Profits in peril?

Yahoo was on a roll with an unbroken run of 16 quarters in the black and a soaring stock. Recent months have seen a falling share...

Yahoo was on a roll with an unbroken run of 16 quarters in the black and a soaring stock. Recent months have seen a falling share price and a profit warning and rivals are waiting to pounce, writes Stephen Phillips

Internet mega portal Yahoo has resoundingly cracked that most elusive of dotcom business conundrums - how to actually make money from the Web. The Santa Clara, California-based firm boasts the rare distinction among its Internet peers of profitability; rarer still, sustained profitability.

For the closing three months of 2000, Yahoo notched its 16th consecutive quarter in the black, successfully parlaying the estimated 60% of Web users visiting its multi-service website into a booming advertising-based revenue model. Yahoo counts almost 3,500 advertisers and - based on its ability to offer clients highly targeted access to the estimated 54 million people passing through its portal each month - charges premium rates that hand it one of the highest profit margins of any Internet business.

Nevertheless, while its financial credentials are the envy of the 'dotconomy', Yahoo's competitive horizon is clouded by the faltering fortunes of many Internet firms, which jeopardises a major advertising revenue source. Meanwhile, the corresponding collapse of investor confidence in Internet businesses has dragged the price of Yahoo's shares down by more than 80% since the start of 2000, devaluing the currency previously used to bankroll its all-important acquisition strategy.

Others loom large

Furthermore, the looming presence of the recently merged America Online Time Warner and Terra Lycos combinations, both pooling Internet access services with a wealth of proprietary market-leading content, poses a formidable threat that raises questions about Yahoo's ability to compete on a standalone footing. Meanwhile, Microsoft's lavishly funded Microsoft Network (MSN) is snapping at its heels as the leading free search engine and source of aggregated content.

Yahoo, founded in March 1995, was the brainchild of Stanford University classmates Jerry Yang and David Filo. The 20-something-year-olds convinced venture capitalist Sequoia Capital, whose offices adjoined their Silicon Valley campus, to invest $2m (£1.4m) on the basis that the list of cool websites they had compiled held commercial possibilities.

Sequoia brought aboard seasoned executive Tim Koogle as CEO to add management steel to the founders' entrepreneurial flair, and the quest was on for ways to cash in on what was the Web's first online directory (followed soon after by one of the first text-based search engines). The key was to transcend the limiting idea of a portal as a mere gateway to the Web and transform it into a destination in its own right, drawing enough traffic to function as a viable advertising platform.

Building the so-called 'stickiness' factor entailed amassing enough compelling content and services to keep users' eyes glued to Yahoo's Web pages for as long as possible. To this end, the firm embarked on a bold and opportunistic acquisition spree. Since floating its shares on the Nasdaq in April 1996, Yahoo has used its soaring stock price to snap up $10.7bn (£7.3bn) worth of businesses.

Yahoo's original directory and search services now claim only 20% of page views with services such as free email, instant messaging, scheduling, personal home pages, shopping, bill paying, games and auctions serving as the primary drawcards.

During the week of 15-21 January, Yahoo drew 23.4 million home-based visitors for an average 27 minutes, according to the Nielsen/ NetRatings Web traffic survey. This ranked it the second most popular site for home users after the paid-for proprietary AOL network of sites, which counted 28.3 million visitors but logged only 16 minutes per visitor. Among work-time Web surfers, Yahoo came out top with 15.1 million visitors who spent an average 39 minutes browsing its services, versus second-placed MSN with 13.6 million visitors spending an average 30 minutes on its pages.

Yahoo's extensive reach is a marketer's dream, while its ability to track the browsing behaviour of millions of visitors to its site permits highly targeted advertising campaigns. Banner advertisements can be served up to individual users based on their inferred interests. In the case of 55 million of the 166 million users that Yahoo tracks, the firm actually has explicit information - voluntarily given in the course of transactions - about their identities, home addresses and personal preferences. The Internet affords a level of marketing precision not possible using more traditional media, such as print and TV. Accordingly, Yahoo can command rates of $156 (£107) per 1,000 impressions for premium targeted advertisements - nine times the cost of a prime-time, 30-second slot on US TV.

The advent of broadband services opening up the possibility of interactive TV, for instance, can only increase Yahoo's earnings potential with advertisers. Forrester Research expects online advertising spend to triple by 2003, and by 2004 total $33bn (£23bn). Nevertheless, while advertisements have proved a cash cow, analysts concur that Yahoo must wean itself off an over-reliance on them to build a more stable revenue model.

Relying on advertisements for an estimated 70-80% of its revenue, according to a recent report from US investment bank CIBC World Markets, Yahoo dramatically scaled back 2001 earnings forecasts in January, citing the impact of the dotcom downturn on its core earner.

Executives jarred Wall Street analysts by warning that 2001 earnings would likely fall a gaping 25-42% short of the range of their forecasts based on previous company guidance. "2001 will be a transition year. We will respond to the global economic slowdown and complete a realignment of our client base," says chief financial officer Sue Decker.

Meanwhile, although Yahoo has reduced its exposure to volatile pure-play dotcoms from 41% of revenue to 33% in the fourth quarter, the bricks-and-mortar companies it is courting as preferred clients are themselves scaling back advertising budgets amid the receding competitive threat from dotcom upstarts.

While Yahoo already charges for premium services such as extra storage capacity within its free email accounts, the decline in advertising revenue expectations presents it with the tough task of introducing charges for previously free services. The company signaled such intentions in January, announcing it would charge users to post items for sale on its auction sites. However, a wholesale move to paid-for services is expected to encounter resistance. "It will take a while for consumers to come round to paying for many services," predicts Barry Parr, director of e-commerce research at market researcher IDC.

Premier league customers

Nevertheless, Yahoo holds one important card up its sleeve in its quest to diversify revenue. An estimated 70% of employees in the 500 biggest US corporations log on to Yahoo, handing it ample opportunity to tap a market considered more receptive than consumers to paying for premium services. Analyst Derek Brown at San Francisco investment bank WR Hambrecht & Co expects Yahoo to build on the custom portals and broadcast services it already sells successfully to corporations as it bids to increase non-advertising revenue.

Yahoo's aggressive diversification is also driven by the need to respond to stiff competition. As well as the ongoing threat from Microsoft, the firm now finds itself stalked by two behemoths; AOL Time Warner and Terra Lycos, both of which bundle Internet access with exclusive content.

AOL's $106.3bn (£73.2bn) acquisition of media conglomerate Time Warner, closed in January, buys the leading ISP exclusive rights to a stable of properties, including US consumer magazines such as Time, Sports Illustrated, People and Fortune, major record label Time Warner Music, movie studio Warner Brothers and pay-per-view cable TV channel HBO. AOL is banking on the pulling power of such leading brands to persuade more subscribers to spend longer inside its network of websites.

Terra Lycos, meanwhile, is a combination of Europe's third-largest ISP, Spain's Terra Networks, and third-ranked US Web portal Lycos. Terra's $6.5bn (£4.5bn) buyout of Lycos sets up a global pretender to AOL's crown and a vehicle to drive traffic to content and search tools competing with Yahoo.

The feeling that on its own Yahoo lacks the firepower to compete with these new powerhouses fuelled speculation in January that the firm was ripe for a takeover. Viacom, the owner of US TV network CBS and the third-largest media entity after Disney and AOL Time Warner, was named as a potential suitor, but the rumours came to nothing.

According to Lowell Singer, senior analyst at San Francisco-based investment bank Robertson Stephens, Yahoo's stock, while deflated, is still prohibitively expensive for any media company. But he doesn't rule out a future sale if Yahoo's share price continues to tumble.

However, other observers argue that the mergers entered into by its competitors may play into Yahoo's hands. "Yahoo may actually be more relevant and valuable as an independent company representing the largest distribution channel for other peoples' content," says Brown. "AOL has the ability to distribute other people's content but its likely bias will be toward Time Warner."

According to Parr, AOL Time Warner will be under pressure from shareholders to tap synergies across its businesses; a mission it has already embarked on, plowing resources into online promotions of subscriptions to Time and new music releases from Time Warner artists. Such endeavours pose the "risk of distraction [while] Yahoo is free to think simply about improving its services", says Parr.

Where Yahoo will need to be on its best mettle against the competition is in the international (non-US) market, expected to be a critical battleground over the next few years. Countries outside the US offer all the rich pickings associated with untapped markets.

Yahoo's go-it-alone international approach, spurning pacts with local players (except in Japan) has so far served it well. The firm counts a non-US audience several times that of AOL and experts compliment it on an unprecedented global reach among Internet brands spanning 23 local versions and 12 languages.

"The advantage of Yahoo's model is that it is not based on access. This makes it easier to go into countries and customise without worrying about how people are going to get online," says Parr. Accordingly, the kinds of deals with local players struck by AOL Time Warner and Terra Lycos, which have to sell access as well, are at less of a premium.

Yahoo is banking that such superior nimbleness will enable it to beat its rivals to the opportunities ahead.

What do you think of Yahoo's prospects? Is its business model doomed to failure or is the poor profits warning just a minor blip? Email us at [email protected]

Time line: Yahoo Chronology

March 1995: Yahoo! Inc is born. The firm offers the first online navigational guide to the Web
April 1996: Shares float on Nasdaq
1996 to 2000: Uses soaring stock price for acquisition spree, festooning website with new services to draw traffic
1997: Clears first profit, beginning unbroken run of 16 quarters in the black
Mid 1999: Acquisition activity peaks with $4bn (£2.8bn) splashed on GeoCities, a chat-room host and developer of personal Web page tools, and $5.7bn (£3.9bn) paid for to audio and video webcast capabilities to site.
January 2000: Share price peaks at $237.50 (£163.44)
January 2000 to February 2001: Stock reels from dotcom downturn, plunging 80% in value. Shares priced at $33 (£22.70) each as of February 5
January 2001: Speculation that Yahoo will merge with a media company to meet challenge posed by new AOL Time Warner and Terra Lycos pairings. No deal materialises
January 2001: Yahoo warns that 2001 earnings will fall short of Wall Street expectations by up to 42%

Company CV: Yahoo

Headquarters: Santa Clara, California
International Presence: Operations in 23 countries cross Europ, Asia-Pacific, Latin America and North America
2000 sales: $1.1bn (£76m)
One-year growth: 88.6%
2000 net income: $71m (£49m)
Employees 1999: 1,992

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