Up Close, Yahoo!'s Profits Look Worse

Yahoo! issued yet another disappointing earnings report, with earnings dropping 64%.

It also lowered its revenue estimates for the rest of the year, as it expects a continued downturn in online ad spending as the economy weakens.

But when you dig into the footnotes, Yahoo!'s profit result look worse upon closer examination. Wall Street analysts have typically overlooked these items, which pose significant quality of earnings concerns for the Internet giant.

Yahoo! (YHOO) estimated its 2008 revenue will range from $7.18 bn to $7.38 bn. That's down from a forecast of $7.35 bn to $7.85 bn issued three months ago.

Like most all Internet companies, Yahoo! depends mightily on advertising for most of its profits, but online advertisers are dialing back during a recession that's expected to be as bad as the one that hit the US economy in the early ‘80s. Yahoo! now plans to fire at least 1,500 workers or at least 10% of its workforce.

The Profit Pothole

As I've warned you before, Yahoo! continues to have a big profit pothole in its results (see "Yahoo!'s Big Profit Pothole," "Why Microsoft Should NOT Up its Bid for Yahoo!," "Why Yahoo! Can't Go it Alone," and "Why Carl Icahn May Fail at Yahoo!")

Yahoo!'s $727.7 mn profit over the last nine months would have dropped 55% without the gigantic non-cash, paper gains it gets to include in its bottom line, a big $401 mn, from an investment it owns in a Chinese e-commerce company.

The non-cash, paper gains comes from its 39% equity stake in Alibaba.com, the Internet commerce company.

Load in the other $136 mn Yahoo! also got from its equity stakes in other concerns, and the profit result looks a lot worse without the full $537 mn the Internet giant earned from its stock holdings in other companies. Net earnings would have dropped 74%. Not a big vote of confidence in Yahoo!'s profits from its operations, what it can earn organically.

Without those colossal paper gains, Yahoo!'s profit results would have been in a ditch and its operating profits would have been deep into the red. US companies are allowed to book in their profits paper investment gains they earn from investing in other businesses, according to US accounting rules.

Yahoo! does not break out what companies it owns equity stakes in. It does disclose in prior earnings reports that it bought its 39% stake in Alibaba.com in 2005.

The deal gave Alibaba.com the right to buy back Yahoo!'s stake if the Internet giant were to be taken over, in order to preserve its management independence, according to a filing with the Securities and Exchange Commission.

The Chinese company had planned to exercise its right to buy back Yahoo!'s investment in its company if Microsoft bought Yahoo!, reports indicate.

If  Microsoft successfully bought Yahoo!, and Alibaba.com then yanked back Yahoo!!'s stake in it, Yahoo!!'s profits would have seen a gigantic hole blown wide open in its profits.

Operating Costs Rise

You can see why Yahoo! desperately needed those non-cash paper gains. For the first nine months, Yahoo!'s operating expenses rose 13% to $2.8 bn from $2.5 bn vs the year ago period.

That's why operating income dropped to $291 mn for the nine-month period from $504 mn in the same period a year ago.

Free Cash Flow Boost

Yahoo! posted $1.1 bn in free cash flow, a little bit better than the $1.0 bn result for the nine month period a year ago.

But Yahoo!'s result looks better here because it loaded into that result a one-time $350 mn payment it got from AT&T. The company did not give further explanation about this one-time payment from the telecom giant.

Yahoo!'s Bad Balance Sheet

I've been reading the footnotes in Yahoo!'s latest results and found other problem areas as well, other issues that Wall Street analysts have also overlooked.

Here's what you also should be worried about. Yahoo! has $11.6 bn in net worth, generally assets minus liabilities. That's up from $9.5 bn at the end of last year. Again, sounds ok right?

Wrong.

More than a third of that sum, $4.6 bn, comes in the form of good will and intangible assets, the mushy stuff actuaries, auditors and accountants help Yahoo! to price tag on its own. These sums usually represent the future value of research projects, or things like the brains in an R&D operation and such.

Yahoo! owns $3.1 bn in equity interests in other companies, helping to drive its net worth higher. It's those equity stakes that have tossed off paper gains that have helped Yahoo!'s net income results.

It does have $3.1 bn in cash and equivalents, as well as short-term debt securities it can unload in a pinch.

What the heck is in those line items? The earnings release don't tell us, you'll have to wait for the full quarterly report it files in a month or so with the Securities and Exchange Commission.

Google Monster

Microsoft has not resurrected its $31 (later increased) a share bid for Yahoo!, as the software giant, for now, has ditched its attempt to get at Yahoo!'s search engine. Google, the dominant force in search with anywhere from two-thirds to three-quarters of the market share, continues to crush the competition.

Yahoo! only has about a third of Google's search share, and Microsoft's own inhouse search engine is on life support. 

Why Jerry Yang didn't do what Henny Youngman advised--nem di gelt, Yiddish for take the money--when Microsoft came calling is worth pondering, given the flat tires in Yahoo!'s earnings.