The Internet Observer, 02.28.99
DLJ Internet Research
Weather Report
Much wind, no rain. That's a good metaphor for the posturing by Internet
companies (and pundits) of an all-too-common type, those that substitute
self-promotion for accomplishment, opinion for analysis. There's so much
gassy nonsense out there in the realm of Internet capitalism that we wonder
whether smart investors are finding it too difficult or too easy to deploy
cash. Such tornadic chatter can be deafening as it passes, but the good news
is that only real franchises are left standing in the clear aftermath. Put
most simply, lasting value gets created by the best business models run by
the best people, not by amplification of the average.
For relief from a winter of overstatement, we turn this week to Yahoo!, one
of the least self-aggrandizing companies around. Despite the absence of
bluster, Yahoo! has created a franchise that continues to deflect rage and
reward wonder. Investors are paying a dramatic premium for Yahoo!'s shares
relative to its competitors, but no other company has a model that combines
such scalability, profitability, and (we will argue) predictability. And
that's what commands (and earns) a premium.
First, a brief review of some recent history. On every key metric in the
December quarter, Yahoo! showed accelerating momentum: revenue (up 40%
sequentially), registered users (up 40%), page views (up 16%, even in a
seasonally tough month), revenue per customer (up 27%), and operating margin
(up almost 850 basis points, to 36%). Assuming a continued high level of
execution (and assuming the Internet isn't one of the great head-fakes of
the century), this kind of overall strength versus competitors should be
sustainable, even if certain metrics do not follow a straight line up. From
an execution standpoint, management operates as if the competition is about
to crawl up its back, which almost always is one of the clearest signs that
you're investing in the right attitude.
Yahoo! embodies a number of basic tenets about category-leading Internet
companies, especially in its focus on the customer. The best consumer
Internet companies originate at the customer level, which is as true for
Yahoo! as it is for AOL and Amazon. We've spent a lot of time trying to
quantify the value of an Internet consumer (see, for instance, "River Of
Light", 10.19.98), using this method to arrive at the enterprise value of an
Internet franchise. From day one of its corporate life, Yahoo! has at least
implicitly done this calculation as well, religiously adhering to a mission
of providing each consumer whatever it seeks from the Internet (even if it
means directing the customer to a non-Yahoo! site).
In fact, Yahoo!'s entire site is oriented toward customizing the service for
each individual user. Initiatives such as My Yahoo!, Yahoo! Email, Yahoo!
Chat, Yahoo! Calendar and a whole array of other services involve
registering and customizing the site to the needs of the individual user.
And 35 million have registered, almost 70% more than its nearest competitor.
That's a big customer base, and it highlights a couple of elements of
Yahoo!'s scalability. As consumer demand comes online, Yahoo! can capture a
share of it (we'd suggest an increasing share of it) without significant
incremental spending on infrastructure.
Look at it this way: In the December quarter, the company's operating
expenses increased to $41.2 million from $33.4 million in the September
quarter, a delta of $7.8 million. In other words, Yahoo! only had to spend
an incremental $7.8 million to capture 10 million new registered users.
That's $0.78 per user. That's scary. And from an advertiser's standpoint,
the data released by the registered user enables marketers to tailor
specific messages and solicitations that will be much more attractive to the
user. That results in a greater ROI for the marketer, which means Yahoo! can
sell that ad space for a significantly higher price, further increasing the
revenue per customer. We'll take those topline dynamics any day.
It's also worth making a point about the quality of the Yahoo! customer
base. Much of the bragging that goes on among the lesser portals revolves
around the measurement of "reach", which is a way of calibrating the size of
the audience that a given Web site attracts. But a more critical measure is
"effective reach", which tries to get at the quality of the audience (i.e.
how long does the consumer stay at the site once he or she arrives?). As one
proxy for this, in the month of January, the average Yahoo! user generated
56.5 page views per user per month, while Lycos, AOL.com, and Excite
generated 17.4, 18.4 and 25.5 page views per user per month, respectively.
You don't need a weatherman to tell you which way the wind is blowing on
this metric.
Building off of these impressive Yahoo! usage metrics, we're able to develop
a customer-based valuation model. Here's our simplified approach (it's easy,
honest): Yahoo! acquires a customer in year one, and by year two the
customer economics are at a relatively steady state. In year one, Yahoo!'s
per customer margins are lower (20%-25%) than the margin level reported in
the financial statements, as there are steep initial marketing and
acquisition costs. In year two, Yahoo!'s per customer margins expand toward
70%, as the principle operating costs are G&A, R&D and some retention
branding (since the bulk of the marketing/customer acquisition costs have
been previously incurred). We then take the steady-state per-customer
operating income (as a proxy for cash flow) and apply a dividend discount
model [cash flow/ (cost of capital - terminal growth rate)] to come up with
a value per customer.
Now it's time for the sharp pencils to have some fun. As a check on our
discounted cash flow valuation (which is the primary way we arrive at our
$250 12-month target), we can input real data into our customer value
equation. If we assume a year 2000 starting point (given the time horizon of
our target), the first steady-state year for customers acquired in that
timeframe is 2001. In 2001, we estimate Yahoo! will generate close to $800
million in revenue (skip to our discussion below if you want to gauge how
conservative that number is), and we estimate that Yahoo! will have captured
60 million registered users worldwide by then. This equals $13.33 per user
in revenue, and, given the per-customer margin defined above, $8.93 in
per-customer operating profit. We apply our dividend discount valuation
model, which incorporates a cost-of-capital of 13.5% and a terminal growth
rate of 12.5%, to the $8.93 in per-customer profit. The result is a customer
value of $933, which we then multiply by our projected customer base of 60
million to arrive at a $56 billion valuation. Divide that by 236 million
shares, and you should come out somewhere around $240. That's close enough
to $250, especially given the wiggle room around the key assumptions in this
math.
How much wiggle room? Enough to rotate a hula-hoop, and most of it's on the
upside (as it were). We've described a few elements of Yahoo!'s scalability,
and its profitability is increasingly self-evident, but predictability is
ultimately what investors pay up for. Let's return to our 2001 revenue
number of $800 million and look at some of the key underlying assumptions
that drive our model. Let's say Yahoo! only has one revenue source in 2001,
advertising, thereby excluding transaction and commerce revenues of various
kinds that are already starting to work their way into the mix. For Yahoo!
to achieve $800 million in advertising revenue by 2001, two things need to
happen: 1.5% of the total ad spending in the world needs to migrate online,
and Yahoo! needs to maintain its existing 14% market share. Now, not to
suggest anything in the Internet space is a layup, but we're sure driving to
the basket on this one. If you believe (as we do) in the value proposition
to advertisers provided by the Internet, going from 0.75% of spending today
to 1.5% of spending three years from now looks pretty doable, without even
factoring in an inflection point when broadband platforms become ubiquitous.
And with the consolidation happening in the sector, and with Yahoo!
out-executing its portal brethren, flat market share starts to look like an
unlikely scenario, short of an apocalypse.
Other sources of upside? How about Yahoo!'s acquisition of GeoCities, a deal
that makes tremendous sense to us. In a medium where dominant market share
yields the kind of premium valuation accorded to increasing returns
businesses, the pending addition of GeoCities to Yahoo! creates an entity
that already generates over 210 million page views per day and gives Yahoo!
an unduplicated reach of at least 58%. In other words, from a pure numbers
standpoint, GeoCities dramatically extends Yahoo!'s usage lead.
But while the raw data is great, there's a lot more to the combination that
should enhance the visibility of our projections. GeoCities offers Yahoo!
incremental and complementary registered users, content, commerce
opportunities and traffic which leverage Yahoo!'s formidable existing
traffic, sales force and commerce utilities. Yahoo! will also have the
opportunity to channel its enormous stream of traffic into relevant
GeoCities' content. For example, the Yahoo! sports page can now include
selections from GeoCities content derived from its base of 3.25 million
"homesteaders", individuals who've built their own home pages on GeoCities.
Moreover, GeoCities has the raw material to be a huge grass-roots commerce
site. Consumers have definitely embraced the Internet as an environment for
selling personal items, and Yahoo! has attempted to capture some of that
activity on its Yahoo! Auctions and Yahoo! Classifieds sites. GeoCities
offers an additional means of capturing individual Internet commerce by
providing users with the tools to publish and sell items through it GeoShops
program. Ultimately, we can see a tight connection between GeoCities and
Yahoo! Auctions. More users, more traffic, and more commerce should equate
to more than the combination of our projected revenue numbers for the two
companies in the coming few years. Further indication that the Yahoo! model
should be a beacon as the Internet hurricane rages on.
Lastly, the Observer celebrates the arrival of Olivia Clayton Lamarre, the
newest and, at 7 pounds 4 ounces, the smallest member of the DLJ Internet
team.
And we commemorate Katherine Bontecou, bravest and truest of friends. The
power of the world works in circles. |
