions. Consider Kmart's BlueLight.com, which is a free ISP turnkey service offered by Spinway and Y! as an audience solution that creates a platform for frequent customer communication and future commerce. Its formula for success is: Targeting + Customer Modeling + Free ISP + Banners + Promotions + Sponsorships + Yahoo! Delivers = Strong Customer Relationships. This FM solution produced the fastest growing ISP in the US, from 12/15/99 to 9/6/00 growing to 4 million users of its free service, seeking 6 million by year-end. BlueLight is the top-site for visitors to discount stores according to Media Metrix, with 1.92 million visitors in July compared to Wal-Mart's 1.48 million. Kmart hope to convert one-quarter of its users to customers; it expects to reach profitability next year on $100 million in projected sales. It site is being upgraded to include improved search functions and more than a half-million products. It is seeking to increase participation by a stepped-up presence in Kmart's 72 million advertising circulars, installing kiosks in 1600 stores, and cooperative ventures with National Enquirer and Kodak.
Or, consider PepsiStuff.com, one of the largest online-offline promotions ever, that was launched in mid-August. Targeted at teenagers who make single bottle a purchase of Pepsi or Mountain Dew, this "under the cap" program is Pepsi's largest ever single-serve promotion, involving 1.5 billion bottles and nearly 80,000 retail outlets-all displaying the Y! logo. Teens log on to PepsiStuff.com and set up a point-account system that is used to exchange points for merchandise (video games, DVD, CD, etc.), win prizes in contests, and give gift certificates. TV and in-store promotions not only help Pepsi but they also emblazon Yahoo!'s brand in teens' minds. Best of all, teens have a web site where they can chat with one another. This interactivity that builds community is an unrivaled advantage in Internet marketing when compared to other media.
To date, Spiegel, Costco, and Barnes & Noble have similar free ISPs through Yahoo. These arrangements increase Y!'s reach as a portal, build interactive communities, expand brand awareness, and add revenues that will grow as results are demonstrated. When Y! is characterized as overly reliant on banner adds, it says the Fusion Marketing strategy is still not widely known, although it is effective and growing. No wonder Y! welcomes being held to a higher standard!
Commerce. Yahoo!'s comprehensive suite of commerce services includes Y! Shopping, Travel, Auctions, and Store. In the first three quarters, Y! enabled $3 billion dollars in transaction through Y! Shopping, Neilsen/NetRatings # 1 portal shopping site. In addition to a fee for hosting merchants, this year Y! began to charge a commission of 2% on total enabled transactions above $5,000 dollars. In addition, Store merchants are offered a variety of hardware and software services. For example, merchants can choose either to use Y!'s Cobalt Networks RaQ Servers or to build their own servers from selected offerings or, for software, to use Y!'s integrated NetLedger's accounting systems that synchronizes inventory, shipping and payment methods, order history, and sales orders totally online. Recently, Visa and Y! announced an expanded e-commerce relationship, where Visa is the default credit card for Travel and Wallet, as well as Shopping, plus a co-branded marketing program, point-reward loyalty program, and future authentication services. Also, Y! launched My Shopping, a personalized shopping service where consumers can aggregate their favorite stores, track recent orders, and shop for products that are personally relevant.
Y! Auctions operate in 16 countries and 11 languages and offer three million items. Although Auctions increased its growth 400%, increased sell through by 25% in the last quarter, and featured sellers increased their likelihood of selling by six times over non-featured-sellers, I believe the Principle of New Frontiers still applies. Whoever achieves critical mass in local markets will prevail in auctions or other niches. Y!'s new Auction services, however, enable investors to understand its global strategy. This year, Y! introduced Custom Booth--unique free customized auction sites' Neighborhood Watch-reporting of suspicious items and the like; Charity Auctions Program-non-profit auctions, for example, the "Undress for MS celebrity jean auction" raised $110,000 for MS research; Featured Sellers-priority placement and branding; Seller Performance Reward Program-rewards quality; PayDirect-free online person to person payment, linked to existing credit or debit cards; and a new Buyer Protection Program for Auctions and Shopping.
What is most important for investors to notice here are the synergy of integrated services and their rapid rate of advance. It is not so much what has been achieved by Y!, but what is achievable. Consider Yahoo! Finance. If you list your stock portfolio there and use Y!'s calendar, then information appears automatically about quarterly reporting dates for the stock that you own or wished you owned. If you use E*Trade, then you can access your account balances directly in Y!, which provides a better interface for stocks and their analysis. Fool poster Morgan noted two advantages for E*Trade of expanding its relationship with Y!. First, a seamless plug-in would provide E*Trade with a decided advantage in recruiting new customers in a ruthlessly competitive discount brokerage market. Second, using Y!'s website would let E*Trade concentrate on their core business while outsourcing building and maintaining an interface to Y!. Morgan recognized that this model is general. That is, that Y!, because it has a huge audience, can establish itself as an ASP in the lucrative market of integrating specific businesses with a huge customer data base.
As a second example, consider Y! Sports as a source of synergy. In September, Y announced a groundbreaking global agreement with the NBA and WNBA to enhance their specific web sites and to jointly market products. Included are provision to: offer Sports users NBA/WNBA digital content such as video highlights, real-time game statistics, photos, and audio of live games; develop their live game web sites; have Y! Broadcast provide steaming audio hosting and distribution service, including live games, web-based shows, press conferences, and events; jointly advertise on TV and the web; be a primary source of online Auctions for memorabilia and authentic gear; include the NBA Store in Shopping; license the right to use players names and trademarks in Fantasy Basketball; and develop international versions, including customization for different languages, real time scores and stats, specific region based content, and apply tools such as Y! Auctions, Messenger, and My Yahoo!. This is an example of how valuable Y!'s audience and tool set of services are to diverse franchises when cross-branded and leveraged to enhance the value of Y!'s targeted audiences.
Business and Enterprise Customers. In the nine months that Y! has begun to focus on the commercial potential of this sector, several opportunities for new revenues have been developed. First, Y! launched a B2B Marketplace that aggregates several company's sites into a one-stop business-to-business directory that connects business users with everything they need to research, price, and purchase products needed for their business. Second, Y! introduced a new suite of services that offers a solution that provides one-stop shop for creating and maintaining a web site for individuals and small businesses, including web site hosting, domain registration, servers, and tight integration with Classifieds, Auctions, and other Y! properties. Third, Y!, with Tibco's ActivePortal technology, introduced Corporate Yahoo! services for the global 2000 companies, allowing them to maximize their investments in intranets and extranets by creating a customized portal, which is based on Y!'s My Yahoo!, and that permits the integration Y!'s content and corporate content behind the corporate firewall. Fourth, Y!, with Tiger Electronics, introduced its first branded media player as a lifestyle product. Fifth, Y! hosted web conferences and streaming media events that were discussed above. Sixth, Y! announced a free ISP for small businesses, in conjunction with Spinway and Equalfooting.com, that serves as a B2B online market place, placing small business on an equal footing with larger companies by aggregating purchasing, financing, and shipping.
How To Think About Money That Y! Hasn't Even Made Yet
In the CSFB "Frontiers of Finance" series, in a paper entitled "Get Real," Michael Mauboussin recommended the use of real options theory in security analysis. This approach weds strategic intuition with analytical rigor. The real option approach becomes vital to analyzing emerging businesses in rapidly changing markets where the search is on for the next big thing. Real options are applicable when: (a) a smart management team is focused on creating, identifying, and exercising real options, (b) a market-leading company, who has economies of scale and scope, and gets the best look at strategic opportunities, and (c) better yet, this occurs in markets where uncertainty is high, increasing the value of its real options.
Real options analysis extends financial option theory to real or non-financial assets. The basic idea is that a company has the right but not the obligation to make a value-accretive investment in real assets to extend their value proposition. Real option analysis is a way of thinking that is modeled after the Black-Scholes financial option model where stock price is equated to present value of a project free cash flow, the exercise price is equated to the expenditure required to acquire project assets, the time to expiration is equated to the length of time the decision may be deferred, the risk-free rate is equated to the time value of money, and the variance of returns is related to the riskiness of project assets.
Real options analysis targets strategic actions that create valuable new options. Koogle's strategic thinking aligns precisely with this approach across both his long-run strategy of using self-reinforcing scale and his five specific business objectives. First, consider self-reinforcing scale. By riding the technology wave of the expanding World Wide Web and the Telecosm's growing abundance of bandwidth, Y! has the means both to increase its audience as the WWW expands and to deepen its services as bandwidth increases. The successful creation of a single branded platform with 166 million users creates many potential options. Achieving critical mass in the U. S. and in some of its 24 local presences ensures that other users will join Y! because of direct network effects. This huge global audience attracts partners into Y!'s b-web, particularly advertisers and merchants who always seek access to large networks of users. Here Y!'s real options are potential means of generating revenues from its innovative business model. Will Y! use its Classified Ads or its Auctions or it Yellow Pages or its Shopping or its Travel as new sources of income from advertisers and merchants? All of the above seems likely. Y!'s appealing content and essential services drive further growth in audience reach, stickiness, and loyalty that drives consumer, business, and enterprise services. Personalized premium services, joint ventures, and acquisitions increase sources of revenues, profits, and cash flows. As the cost of adding new members, of replicating and deepening services, and of enabling transactions decreases asymptotically toward zero, margins expand exponentially. Remember that such costs can approach zero as profits expand indefinitely.
Second, if Y! drives globalization, mobilization, and the usage of expanding bandwidth, it increases its real options as an enabler of transaction and in offering business services. What Y! has learned to do well in the U.S. can be replicated, yet made local, in its 24 worldwide locations. This is a real option to expand successful strategies and outcomes worldwide. Given the Principle of New Frontiers, sometimes you can become a winner in a niche abroad where you may not have been able to reach critical mass in the U. S. Mobilization of Y! Everywhere, not only at work or at home, but also in cars, taxis, airplanes, ships, and wherever you can carry a phone, increases essentiality-the ultimate in reach, stickiness, and loyalty. Imagine having your calendar, messages, mail, and map always available and voice-enriched. Is this a premium service? Is it a new advertising medium? And, what options will be created by expanding bandwidth? Imagine video added to your personal communicator. Currently, Y! uses its Broadcast.com acquisition to broadcast streaming video from Silicon Valley as :FinanceVision. Yahoo! says that this is an X-vision strategy. The real options here are exciting, from FinanceVision to HealthVision to NBA-Vision to whatever.
Finally, consider the direct and indirect network effects of having achieved critical mass in audience and the implications for essentiality of being global yet local, universal yet personal. Direct network effects ensure that the audience continues to enlarge with near zero costs from cascading diffusions of innovations transmitted by word of mouth. Indirect network effects from broader services, whether from new features or new services, ensure the advantages of compatibility must increase the value proposition for users, and, thus, for Yahoo! When Y! becomes essential for users worldwide, it will have succeeded in its strategic goal of become a very big and profitable business.
Yahoo!'s trump card, however, remain interactivity. Building communities around interests includes building communities around travel and commercial products. It permits Ford to respond to problems around its Explorer or Firestone tires. It lets users add value to almost any value proposition. For example, Y! recently began offering expert service, recruiting both experts and expert-seekers from its huge audience. Imagine that this expands and is successful for a few years, then Y! permits vetted experts to offer a fee for premium services, takes a small commission, ties it to its Yellow Pages, and offers featured ads. Your imagination is as fertile as mine. What do you want in your MyYahoo!?
When you have a vision of real options dancing in your head, you can appreciate the future value of becoming the single trusted place for a huge audience of users. It's better than Christmas! When you realize that Y! provides not only profits but, better yet, exciting cash flow, then you can wait patiently as Y! rapidly executes its strategic vision. According to TMF Zeke Ashton, who characterized Yahoo! as the king of expanding possibilities, " . . . the market perpetually overvalues predictability and undervalues expanding possibilities." This creates an exploitable investing opportunity. In contrast to backward-looking investors who favor "rules of thumb like P/E ratios, Ashton argued that forward looking investors can extrapolate FCF forward to 2004 by assuming that it doubles each year. If that does happen, Yahoo! garners $5.1BB in free cash flow. And, Y! has no debt because of its tremendous cash flow and its exceptional return on cash invested in new operations. Yes, these extraordinary financials and Y!'s management create endless real options for a global communications, commerce, and media enterprise using an Internet platform. Yes, Virginia, there is a Santa Claus.
I hope this help understand both Y! and how network effects secure sustainable competitive advantage.
Don
Disclaimer: I am long a half-position in Y!. Although fully invested, I plan to increase that position as soon as I can. Currently, by investment size, Y! is my seventh favorite stock. I am not a financial professional, and all of the above is just my opinion. My interest here is primarily educational. Although it was a lot of work, I enjoyed doing much of it because I leaned a lot and enjoyed telling Y!'s story. If you like the piece, let me know. If you disagree, please comment. I have more to learn than to teach. |
