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click here for a free trial. It might seem crazy to argue that Yahoo!'s ( YHOO) stock should fall after Tuesday's blowout 2004 earnings and fantastic 2005 forecast. But despite all the giddiness coming from management, and no doubt from most of Wall Street, there are a number of very good reasons why Yahoo!'s stock should trade at least $10 lower. There is no denying that 2004 was a superb year for Yahoo!. Its earnings and revenue growth show without a doubt that the company will be a dominant force in the Internet for the foreseeable future. Earningsper share in 2004 doubled to 36 cents (excluding a gain) from 18 centsin the previous year. Moreover, profitability improved: In 2004, operating income before depreciation, amortization of intangible assets and stock-compensation expense, or OIBDA, jumped to 39.7% of revenue from 32.4% in the previous year. Yahoo! management forecast even stronger profitability in 2005. Themidpoint of Yahoo!'s guidance for OIBDA is $1.44 billion, which wouldbe equivalent to over 41% of revenue. The company was eager topersuade listeners on its call that Yahoo! stands to benefit massively as more and more money is spent on Internet advertising. With all that good news, it would seem wholly justified for Yahoo!'s stock to rise from current levels, even though it's up 56% over the past 12 months. The stock climbed 49 cents to $37.67 early Wednesday. So why argue that Yahoo! should be trading $10 lower? Look at Yahoo!'s valuation -- it's extortionate. Let's assume Yahoo!does make around 50 cents a share this year, as analysts claim. (Yahoo!conveniently doesn't provide an earnings per share forecast. A per-shareforecast requires projecting the number of shares likely to beoutstanding through the year, and the company most likely doesn't wantto draw attention to the huge amounts of shares it issues to pay itsemployees.) At 50 cents a share, Yahoo! is trading at a price-to-earnings ratio of74 times. On 2004 earnings, the ratio is 100 times. These arestratospheric numbers. They imply absolute confidence among investorsthat Yahoo! can meet its earnings and revenue goals in 2005 -- and doso without reducing earnings quality.
But already doubt surrounds Yahoo!'s extremely bullish 2005 forecasts. Companies find it very easy to make big promises for far-off dates,but it's much harder to be so aggressive for periods that are closer. For example, Yahoo! says its operating margin could be ashigh as 42% for all of 2005 -- yet it's forecasting only a 38% marginfor the first quarter of this year. Clearly, it's counting on a big pickup in profitability during therest of the year. But this looks like a very difficult feat. Look atwhat happened in 2004, which was a great year for the company. In thefirst quarter of 2004, the operating margin was 38%, while Yahoo!'sfull-year margin was 39.7%. If the company could only boost the marginby 1.7 percentage points in a banner year like 2004, how will itgain 4 points in 2005? To be sure, Yahoo! named some special items that will depress themargin in the first quarter, like a spillover of fourth quarter-relatedexpenses, taxes and marketing spending on an unnamed initiative. But,as you can see, none of those look to be extraordinary in any way.Maybe the first quarter will be weak because business is weaker thanpeople expected. And low-quality cash flow figures could be asign that investors shouldn't trust the headline operating earningsnumbers. For instance, free cash flow was a solid $844 million lastyear, but just under half of that came from the tax benefit fromissuing stock options. The other way to expose the unsustainability of Yahoo!'s valuation isto compare it with Google's ( GOOG). The Yahoo! rival trades at around 60times forecast 2005 earnings. To be sure, Yahoo! has certain businessactivities that Google doesn't -- but Google's offerings, whether in email or search, are generally far superior to Yahoo!'s.One has to wonder if Google's ad clients also get a much better returnon their ads, given that Google's technology is invariably better.And if Yahoo! traded at Google's 2005 price-to-earnings ratio of 60,the stock would be at $30, nearly 20% below current levels.
An off-the-charts valuation is especially dangerous when a company is particularly vulnerable to slowdowns in the economy. Remember that it took only the slight economic downturn of 2001 to tip Yahoo! into abig loss. Yes, Yahoo! is on a much stronger footing these days. ButInternet advertising has never been through a true recession in thewider economy. If the weak dollar causes the U.S. economy to slow markedly, Yahoo! could miss its targets by a mile, and the high valuationwould cause the stock to crater. Very few companies have been able tokeep growing through recessions and those that did manage tended to have much lower price-to-earnings ratios than Yahoo! Microsoft ( MSFT), for instance, sailed through the 1990-91 crunch, growing earnings at 66% in 1991. At that time, its price-to-earnings ratio was in the mid-20s. Sure, in hindsight it should have been higher. But if Yahoo! had to operate through a similar trough, its P/E ratio would surely end up closer to 25 than the current 75. Recession scenarios aside, bears must answer the seeminglyseductive argument that Yahoo! will continue cleaning up as moreadvertising gets done on the Internet. That shift is most certainlyhappening, but it is a leap to say this will mean much stronger earningsfor Yahoo! for much longer. Yahoo! gets the ad dollars nowbecause it has the sort of impressive page view statistics that canattract advertisers. But Yahoo!'s content and services, perhaps withthe exception of Yahoo! Finance, are mediocre and subpar, so it shouldbe easy for savvier sites to steal users from Yahoo! over time. AndGoogle is already doing that, as the success of Gmail shows. What's more, the Yahoo! bulls overlook one important fact: One bigreason people are gravitating away from television is to avoid ads.There is a limit to the amount of ads surfers will tolerate, just asthere is on TV. And looking at Yahoo!'s cluttered pages, that limit isclose to getting hit, if it hasn't been already. You see, there's plenty of reasons to boo Yahoo!.