Top Gun Gets It Wrong: Yahoo! Reports an Expected Mediocre Quarter – And Gets Hammered!

October 19, 2006 at 10:16 am  ·  Category: Accounting, Options, Stocks

The market responded negatively to Yahoo!’s mediocre 3rd quarter – even though everybody knew it was coming!  Yahoo’s shares lost $1.16 yesterday to close at $22.99 on volume of almost 112 million shares.  The shares have bounced a bit today and are currently (9:26am PST) trading around $23.25.

Top Gun’s trading recommendations (sell Oct06 $25 puts for $1.35, buy Oct06 $22.50 calls for $2) have necesarily gotten hammered as well.  But its not awful.  If we have to take posession of the shares because of the puts we sold, we’ll pay an effective price of $23.65 ($25 minus the $1.35 we collected on the puts we sold), only 40 cents per share higher than the current market price.  If we sell the shares right way, we are talking about a loss of $40 per contract.  If you sold 8 or 10 contracts, that’s $320 or $400.  Not fun, but not a complete debacle. 

The calls have been knocked down from $2 to 80 cents.  If you took half the money you got from selling puts and bought calls, that position is down 60 percent.  So if you bought 3 contracts for $600, those are now worth $240 – you’re out $360.  All in all, it adds up to a loss about $680 if you sold 8 put contracts and used half the proceeds to buy 3 call contracts. 

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What did the earnings report say?  Well, lets focus on what I think most investors are focused on and which would have thus been the cause of the stock getting hit. 

Number 1: Net Income in the 3rd quarter was $158.5 million compared with $253.8 million in last year’s 3rd quarter – a 37.5% decrease.  I suppose everybody at this point is thinking that I’m a complete jackass: 37.5%!!!! 

But that number is, in all honesty, meaningless.  The rules for accounting for stock options changed between this year’s 3rd quarter and last.  Starting this year, firms have been required to expense options at fair value.  Prior to that they used another method and the result has been that stock options expenses have been much, much higher this year.  Higher expenses = lower profit. 

But that’s just an accounting change and has nothing to do with the actual operation and performance of the business.  If you account for stock options in the same way for last year’s 3rd quarter as this year’s you have to deduct another $51 million to get approximately $203 million: a decrease of around 22%.

[The following on options accounting is somewhat complicated and can be skipped without losing the gist of the point I am making:

But I personally don’t think options should be treated as an expense.  Yes they are a form of compensation and they do affect the value of the business but they are a non-cash expense.  Therefore we have to use accounting and financial methods to estimate their “true” and “fair” value for purposes of the income statement.  But options also add to the diluted share count.  Diluted shares increase the effective market capitalization of the company and therefore reduce the earnings attributable to each share. 

Think of it this way: if a company issues 1 million in the money options, that is going to increase the diluted share count listed on the income statement, and thus the company’s market cap and enterprise value.  Effectively, each share now owns less of the company.  The dilution caused by options can be accounted for this way, much more naturally I think, rather than coming up with some “fair value” estimate to put on the income sheet.  Of course, everybody was scandalized by the tech crash in 2000 and so now everybody wants to make sure that those sneaky corporations aren’t getting away with anything.  Hence, the expensing of options.]

If you take out options expensing altogether, as I suggest is appropriate above, you get $238 million in net income for the 3rd quarter 2006 compared with $262 last year – a 9.2% drop.  As far as I’m concerned, and there is no fudging here, that’s the real number as far as net income is concerned. 

But, as those of you who read the blog know, I place a much higher value on cash flow than I do earnings.  The reason is that cash flow represents actual dollars taken in by the business and is not influenced by non cash accounting numbers such as Depreciation and Amortization and Options Expensing. 

So how were cash flow?  Again, the initial number is likely to induce terror in the crowd.  Operating cash flows were $390 million compared with last year’s $440 million – an 11.5% decrease. 

But again: this isn’t a fair compare because of the changes in options accounting.  Along with having to expense options on the income statement companies have had to move so called “Excess Tax Benefits from Stock Based Compensation” from operating cash flows to financing cash flows.  This is a complicated subject that I’m not going to get into here (if you want to pursue it yourself, this article from the Motley Fool is a good starting point).

If you do the accounting the same, and the way I think it should be done as far as the “Excess tax benefits” issue, operating cash flow in fact increased by 20% – rather than decreased by 11.5%!  That makes all the difference doesn’t it? 

Free cash flow decreased but only because capital expenditures (again, a real number to account for investments in capital and not an accounting number, “Depreciation and Amortization”, to account for the same thing) increased dramatically: from $95.5 million to $240.8 million.  Whether this increased investment is a bad thing will depend on how the investments turn out i.e. what the return on that invested money is.  This money might pay off in the long term.  Alot of it, I assume though I don’t know, is going towards their new advertising platform, called Panama. 

To wrap up: the net income number looked terrible and alot of the headlines I read in the press focused on this.  But, if you dig a little deeper, not only did Yahoo! not make 37% less in this year’s 3rd quarter: They probably made something like 20% more!  But I’ll bet you alot of people sold on the -37% net income number.

Number 2: Revenue was, admittedly, weak.  Yahoo’s core business, online advertising, had an increase in revenue of only 18.2% – overall revenue was up 18.8%.  This is a somewhat dramatic fall off from previous quarters of 30 and 40 percent revenue increases.  The crowd was right to focus on this number and be concerned.  Its really this number that makes me rate this quarter a ‘4’ (out of 10).  I was hoping for a ‘5’ when I wrote the post on Monday night. 

But, the truth is, they told us this was coming! Semel and Decker announced, as I wrote in the last post, that advertising revenue would be weak in the 3rd quarter.  Personally, I didn’t fully take this into account, hence my expectation of a ‘5’ and the reality of a ‘4’.  

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So where does this leave us?  Yahoo! is still an excellent long term investment in my opinion for the reasons I made in Monday’s post

The immediate concern is, of course, the trades.  I’d sit tight, see what happens the rest of today and tomorrow, and consider holding some of the shares the calls entitle you to and the puts require you to buy.

UPDATE (Thu 12:40pm PST): Let’s just sell the calls.  I don’t think we are going to get much of a rally tomorrow. 

Shares are currently trading at $23.12.  That means our Oct06 $22.50 calls have 62 cents in cash value, plus the time value until the end of the day tomorrow.  The last calls traded hands at 65 cents and the current bid is 65 cents and the current ask 70 cents.  You can try and get 70 cents with a limit order.  But I’d just place a limit order at 65 cents and get out.

Posted by Greg Feirman  ·  Trackback URL  ·  Link
 

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