UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

FORM 10-Q

 

x

 

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended September 30, 2005

 

OR

 

o

 

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from     to     

 

Commission File Number 0-28018

 


 

YAHOO! INC.

(Exact name of Registrant as specified in its charter)

 

Delaware

 

77-0398689

(State or other jurisdiction of
incorporation or organization)

 

(I.R.S. Employer
Identification No.)

 

701 First Avenue
Sunnyvale, California 94089

(Address of principal executive offices)

 

Registrant’s telephone number, including area code: (408) 349-3300

 


 

Indicate by check mark whether the Registrant (1) has filed all reports required by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days: Yes ý  No o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
Yes 
ý  No o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o  No ý

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

Class

 

Outstanding at November 1, 2005

Common stock, $0.001 par value

 

1,418,736,194

 

 



 

YAHOO! INC.

 

Table of Contents

 

 

 

Page

PART I.

FINANCIAL INFORMATION

2

 

 

 

Item 1.

Condensed Consolidated Financial Statements (unaudited)

2

 

Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2004 and 2005

2

 

Condensed Consolidated Balance Sheets at December 31, 2004 and September 30, 2005

3

 

Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2004 and 2005

4

 

Notes to Condensed Consolidated Financial Statements

6

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

19

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

42

Item 4.

Controls and Procedures

43

 

 

 

PART II.

OTHER INFORMATION

44

 

 

 

Item 1.

Legal Proceedings

44

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

45

Item 3.

Defaults Upon Senior Securities

45

Item 4.

Submission of Matters to a Vote of Security Holders

45

Item 5.

Other Information

45

Item 6.

Exhibits

46

 

Signatures

47

 

1



 

PART I—FINANCIAL INFORMATION

 

Item 1.  Condensed Consolidated Financial Statements (unaudited)

 

YAHOO! INC.

 

Condensed Consolidated Statements of Operations

(unaudited, in thousands except per share amounts)

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,
2004

 

September 30,
2005

 

September 30,
2004

 

September 30,
2005

 

 

 

 

 

 

 

 

 

 

 

Revenues

 

$906,715

 

$1,329,929

 

$2,496,800

 

$3,756,668

 

Cost of revenues

 

332,333

 

520,238

 

911,421

 

1,459,433

 

Gross profit

 

574,382

 

809,691

 

1,585,379

 

2,297,235

 

 

 

 

 

 

 

 

 

 

 

Operating expenses:

 

 

 

 

 

 

 

 

 

Sales and marketing

 

192,950

 

265,714

 

551,120

 

742,639

 

Product development

 

97,033

 

141,616

 

261,162

 

386,509

 

General and administrative

 

69,215

 

77,733

 

189,930

 

232,708

 

Stock compensation expense*

 

6,111

 

13,524

 

25,823

 

33,938

 

Amortization of intangibles

 

36,968

 

41,047

 

103,588

 

122,664

 

Total operating expenses

 

402,277

 

539,634

 

1,131,623

 

1,518,458

 

 

 

 

 

 

 

 

 

 

 

Income from operations

 

172,105

 

270,057

 

453,756

 

778,777

 

Other income, net

 

123,281

 

65,995

 

150,838

 

1,095,725

 

Income before income taxes, earnings in equity interests and minority interests

 

295,386

 

336,052

 

604,594

 

1,874,502

 

Provision for income taxes

 

(67,117

)

(113,797

)

(204,343

)

(750,087

)

Earnings in equity interests

 

25,696

 

32,164

 

69,672

 

94,647

 

Minority interests in operations of consolidated subsidiaries

 

(660

)

(646

)

(2,894

)

(6,040

)

Net income

 

$253,305

 

$253,773

 

$467,029

 

$1,213,022

 

 

 

 

 

 

 

 

 

 

 

Net income per share—basic

 

$0.19

 

$0.18

 

$0.35

 

$0.87

 

 

 

 

 

 

 

 

 

 

 

Net income per share—diluted

 

$0.17

 

$0.17

 

$0.32

 

$0.82

 

 

 

 

 

 

 

 

 

 

 

Shares used in per share calculation—basic

 

1,361,136

 

1,405,012

 

1,345,583

 

1,395,188

 

 

 

 

 

 

 

 

 

 

 

Shares used in per share calculation—diluted

 

1,458,610

 

1,486,876

 

1,444,955

 

1,482,739

 

 

 

 

 

 

 

 

 

 

 

*Stock compensation expense by function:

 

 

 

 

 

 

 

 

 

Sales and marketing

 

$1,731

 

$2,278

 

$7,712

 

$5,277

 

Product development

 

2,371

 

6,817

 

9,642

 

13,820

 

General and administrative

 

2,009

 

4,429

 

8,469

 

14,841

 

Total stock compensation expense

 

$6,111

 

$13,524

 

$25,823

 

$33,938

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

2



 

YAHOO! INC.

 

Condensed Consolidated Balance Sheets

(unaudited, in thousands, except par values)

 

 

 

December 31,
2004

 

September 30,
2005

 

 

 

 

 

 

 

ASSETS

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$823,723

 

$2,027,003

 

Marketable debt securities

 

1,875,964

 

1,156,688

 

Marketable equity securities

 

812,288

 

 

Accounts receivable, net

 

479,993

 

599,129

 

Prepaid expenses and other current assets

 

98,507

 

179,875

 

Total current assets

 

4,090,475

 

3,962,695

 

Long-term marketable debt securities

 

1,042,575

 

1,579,930

 

Property and equipment, net

 

531,696

 

623,050

 

Goodwill

 

2,550,957

 

2,564,073

 

Intangible assets, net

 

480,666

 

451,018

 

Other assets

 

481,832

 

362,856

 

Total assets

 

$9,178,201

 

$9,543,622

 

 

 

 

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accounts payable

 

$48,205

 

$38,879

 

Accrued expenses and other current liabilities

 

853,115

 

739,813

 

Deferred revenue

 

279,387

 

324,039

 

Total current liabilities

 

1,180,707

 

1,102,731

 

Long-term deferred revenue

 

65,875

 

63,811

 

Long-term debt

 

750,000

 

749,995

 

Other long-term liabilities

 

35,907

 

87,694

 

Minority interests in consolidated subsidiaries

 

44,266

 

51,961

 

 

 

 

 

 

 

Stockholders’ equity:

 

 

 

 

 

Common Stock, $0.001 par value; 5,000,000 shares authorized; 1,383,584 and 1,407,691 issued and outstanding, respectively

 

1,416

 

1,447

 

Additional paid-in capital

 

5,682,884

 

5,891,433

 

Deferred stock-based compensation

 

(28,541

)

(142,999

)

Treasury stock

 

(159,988

)

(533,340

)

Retained earnings

 

1,069,939

 

2,282,961

 

Accumulated other comprehensive income (loss)

 

535,736

 

(12,072

)

Total stockholders’ equity

 

7,101,446

 

7,487,430

 

Total liabilities and stockholders’ equity

 

$9,178,201

 

$9,543,622

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

3



 

YAHOO! INC.

 

Condensed Consolidated Statements of Cash Flows

(unaudited, in thousands)

 

 

 

Nine Months Ended

 

 

 

September 30,
2004

 

September 30,
2005

 

 

 

 

 

 

 

CASH FLOWS FROM OPERATING ACTIVITIES:

 

 

 

 

 

Net income

 

$467,029

 

$1,213,022

 

Adjustments to reconcile net income to net cash provided by operating activities:

 

 

 

 

 

Depreciation and amortization

 

225,108

 

285,909

 

Tax benefits from stock options

 

177,266

 

723,748

 

Earnings in equity interests

 

(69,672

)

(94,647

)

Dividends received

 

 

10,670

 

Minority interests in operations of consolidated subsidiaries

 

2,894

 

6,040

 

Stock compensation expense

 

25,823

 

33,938

 

Gains from sales of investments, assets, and other, net

 

(91,067

)

(976,738

)

Changes in assets and liabilities, net of effects of acquisitions:

 

 

 

 

 

Accounts receivable, net

 

(83,288

)

(128,921

)

Prepaid expenses and other assets

 

(6,434

)

7,736

 

Accounts payable

 

(899

)

(5,354

)

Accrued expenses and other liabilities

 

83,561

 

111,396

 

Deferred revenue

 

22,780

 

43,242

 

Net cash provided by operating activities

 

753,101

 

1,230,041

 

 

 

 

 

 

 

CASH FLOWS FROM INVESTING ACTIVITIES:

 

 

 

 

 

Acquisition of property and equipment, net

 

(160,132

)

(257,294

)

Purchases of marketable debt securities

 

(2,157,888

)

(6,632,419

)

Proceeds from sales and maturities of marketable debt securities

 

1,865,276

 

6,789,521

 

Acquisitions, net of cash acquired

 

(608,525

)

(127,463

)

Proceeds from sales of marketable equity securities

 

192,780

 

1,006,142

 

Other investing activities, net

 

14,986

 

(39,030

)

Net cash provided by (used in) investing activities

 

(853,503

)

739,457

 

 

 

 

 

 

 

CASH FLOWS FROM FINANCING ACTIVITIES:

 

 

 

 

 

Proceeds from issuance of common stock, net

 

423,591

 

377,751

 

Repurchases of common stock

 

 

(373,352

)

Structured stock repurchases, net

 

(95,907

)

(752,717

)

Other financing activities, net

 

 

1,749

 

Net cash provided by (used in) financing activities

 

327,684

 

(746,569

)

Effect of exchange rate changes on cash and cash equivalents

 

6,764

 

(19,649

)

Net change in cash and cash equivalents

 

234,046

 

1,203,280

 

Cash and cash equivalents at beginning of period

 

415,892

 

823,723

 

Cash and cash equivalents at end of period

 

$649,938

 

$2,027,003

 

 

4



 

YAHOO! INC.

 

Supplemental schedule:

 

Acquisition-related activities (in thousands):

 

 

 

Nine Months Ended

 

 

 

September 30,
2004

 

September 30,
2005

 

 

 

 

 

 

 

Cash paid for acquisitions

 

$656,014

 

$128,592

 

Cash acquired in acquisitions

 

(47,489

)

(1,129

)

 

 

$608,525

 

$127,463

 

 

 

 

 

 

 

Common stock, restricted stock and stock options issued in connection with acquisitions

 

$3,384

 

$44,381

 

 

See Note 3—“Acquisitions” for additional information.

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

5



 

YAHOO! INC.

Notes to Condensed Consolidated Financial Statements

(unaudited)

 

Note 1—The Company and Summary of Significant Accounting Policies

 

The Company.  Yahoo! Inc., together with its consolidated subsidiaries (“Yahoo!” or the “Company”) is a leading global Internet brand and one of the most trafficked Internet destinations worldwide.  Yahoo! seeks to provide Internet services that are essential and relevant to users and businesses through the provision of online properties (collectively referred to as the “Yahoo! Network”) to Internet users and a range of tools and marketing solutions for businesses to market to that community of users.

 

Stock Split.  On April 7, 2004, the Yahoo! Board of Directors approved a two-for-one split of the Company’s shares of common stock effected in the form of a stock dividend.  As a result of the stock split, Yahoo! stockholders received one additional share of Yahoo! common stock for each share of common stock held of record on April 26, 2004.  The additional shares of Yahoo! common stock were distributed on May 11, 2004.  All share and per share amounts in these condensed consolidated financial statements and related notes have been retroactively adjusted to reflect the stock split for all periods presented.

 

Basis of Presentation.  The condensed consolidated financial statements include the accounts of Yahoo! and its majority-owned subsidiaries.  All significant intercompany accounts and transactions have been eliminated.  Investments in entities in which the Company can exercise significant influence, but are less than majority owned and not otherwise controlled by the Company, are accounted for under the equity method and are included in other assets on the condensed consolidated balance sheets.  The Company has included the results of operations of acquired companies from the closing dates of the acquisitions.

 

The accompanying unaudited condensed consolidated interim financial statements reflect all adjustments, consisting of only normal recurring items, which in the opinion of management, are necessary for a fair statement of the results of operations for the periods shown.  The results of operations for such periods are not necessarily indicative of the results expected for the full year or for any future period.

 

The preparation of condensed consolidated financial statements in conformity with generally accepted accounting principles in the United States requires management to make estimates, judgments and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities.  On an on-going basis, the Company evaluates its estimates, including those related to uncollectible receivables, the useful lives of long-lived assets including property and equipment, investment fair values, goodwill and other intangible assets, income taxes and contingencies.  In addition, the Company uses assumptions when employing the Black-Scholes option valuation model to estimate the fair value of stock options granted for pro forma disclosure purposes.  The Company bases its estimates of the carrying value of certain assets and liabilities on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, when these carrying values are not readily available from other sources.  Actual results may differ from these estimates.

 

Certain prior period balances have been reclassified to conform to the current year presentation.  A new subtotal is being presented in the consolidated statement of operations: Income before income taxes, earnings in equity interests, and minority interests.  Earnings in equity interests and minority interests in operations of consolidated subsidiaries are now presented below the provision for income taxes.  In accordance with generally accepted accounting principles, these items have consistently been presented net of income taxes.  In addition, beginning in the fourth quarter of 2004, the Company made reclassifications in the consolidated balance sheets and consolidated cash flow statements related to the classification of auction rate securities.  Certain of these securities were included in the cash and cash equivalents lines in prior periods.  These amounts have been reclassified to short term marketable debt securities.  The reclassification resulted in an increase of $16 million in previously reported net cash used in investing activities and a decrease of $16 million in the previously reported net change in cash and cash equivalents for the nine months ended September 30, 2004.  The increase of $16 million in cash used in investing activities is the result of an increase of $979 million in purchases of marketable debt securities and an increase of $963 million in proceeds from sales and maturities of marketable debt securities.

 

These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004.

 

6



 

Stock-Based Compensation.  The Company measures compensation expense for its stock-based employee compensation plans using the intrinsic value method.  The Company recorded compensation expense of $6 million and $14 million in the three months ended September 30, 2004 and 2005, respectively.  The Company recorded compensation expense of $26 million and $34 million in the nine months ended September 30, 2004 and 2005 respectively.  If the fair value based method had been applied in measuring stock compensation expense, the pro forma effect on net income and net income per share would have been as follows (in thousands, except per share amounts):

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,
2004

 

September 30,
2005

 

September 30,
2004

 

September 30,
2005

 

 

 

 

 

 

 

 

 

 

 

Net income:

 

 

 

 

 

 

 

 

 

As reported

 

$253,305

 

$253,773

 

$467,029

 

$1,213,022

 

Add: Stock compensation expense included in reported net income, net of related tax effects

 

3,667

 

8,114

 

15,494

 

20,363

 

Less: Stock compensation expense determined under fair value based method for all awards, net of related tax effects*

 

(53,252

)

(58,570

)

(175,750

)

(172,764

)

Pro forma net income

 

$203,720

 

$203,317

 

$306,773

 

$1,060,621

 

 

 

 

 

 

 

 

 

 

 

Net income per share:

 

 

 

 

 

 

 

 

 

As reported - basic

 

$0.19

 

$0.18

 

$0.35

 

$0.87

 

As reported - diluted

 

$0.17

 

$0.17

 

$0.32

 

$0.82

 

 

 

 

 

 

 

 

 

 

 

Pro forma - basic

 

$0.15

 

$0.14

 

$0.23

 

$0.76

 

Pro forma - diluted

 

$0.14

 

$0.14

 

$0.21

 

$0.71

 

 

*                                         For the three and nine months ended September 30, 2004, the stock compensation expense amount has been adjusted to reflect lower calculated fair values for employee stock options which resulted in an increase of $7 million ($0.01 per share – basic and diluted) and $17 million ($0.01 per share – basic and diluted), respectively, in pro forma net income.  The adjustment was required as the Company’s estimate of the fair value of employee stock options was incorrectly based on a five-and-one-half year expected life rather than the three-and-one-half year expected life intended by management.

 

The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable.  In addition, option valuation models require the input of highly subjective assumptions, including the expected stock price volatility and expected life of the options granted.  Because the Company’s options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in the opinion of management, the existing models do not necessarily provide a reliable single measure of the fair value of its options.

 

See “Recent Accounting Pronouncements” below regarding the impact of the adoption of Statement of Financial Accounting Standards (“SFAS”) No. 123R, “Share-Based Payment” (“SFAS 123R”).

 

Recent Accounting Pronouncements

 

In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS 123R, which requires companies to recognize in the statement of operations all share-based payments to employees, including grants of employee stock options, based on their fair values.  Accounting for share-based compensation transactions using the intrinsic method supplemented by pro forma disclosures will no longer be permissible.  The new statement will be effective for public entities no later than the beginning of the first fiscal year beginning after June 15, 2005.  The Company will adopt the new statement on January 1, 2006.  The Company has not yet completed its analysis of the impact of adopting SFAS 123R and is therefore currently unable to quantify the effect on its financial statements.  However, the adoption of this new statement will have a significant impact on the results of operations and net income per share of the Company as the Company will be required to expense the fair value of all share-based payments.

 

7



 

In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections”, a replacement of Accounting Principles Board Opinion No. 20, “Accounting Changes”, and SFAS No. 3, “Reporting Accounting Changes in Interim Financial Statements” (“SFAS 154”).  SFAS 154 changes the requirements for the accounting for, and reporting of, a change in accounting principle.  Previously, voluntary changes in accounting principles were generally required to be recognized by way of a cumulative effect adjustment within net income during the period of the change. SFAS 154 requires retrospective application to prior periods’ financial statements, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change.  SFAS 154 is effective for accounting changes made in fiscal years beginning after December 15, 2005; however, the statement does not change the transition provisions of any existing accounting pronouncements.  The Company does not believe adoption of SFAS 154 will have a material effect on its financial position, cash flows or results of operations.

 

Note 2—Basic and Diluted Net Income Per Share

 

Basic net income per share is computed using the weighted average number of common shares outstanding during the period, excluding any unvested restricted stock that is subject to repurchase.  Diluted net income per share is computed using the weighted average number of common shares and, if dilutive, potential common shares outstanding during the period.  Potential common shares consist of unvested restricted stock (using the treasury stock method), the incremental common shares issuable upon the exercise of stock options (using the treasury stock method) and the conversion of the Company’s zero coupon senior convertible notes (using the if-converted method).  For the three months ended September 30, 2004 and 2005, approximately 45 million and 67 million options to purchase common stock, respectively, were excluded from the calculation, as their exercise prices were greater than the average market price of the common stock during the periods.  For the nine months ended September 30, 2004 and 2005, approximately 62 million options to purchase common stock were excluded from the calculations, as their exercise prices were greater than the average market price of the common stock during the periods.  See Note 8—“Long-Term Debt” for additional information related to the Company’s zero coupon senior convertible notes.

 

The following table sets forth the computation of basic and diluted net income per share (in thousands, except per share amounts):

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,
2004

 

September 30,
2005

 

September 30,
2004

 

September 30,
2005

 

 

 

 

 

 

 

 

 

 

 

Numerator:

 

 

 

 

 

 

 

 

 

Net income

 

$253,305

 

$253,773

 

$467,029

 

$1,213,022

 

 

 

 

 

 

 

 

 

 

 

Denominator:

 

 

 

 

 

 

 

 

 

Weighted average common shares

 

1,361,652

 

1,409,065

 

1,346,047

 

1,398,276

 

Weighted average unvested restricted stock subject to repurchase

 

(516

)

(4,053

)

(464

)

(3,088

)

Denominator for basic calculation

 

1,361,136

 

1,405,012

 

1,345,583

 

1,395,188

 

 

 

 

 

 

 

 

 

 

 

Weighted average effect of dilutive securities:

 

 

 

 

 

 

 

 

 

Employee stock options

 

60,611

 

44,643

 

62,621

 

50,189

 

Convertible notes

 

36,585

 

36,585

 

36,585

 

36,585

 

Restricted stock

 

278

 

636

 

166

 

777

 

Denominator for diluted calculation

 

1,458,610

 

1,486,876

 

1,444,955

 

1,482,739

 

Net income per share - basic

 

$0.19

 

$0.18

 

$0.35

 

$0.87

 

Net income per share - diluted

 

$0.17

 

$0.17

 

$0.32

 

$0.82

 

 

8



 

Note 3—Acquisitions

 

Acquisitions completed in 2004

 

3721.  On January 2, 2004, the Company completed the acquisition of all of the outstanding capital shares of 3721 Network Software Company Limited (“3721”), a Hong Kong-based software development company.  The acquisition combined the Company’s global audience and 3721’s keyword search technology to enable the Company to continue improving its global search services.  These factors contributed to a purchase price in excess of the fair value of 3721’s net tangible and intangible assets acquired, and as a result, the Company has recorded goodwill in connection with this transaction.

 

The total purchase price of approximately $95 million consisted of $92 million in cash consideration, including $41 million related to a contingent earnout, which was finalized and paid in the three months ended June 30, 2005, $2 million related to stock options exchanged, and direct transaction costs of $1 million.  The total cash consideration of approximately $92 million less cash acquired of $7 million resulted in a net cash outlay of $85 million.

 

The allocation of the purchase price to the assets acquired and liabilities assumed based on the fair values was as follows (in thousands):

 

Cash acquired

 

$6,917

 

Other tangible assets acquired

 

4,498

 

Amortizable intangible assets:

 

 

 

Trade name, trademark, and domain name

 

1,000

 

Customer, affiliate, and advertiser related relationships

 

7,600

 

Developed technology and patents

 

3,800

 

Goodwill

 

80,957

 

Total assets acquired

 

104,772

 

 

 

 

 

Liabilities assumed

 

(11,186

)

Deferred stock-based compensation

 

1,757

 

Total

 

$95,343

 

 

The amortizable intangible assets have useful lives not exceeding five years.  No amount has been allocated to in-process research and development, and $81 million has been allocated to goodwill.  Goodwill represents the excess of the purchase price over the fair value of the net tangible and intangible assets acquired, and is not deductible for tax purposes.

 

Kelkoo.  On April 5, 2004, the Company completed the acquisition of a majority interest in Kelkoo S.A. (“Kelkoo”), a leading European online comparison shopping service.  In July 2004, the Company completed the acquisition of additional interests in Kelkoo, increasing the Company’s total ownership interest in Kelkoo to 100 percent.  The acquisition expanded the Company’s global commerce presence and together with the Company’s current services is expected to increase the Company’s competitive position in Europe.  These factors contributed to a purchase price in excess of the fair value of Kelkoo’s net tangible and intangible assets acquired, and as a result, the Company has recorded goodwill in connection with this transaction.

 

The total purchase price of approximately $571 million consisted of $562 million in cash consideration, $6 million in incurred liabilities and direct transaction costs of $3 million.  The total cash consideration of approximately $562 million less cash acquired of $39 million resulted in a net cash outlay of $523 million.

 

The allocation of the purchase price to the assets acquired and liabilities assumed based on the fair values was as follows (in thousands):

 

Cash acquired

 

$38,817

 

Other tangible assets acquired

 

24,068

 

Amortizable intangible assets:

 

 

 

Trade name, trademark, and domain name

 

61,300

 

Customer, affiliate, and advertiser related relationships

 

36,100

 

Developed technology and patents

 

9,100

 

Goodwill

 

453,555

 

Total assets acquired

 

622,940

 

 

 

 

 

Liabilities assumed

 

(51,832

)

Total

 

$571,108

 

 

9



 

The amortizable intangible assets have useful lives not exceeding five years.  No amount has been allocated to in-process research and development, and $454 million has been allocated to goodwill.  Goodwill represents the excess of the purchase price over the fair value of the net tangible and intangible assets acquired, and is not deductible for tax purposes.

 

Musicmatch.  On October 18, 2004, the Company completed the acquisition of Musicmatch, Inc. (“Musicmatch”), a leading provider of personalized music software and services.  The acquisition significantly increased the Company’s presence in the digital music business and together with the Company’s current music services,  Yahoo! Music, is expected to provide one of the most comprehensive suites of music services available for users, marketers, artists and record labels.  These factors contributed to a purchase price in excess of the fair value of Musicmatch’s net tangible and intangible assets acquired, and as a result, the Company has recorded goodwill in connection with this transaction.

 

The total estimated purchase price of approximately $158 million consisted of $156 million in cash consideration, and direct transaction costs of $2 million.  The approximate $156 million of total cash consideration less cash acquired of $3 million resulted in a net cash outlay of $153 million.

 

The preliminary allocation of the purchase price to the assets acquired and liabilities assumed based on the fair values was as follows (in thousands):

 

Cash acquired

 

$2,516

 

Other tangible assets acquired

 

8,591

 

Amortizable intangible assets:

 

 

 

Developed technology and patents

 

18,100

 

Customer contracts and related relationships

 

1,700

 

Trade name, trademark and domain name

 

1,100

 

Goodwill

 

170,984

 

Total assets acquired

 

202,991

 

 

 

 

 

Liabilities assumed

 

(45,317

)

Total

 

$157,674

 

 

The amortizable intangible assets have useful lives not exceeding 3 years.  Based on a preliminary estimate, no amount has been allocated to in-process research and development, and $171 million has been allocated to goodwill.  Goodwill represents the excess of the purchase price over the fair value of the net tangible and intangible assets acquired, and is not deductible for tax purposes.   The preliminary purchase price allocation for Musicmatch is subject to revision as more detailed analysis is completed and additional information on the fair value of assets and liabilities becomes available.  Any changes in the fair value of the net assets of Musicmatch will change the amount of the purchase price allocable to goodwill.

 

Other Acquisitions.  During the year ended December 31, 2004 the Company acquired three other companies which were each accounted for as business combinations.  The total purchase price for these three acquisitions was approximately $49 million and consisted of $46 million in cash consideration, $2 million related to stock options exchanged and $1 million of direct transaction costs.  The total cash consideration of $46 million less cash acquired of $2 million resulted in a net cash outlay of $44 million.  Of the purchase price, approximately $41 million was allocated to goodwill, $14 million to amortizable intangible assets and $6 million to net assumed liabilities.  No amounts have been allocated to in-process research and development.  Goodwill represents the excess of the purchase price over the fair value of the net tangible and intangible assets acquired, and is not deductible for tax purposes.

 

Acquisitions completed in 2005

 

During the three months ended March 31, 2005 the Company acquired Verdisoft Corporation (“Verdisoft”), a software development company.  The acquisition of Verdisoft enhanced the Company’s platform for delivering content and services to mobile phones and other handheld devices as part of the Company’s strategy to provide users with seamless access to its network. The transaction was treated as an asset acquisition for accounting purposes and therefore no goodwill was recorded.  The estimated purchase price was approximately $58 million and consisted of $54 million in cash consideration, $3 million related to stock options exchanged and $1 million of direct transaction costs.  In connection with the acquisition, the Company also issued approximately 1 million shares of restricted stock valued at $35 million that will be recognized as expense over three years.  For accounting purposes, approximately $93 million was allocated to amortizable intangible assets, with lives not exceeding three years, $37 million to liabilities, primarily deferred income tax liabilities, and $2 million to deferred stock-based compensation.

 

10



 

During the three months ended June 30, 2005 the Company acquired three companies which were each accounted for as business combinations.  The total estimated purchase price for the three acquisitions was approximately $37 million and consisted of $32 million in cash consideration, $3 million related to stock options exchanged, and $2 million of incurred liabilities and direct transaction costs.  The total cash consideration of approximately $32 million less cash acquired of $1 million resulted in a net cash outlay of $31 million.  Of the total estimated purchase price, approximately $32 million was allocated to goodwill, $6 million to amortizable intangible assets and $1 million to net assumed liabilities.  Less than $1 million has been allocated to in-process research and development and recorded in product development expenses.  Goodwill represents the excess of the purchase price over the fair value of the net tangible and intangible assets acquired, and is not deductible for tax purposes.

 

The purchase price allocations for these acquisitions are preliminary and subject to revision as more detailed analyses are completed and additional information on the fair value of assets and liabilities becomes available.  Any change in the fair value of the net assets of the acquired companies will change the amount of the purchase price allocable to goodwill.

 

Pro forma results of operations have not been presented for the acquisitions completed during the nine months ended September 30, 2004 or September 30, 2005 as the results of the acquired companies either individually or in the aggregate were not material to the Company.

 

Note 4—Goodwill

 

The changes in the carrying amount of goodwill for the nine months ended September 30, 2005 are as follows (in thousands):

 

 

 

United States

 

International

 

Total

 

 

 

 

 

 

 

 

 

Balance as of January 1, 2005

 

$1,673,419

 

$877,538

 

$2,550,957

 

Acquisitions and other*

 

30,864

 

21,283

 

52,147

 

Foreign currency translation adjustments

 

 

(39,031

)

(39,031

)

Balance as of September 30, 2005

 

$1,704,283

 

$859,790

 

$2,564,073

 

 

*                                         Other primarily includes certain purchase price adjustments that affect existing goodwill.

 

Note 5—Intangible Assets, Net

 

The following table summarizes the Company’s intangible assets, net (in thousands):

 

 

 

December 31, 2004

 

September 30, 2005

 

 

 

 

 

Gross carrying

 

Accumulated

 

 

 

 

 

Net

 

amount

 

amortization*

 

Net

 

 

 

 

 

 

 

 

 

 

 

Trademark, trade name and domain name

 

$103,796

 

$134,000

 

$(51,732

)

$82,268

 

Customer, affiliate, and advertiser related relationships

 

205,032

 

323,062

 

(166,363

)

156,699

 

Developed technology and patents

 

171,838

 

311,146

 

(99,095

)

212,051

 

Total intangible assets, net

 

$480,666

 

$768,208

 

$(317,190

)

$451,018

 

 

*                                         Foreign currency translation adjustments, reflecting movement in the currencies of the underlying entities, totaled approximately $2 million as of September 30, 2005.

 

The Company recognized amortization expense for intangible assets of approximately $37 million and $41 million for the three months ended September 30, 2004 and 2005, respectively.  The Company recognized amortization expense for intangible assets of approximately $104 million and $123 million for the nine months ended September 30, 2004 and 2005, respectively.  Based on the current amount of intangibles subject to amortization, the estimated amortization expense for each of the succeeding five years is as follows: three months ending December 31, 2005: $41 million; 2006: $171 million; 2007: $126 million; 2008: $76 million, and 2009: $24 million and 2010: $13 million.

 

Note 6—Other Income, Net

 

Other income, net is comprised of (in thousands):

 

11



 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,
2004

 

September 30,
2005

 

September 30,
2004

 

September 30,
2005

 

 

 

 

 

 

 

 

 

 

 

Interest and investment income

 

$14,962

 

$37,676

 

$40,978

 

$88,548

 

Investment gains (losses), net

 

110,268

 

26,948

 

107,780

 

995,231

 

Other

 

(1,949

)

1,371

 

2,080

 

11,946

 

 

 

 

 

 

 

 

 

 

 

Total other income, net

 

$123,281

 

$65,995

 

$150,838

 

$1,095,725

 

 

Investment gains (losses), net include realized investment gains, realized investment losses, realized gains on derivatives, and impairment charges related to declines in values of privately held companies judged to be other than temporary.  Investment gains (losses) include gains in the amounts of $105 million in the three and nine months ended September 30, 2004 and $27 million and $987 million in the three and nine months ended September 30, 2005, respectively, related to the sale of non-strategic marketable equity security investments.

 

Note 7—Comprehensive Income

 

Comprehensive income, net of taxes, is comprised of (in thousands):

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,
2004

 

September 30,
2005

 

September 30,
2004

 

September 30,
2005

 

 

 

 

 

 

 

 

 

 

 

Net income

 

$253,305

 

$253,773

 

$467,029

 

$1,213,022

 

 

 

 

 

 

 

 

 

 

 

Other comprehensive income (loss):

 

 

 

 

 

 

 

 

 

Change in net unrealized gains (losses) on available-for-sale securities before tax, net of reclassification adjustments

 

760,488

 

(52,641

)

740,958

 

(824,790

)

Tax impact of change in net unrealized gains (losses)

 

(304,205

)

21,057

 

(296,387

)

329,915

 

Change in net unrealized gains (losses) on available-for-sale securities, net of tax and reclassification adjustments

 

456,283

 

(31,584

)

444,571

 

(494,875

)

Foreign currency translation adjustment

 

9,893

 

(3,942

)

(2,366

)

(52,933

)

Other comprehensive income (loss)

 

466,176

 

(35,526

)

442,205

 

(547,808

)

 

 

 

 

 

 

 

 

 

 

Comprehensive income

 

$719,481

 

$218,247

 

$909,234

 

$665,214

 

 

The following table summarizes the components of accumulated other comprehensive income (loss) (in thousands):

 

 

 

December 31,
2004

 

September 30,
2005

 

 

 

 

 

 

 

Unrealized gains (losses) on available-for-sale securities, net of tax

 

$475,314

 

$(19,561

)

Cumulative foreign currency translation adjustment

 

60,422

 

7,489

 

 

 

 

 

 

 

Accumulated other comprehensive income (loss)

 

$535,736

 

$(12,072

)

 

12



 

Note 8—Long-Term Debt

 

In April 2003, the Company issued $750 million of zero coupon senior convertible notes (the “Notes”) due April 2008, which resulted in net proceeds to the Company of approximately $733 million after transaction fees of $17 million, which have been deferred and are included on the condensed consolidated balance sheets in other assets.  As of September 30, 2005, $9 million of the transaction fees remain to be amortized.  The Notes were issued at par and bear no interest.  The Notes are convertible into Yahoo! common stock at a conversion price of $20.50 per share, which would result in the issuance of an aggregate of approximately 37 million shares, subject to adjustment upon the occurrence of specified events.  Each $1,000 principal amount of the Notes will initially be convertible into 48.78 shares of Yahoo! common stock.

 

The Notes are convertible prior to the final maturity date (1) during any fiscal quarter if the closing sale price of the Company’s common stock for at least 20 trading days in the 30 trading-day period ending on the last trading day of the immediately preceding fiscal quarter exceeded 110 percent of the conversion price on that 30th trading day, (2) during the period beginning January 1, 2008 through the maturity date, if the closing sale price of the Company’s common stock on the previous trading day was 110 percent or more of the then current conversion price, and (3) upon specified corporate transactions.  Upon conversion, the Company has the right to deliver cash in lieu of common stock.  The Company may be required to repurchase all of the Notes following a fundamental change of the Company, such as a change of control, prior to maturity at face value.  The Company may not redeem the Notes prior to their maturity.

 

As of September 30, 2005, the market price condition for convertibility of the Notes was satisfied with respect to the fiscal quarter beginning October 1, 2005 and ending on December 31, 2005.  During this period holders of the Notes will be able to convert their Notes into shares of Yahoo! common stock at the rate of 48.78 shares of Yahoo! common stock for each Note.  The Notes will also be convertible into shares of Yahoo! common stock in subsequent fiscal quarters, if any, with respect to which the market price condition for convertibility is met.

 

As of September 30, 2005, the fair value of the Notes was approximately $1.2 billion based on quoted market prices.  The shares issuable upon conversion of the Notes have been included in the computation of diluted net income per share since the Notes were issued.

 

Note 9—Stock Repurchase Programs

 

In March 2001, the Company’s Board of Directors authorized the Company to repurchase up to $500 million of its outstanding shares of common stock from time to time over the next two years, depending on market conditions, share price and other factors. In March 2003, the Company’s Board of Directors authorized a two-year extension of the stock repurchase program until March 2005.  Under this program, from March 2001 through December 31, 2004, the Company repurchased 32.9 million shares of common stock at an average price of $4.86 per share for a total amount of approximately $160 million.  During this period, of the shares repurchased, 32.1 million shares were purchased from SOFTBANK Corp. (“SOFTBANK”) at an average price of $4.84 per share.  During the three months ended March 31, 2005, the Company repurchased an additional 4.9 million shares in the open market, at an average price of $33.60 per share, for total consideration of $165 million.  This stock repurchase program has expired.

 

In March 2005, the Company’s Board of Directors authorized a new stock repurchase program for the Company to repurchase up to $3 billion of its outstanding shares of common stock from time to time over the next five years, depending on market conditions, share price and other factors.  Under this program in the three months ended September 30, 2005 the Company repurchased 6.3 million shares of common stock at an average price of $32.89 per share, for total consideration of $208 million.  For the nine months ended September 30, 2005 under the expired and current stock repurchase programs, the Company repurchased 11.2 million shares of common stock at an average price of $33.20 per share for a total amount of $373 million.  Treasury stock is accounted for under the cost method.

 

In August 2004, the Company entered into a $100 million structured stock repurchase transaction which matured in four separate tranches through March 31, 2005.  One of the four $25 million tranches matured and settled in December 2004.  During the six months ended June 30, 2005, each of the three remaining $25 million tranches settled resulting in the Company receiving $82 million in cash.

 

In February 2005, the Company entered into $150 million in structured stock repurchase transactions which matured in three separate tranches through August 2005.  One of the three $50 million tranches matured and settled in the three months ended June 30, 2005 resulting in the Company receiving $53 million in cash.  Both of the remaining $50 million tranches matured and settled in the three months ended September 30, 2005 resulting in the Company receiving $107 million in cash.

 

13



 

In April 2005, the Company entered into $500 million in structured stock repurchase transactions which mature in three separate tranches through October 2005.  A $150 million tranche matured and settled in the three months ended June 30, 2005 resulting in the Company receiving $156 million in cash.  The remaining two tranches will mature in October 2005.  On each of the remaining maturity dates, if the market price of Yahoo! common stock is at or above $35.11 for both the $150 million and $200 million tranches, the Company will have its investments returned with a premium.  If the market price is below $35.11, the Company will repurchase up to an aggregate of 11.0 million shares of its common stock.

 

In July 2005, the Company entered into $500 million in structured stock repurchase transactions which will mature in two separate tranches in January 2006 and April 2006.  On each of the maturity dates, if the market price of Yahoo! common stock is at or above $33.98 for the $250 million tranche maturing in January 2006 and $33.99 for the $250 million tranche maturing in April 2006, the Company will have its investment returned with a premium.  If the market price of the Company’s common stock is below such pre-determined prices, the Company will repurchase up to an aggregate of 16.3 million shares of its common stock.

 

The outstanding structured stock repurchase transactions as of the balance sheet dates are recorded in stockholders’ equity on the consolidated balance sheets.

 

Note 10—Commitments and Contingencies

 

Operating Leases.  The Company has entered into various non-cancelable operating lease agreements for offices and facilities globally, for original lease periods up to 23 years and expiring between 2005 and 2027.

 

Net lease commitments as of September 30, 2005 can be summarized as follows (in millions):

 

 

 

Gross lease
commitments

 

Sublease
income

 

Net lease
commitments

 

 

 

 

 

 

 

 

 

Three months ending December 31, 2005

 

$17

 

$(2

)

$15

 

Years ending December 31,

 

 

 

 

 

 

 

2006

 

70

 

(4

)

66

 

2007

 

76

 

 

76

 

2008

 

81

 

 

81

 

2009

 

78

 

(1

)

77

 

2010

 

68

 

(1

)

67

 

Due after 5 years

 

389

 

(1

)

388

 

Total net lease commitments

 

$779

 

$(9

)

$770

 

 

Affiliate Commitments.  In connection with contracts to provide sponsored search services to affiliates, the Company is obligated to make payments, which represent traffic acquisition costs, to its affiliates.  As of September 30, 2005, the commitments total $293 million of which $64 million will be payable in the remainder of 2005, $214 million will be payable in 2006 and $15 million will be payable in 2007.

 

Other Commitments.  In the ordinary course of business, the Company may provide indemnifications of varying scope and terms to customers, vendors, lessors, business partners and other parties with respect to certain matters, including, but not limited to, losses arising out of the Company’s breach of agreements, services to be provided by the Company, or from intellectual property infringement claims made by third parties.  In addition, the Company has entered into indemnification agreements with its directors and certain of its officers that will require the Company, among other things, to indemnify them against certain liabilities that may arise by reason of their status or service as directors or officers.  The Company has also agreed to indemnify certain former officers, directors and employees of acquired companies in connection with the acquisition of such companies.  The Company maintains director and officer insurance, which may cover certain liabilities arising from its obligation to indemnify its directors and officers, and former directors and officers of acquired companies, in certain circumstances.

 

It is not possible to determine the maximum potential loss under these indemnification agreements due to the limited history of prior indemnification claims and the unique facts and circumstances involved in each particular agreement.  Such indemnification agreements may not be subject to maximum loss clauses.  Historically, the Company has not incurred material costs as a result of obligations under these agreements and it has not accrued any liabilities related to such indemnification obligations in its condensed consolidated financial statements.

 

14



 

On April 21, 2003, Overture Services Inc. (“Overture”) completed its purchase of the Web Search unit of Fast Search and Transfer ASA, a Norway based developer of search and real-time filtering technologies, for $70 million in cash, plus a contingent earn-out payment of up to $30 million over three years based on specified operating criteria.

 

As of September 30, 2005, the Company did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.  As such, the Company is not exposed to any financing, liquidity, market or credit risk that could arise if the Company had engaged in such relationships.

 

Contingencies.  From time to time, third parties assert patent infringement claims against the Company.  Currently, the Company is engaged in several lawsuits regarding patent issues and has been notified of a number of other potential patent disputes.

 

In addition, from time to time the Company is subject to other legal proceedings and claims in the ordinary course of business, including claims of alleged infringement of trademarks, copyrights and other intellectual property rights, and a variety of claims, including claims alleging defamation or invasion of privacy, arising in connection with its email, message boards, auction sites, shopping services, and other communications and community features.

 

In October 2000, 800-JR-Cigar, Inc. filed a complaint in the United States District Court for the District of New Jersey against Overture, a wholly-owned subsidiary of the Company acquired in October 2003.  The plaintiff in this case, and in certain other cases which have been brought against Overture in the past, claims, among other things, that it has trademark rights in certain search terms and that Overture violates these rights by allowing its advertisers to bid on these search terms.  The complaints seek injunctive relief and damages.  The Company and Overture believe that Overture has meritorious defenses to liability and damages and are contesting the lawsuit vigorously.  In August 2003, Accor filed a similar complaint in the Nanterre District Court in France against Overture and Overture S.A.R.L., Overture’s wholly-owned subsidiary in France.  On January 17, 2005, the Nanterre District Court ruled in favor of Accor and found Overture and Overture S.A.R.L. liable for trademark infringement.  Overture S.A.R.L. and Overture have appealed this decision.

 

On May 24, 2001, Arista Records, Inc., Bad Boy Records, BMG Music d/b/a The RCA Records Label, Capitol Records, Inc., Virgin Records America, Inc., Sony Music Entertainment Inc., UMG Recordings, Inc., Interscope Records, Motown Record Company, L.P., and Zomba Recording Corporation filed a lawsuit alleging copyright infringement against LAUNCH in the United States District Court for the Southern District of New York.  The plaintiffs allege, among other things, that the consumer-influenced portion of LAUNCH’s LAUNCHcast service is “interactive” within the meaning of Section 114 of the Copyright Act and therefore does not qualify for the compulsory license provided for by the Copyright Act.  The Complaint seeks declaratory and injunctive relief and damages for the alleged infringement.  After the lawsuit was commenced, the Company entered into an agreement to acquire LAUNCH.  In June 2001,   LAUNCH settled the LAUNCH litigation as to UMG Recordings, Inc.  The Company’s acquisition of LAUNCH closed in August 2001, and since that time LAUNCH has been a wholly owned subsidiary of the Company.  The Company and LAUNCH do not believe that LAUNCH has infringed any rights of plaintiffs and intend to vigorously contest the lawsuit.  In January 2003, LAUNCH settled the LAUNCH litigation as to Sony Music Entertainment, Inc.  In October 2003, LAUNCH settled the litigation as to Capitol Records, Inc. and Virgin Records America, Inc.  Accordingly, BMG Music d/b/a/ The RCA Records Label is the sole remaining plaintiff in this proceeding.  On March 16, 2004 the plaintiff filed motions for partial summary judgment on the issues of willful infringement and whether the consumer-influenced portion of Launch’s LAUNCHcast service is “interactive” within the meaning of Section 114 of the Copyright Act and therefore does not qualify for the compulsory license provided for by the Copyright Act.  LAUNCH filed its opposition to the motions for partial summary judgment on April 30, 2004, and a hearing on the motions was held on June 18, 2004.  The Court has not yet ruled on the motions for summary judgment.  The Company does not believe it is feasible to predict or determine the outcome or resolution of the remaining LAUNCH litigation at this time.  The range of possible resolutions of such LAUNCH litigation could include judgments against LAUNCH or settlements that could require substantial payments by LAUNCH.

 

On July 12, 2001, the first of several purported securities class action lawsuits was filed in the United States District Court for the Southern District of New York against certain underwriters involved in Overture’s initial public offering, Overture, and certain of Overture’s current and former officers and directors.  The Court consolidated the cases against Overture.  Plaintiffs allege, among other things, violations of the Securities Act of 1933 and the Securities Exchange Act of 1934 involving undisclosed compensation to the underwriters, and improper practices by the underwriters, and seek unspecified damages.  Similar complaints were filed in the same court against numerous public companies that conducted initial public offerings of their common stock since the mid-1990s.  All of these lawsuits were consolidated for pretrial purposes before Judge Shira Scheindlin.  On April 19, 2002, plaintiffs filed an amended complaint, alleging Rule 10b-5 claims of fraud.  On July 15, 2002, the issuers filed a motion to dismiss for failure to comply with applicable pleading standards.  On October 8, 2002, the Court entered an Order of Dismissal as to all of the individual defendants in the Overture IPO litigation, without prejudice.  On February 19, 2003, the Court denied the motion to dismiss the Rule 10b-5 claims against certain defendants, including Overture.  On August 31 2005, the Court entered an

 

15



 

order confirming its preliminary approval of a settlement proposal made by plaintiffs, which includes settlement of, and release of claims against, the issuer defendants, including Overture.  A hearing on the fairness of the settlement to the shareholder class is currently set for April 24, 2006.  If the settlement does not occur, and litigation against Overture continues, the Company and Overture believe that Overture has meritorious defenses to liability and damages and will continue to defend the case vigorously.

 

On or about February 4, 2004, a shareholder derivative action was filed in the Court of Chancery of the State of Delaware in and for New Castle County, against the Company (as nominal defendant) and certain of the Company’s current and former officers and directors (the “Derivative Defendants”).  Two similar shareholder derivative actions were filed in the California Superior Court for the County of San Mateo on February 13, 2004.  The complaints generally alleged breaches of fiduciary duties by the Derivative Defendants related to the alleged purchase of shares in initial public offerings or the alleged acquiescence in such conduct and sought unspecified monetary damages and other relief purportedly on behalf of the Company from the Derivative Defendants.  The action in Delaware was dismissed by the Delaware Court of Chancery, and the dismissal has been affirmed by the Delaware Supreme Court.  The actions in California were dismissed by the California Superior Court on September 13, 2005.

 

The Company does not believe, based on current knowledge, that any of the foregoing legal proceedings or claims are likely to have a material adverse effect on its financial position, results of operations or cash flows.  However, the Company may incur substantial expenses in defending against third party claims.  In the event of a determination adverse to the Company or its subsidiaries, the Company may incur substantial monetary liability, and be required to change its business practices.  Either of these could have a material adverse effect on the Company’s financial position, results of operations or cash flows.

 

Note 11—Segments

 

The Company manages its business geographically.  The primary areas of measurement and decision-making are the United States and International.  Management relies on an internal management reporting process that provides revenue and segment operating income before depreciation and amortization for making financial decisions and allocating resources.  Segment operating income before depreciation and amortization includes income from operations before depreciation, amortization of intangible assets and amortization of stock compensation expense.  Management believes that segment operating income before depreciation and amortization is an appropriate measure of evaluating the operational performance of the Company’s segments.  However, this measure should be considered in addition to, not as a substitute for, or superior to, income from operations or other measures of financial performance prepared in accordance with generally accepted accounting principles.

 

16



 

The following tables present summarized information by segment (in thousands):

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,
2004

 

September 30,
2005

 

September 30,
2004

 

September 30,
2005

 

 

 

 

 

 

 

 

 

 

 

Revenues by segment:

 

 

 

 

 

 

 

 

 

United States

 

$654,985

 

$922,860

 

$1,878,417

 

$2,611,103

 

International

 

251,730

 

407,069

 

618,383

 

1,145,565

 

Total revenues

 

$906,715

 

$1,329,929

 

$2,496,800

 

$3,756,668

 

 

 

 

 

 

 

 

 

 

 

Segment operating income before depreciation and amortization:

 

 

 

 

 

 

 

 

 

United States

 

$223,260

 

$306,031

 

$612,879

 

$867,690

 

International

 

36,444

 

79,091

 

91,808

 

230,934

 

 

 

 

 

 

 

 

 

 

 

Total segment operating income before depreciation and amortization

 

259,704

 

385,122

 

704,687

 

1,098,624

 

 

 

 

 

 

 

 

 

 

 

Depreciation and amortization

 

(81,488

)

(101,541

)

(225,108

)

(285,909

)

Stock compensation expense

 

(6,111

)

(13,524

)

(25,823

)

(33,938

)

Income from operations

 

$172,105

 

$270,057

 

$453,756

 

$778,777

 

 

 

 

 

 

 

 

 

 

 

Capital expenditures, net:

 

 

 

 

 

 

 

 

 

United States

 

$47,757

 

$73,275

 

$126,039

 

$210,209

 

International

 

17,987

 

22,219

 

34,093

 

47,085

 

Total capital expenditures, net

 

$65,744

 

$95,494

 

$160,132

 

$257,294

 

 

 

 

December 31,
2004

 

September 30,
2005

 

Property and equipment, net:

 

 

 

 

 

United States

 

$461,623

 

$537,296

 

International

 

70,073

 

85,754

 

Total property and equipment, net

 

$531,696

 

$623,050

 

 

Revenue is attributed to individual countries according to the international online property that generated the revenue.  No single foreign country accounted for more than 10 percent of revenues in the three and nine months ended September 30, 2004 and 2005.

 

The following table presents revenues for groups of similar services (in thousands):

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,
2004

 

September 30,
2005

 

September 30,
2004

 

September 30,
2005

 

 

 

 

 

 

 

 

 

 

 

Marketing services

 

$796,568

 

$1,159,572

 

$2,184,319

 

$3,278,669

 

Fees

 

110,147

 

170,357

 

312,481

 

477,999

 

Total revenues

 

$906,715

 

$1,329,929

 

$2,496,800

 

$3,756,668

 

 

*                                         In the three and nine months ended September 30, 2004, Fees revenue includes certain revenue previously classified as Marketing services revenues of $6 million and $16 million, respectively.  This reclassification was done to refine the alignment of revenue sources within these classifications of revenue.

 

17



 

Note 12—Related Party Transactions

 

The Company and other third parties are limited partners in Softbank Capital Partners LP (“Softbank Capital”), a venture capital fund which is an affiliate of SOFTBANK.  A Managing Partner of Softbank Capital is also a member of the Company’s Board of Directors.  The total investment by the Company in Softbank Capital is approximately $36 million and represents less than a 5% holding in Softbank Capital.  A significant portion of this investment has been impaired by the Company, with the remaining value included on the condensed consolidated balance sheets in other assets.  Pursuant to the Partnership Agreement, the Company invested on the same terms and on the same basis as all other limited partners.

 

The Company has a joint venture with SOFTBANK in Japan (“Yahoo! Japan”).  The Company has a 34 percent ownership in Yahoo! Japan and accordingly this investment is being accounted for using the equity method.  The Company records its share of the results of Yahoo! Japan one quarter in arrears within earnings in equity interests.  During the three months ended June 30, 2005, the Company received a cash dividend in the amount of $11 million from Yahoo! Japan which was recorded as a reduction in the Company’s investment in Yahoo! Japan.

 

The Company has commercial arrangements with Yahoo! Japan including algorithmic search services, sponsored search services and the related traffic acquisition costs, and license fees.  The net cost of these arrangements was approximately $22 million and $49 million for the three months ended September 30, 2004 and 2005, respectively.  The net cost of these arrangements was approximately $42 million and $121 million for the nine months ended September 30, 2004 and 2005, respectively.

 

Note 13—Subsequent Events

 

Alibaba Investment.  On October 23, 2005, the Company acquired an approximate 46 percent interest in the outstanding common stock of Alibaba.com Corporation, (“Alibaba” ) which represents an approximate 40 percent interest on a fully diluted basis, in exchange for $1 billion in cash, the contribution of the Company’s China based businesses (“Yahoo! China”) and direct transaction costs of $8 million.  Pursuant to the terms of a shareholders agreement, the Company has an approximate 35 percent voting interest in Alibaba, with the remainder of its voting rights subject to a voting agreement with Alibaba management.

 

The Company will account for this investment using the equity method of accounting and the total investment, including identifiable intangible assets, deferred tax liabilities and goodwill will be classified as a long-term investment on the Company’s consolidated balance sheets.  Following the acquisition date, the Company’s consolidated financial results will include its share of the results of Alibaba, together with amortization expense relating to any acquired intangible assets identified.  The Company will record its share of the results of Alibaba, and any related amortization expense, one quarter in arrears within earnings in equity interests.  Following the acquisition date, Yahoo! China will no longer be consolidated in the Company’s results but included within earnings in equity interests to the extent of the Company’s continued ownership interest in Alibaba.  The revenues and operating income of Yahoo! China were not material to the consolidated results of the Company for the year ended December 31, 2004 and the nine months ended September 30, 2005.  In connection with the transaction, the Company also expects to record a non-cash gain based on the difference between Yahoo! China’s fair value and its carrying value, adjusted for the Company’s continued ownership interest in the newly combined entity.  The Company currently estimates a non-cash pre-tax gain of $300 - $350 million in the fourth quarter of 2005.

 

Structured Stock Repurchase.  In October and November 2005, the Company received $386 million in cash from the settlement of two structured stock repurchase transactions totaling $350 million that were entered into in April 2005.

 

18



 

Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Forward Looking Statements

 

In addition to current and historical information, this Report contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.  These statements relate to our future operations, prospects, potential products, services, developments and business strategies.  These statements can, in some cases, be identified by the use of terms such as “may,” “will,” “should,” “could,” “would,” “intend,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “project,” “potential,” or “continue” or the negative of such terms or other comparable terminology.  This Report includes, among others, forward statements regarding our:

 

                                          expectations about revenues for marketing services and fees;

 

                                          expectations about costs of revenues, operating costs and expenses;

 

                                          anticipated capital expenditures;

 

                                          evaluation of possible acquisitions of, or investments in, businesses, products and technologies; and

 

                                          expectations about positive cash flow generation and existing cash and investments being sufficient to meet normal operating requirements.

 

These statements involve certain known and unknown risks and uncertainties that could cause our actual results to differ materially from those expressed or implied in our forward looking statements.  Such risks and uncertainties include, among others, those listed under the heading “Risk Factors” and elsewhere in this Report.  We do not intend, and undertake no obligation, to update any of our forward-looking statements after the date of this Report to reflect actual results or future events or circumstances.

 

Overview

 

We are a leading global Internet brand and one of the most trafficked Internet destinations worldwide.  We seek to provide Internet services that are essential and relevant to users and businesses through the provision of the Yahoo! Network to Internet users and a range of tools and marketing solutions for businesses to market to that community of users.

 

We seek to leverage the power of the Yahoo! Network to create the most innovative and highest quality Internet services for users, and to provide the most efficient and effective marketing services for businesses to reach these users.  Our focus is to increase our user base and to achieve deeper engagement of our users on the Yahoo! Network thereby enhancing the value of that user base and increasing the spending by our advertisers.

 

We are also focused on extending our marketing platform and access to Internet users beyond the Yahoo! Network through our distribution network of affiliates who have integrated our sponsored search offerings into their websites.

 

Many of our services are free to our users.  We generate revenues by providing marketing services to businesses across the majority of our properties and by establishing paying relationships with our users for premium services.  We classify these revenues as either Marketing Services or Fees.  Our offerings to users and businesses currently fall into three categories—Search and Marketplace; Information and Content; and Communications and Consumer Services.  The majority of our offerings are available globally.  We manage and measure our business geographically; our principal geographies being the United States and International.

 

19



 

Operating Highlights

 

Nine Months Ended
September 30,

 

2004-2005

 

(in thousands)

 

2004

 

2005

 

Change

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Revenues

 

$2,496,800

 

$3,756,668

 

$1,259,868

 

Income from operations

 

$453,756

 

$778,777

 

$325,021

 

Net cash provided by operating activities

 

$753,101

 

$1,230,041

 

$476,940

 

Net cash provided by (used in) investing activities

 

$(853,503

)

$739,457

 

$1,592,960

 

Net cash provided by (used in) financing activities

 

$327,684

 

$(746,569

)

$(1,074,253

)

 

During the first year of owning a significant acquired company, our practice has been to disaggregate the results and disclose any material impact on our revenues and expenses separately.  As a result, until the first anniversary of the acquisition date, the revenues and expenses of our acquired businesses are described as “acquisition related” in the discussion that follows.  Thereafter the underlying results of these acquisitions are considered part of our organic base.  Our historical financial statements reflect the impact of these acquired businesses from their respective dates of acquisition and the discussion of our results of operations that follows explains the impact of these acquisitions, if any, on our consolidated results to provide information that will assist in understanding the changes in the periods presented.  Our year over year reported growth rates, calculated on a consolidated basis, include the impact from acquisitions.  Excluding the impact from acquisitions, our growth rates would be lower.

 

Our revenue growth in the nine months ended September 30, 2005 over the same period of 2004 can be attributed to an expanding user base and from increased user activity levels across our offerings on the Yahoo! Network.  The growth in our engaged audience in terms of the number of users and activity levels on our properties have attracted more advertisers to our advertising services and resulted in an increase in our revenues.  In addition, the average spending per advertiser has also increased which further explains the revenue growth over the prior period.

 

Cash generated from our operations is a measure of the cash productivity of our business model and is an area of focus for us.  The growth of cash flow from operations is primarily a function of our increasing net income as well as net changes in our working capital balances that provided a source of cash.  As of September 30, 2005, we had cash, cash equivalents and marketable debt securities totaling $4,764 million, an increase of $1,022 million compared to $3,742 million as of December 31, 2004.  The principal components of the increase in cash, cash equivalents and marketable debt securities were cash generated from operating activities of $1,230 million, proceeds of $1,006 million from the sale of non-strategic marketable equity security investments, proceeds of $378 million from the exercise of employee stock options, offset by net cash used in structured stock repurchase activities of $753 million, $373 million used for direct share repurchases, $127 million used for acquisitions and $257 million used for net capital expenditures.

 

During the three and nine months ended September 30, 2005, we recorded gains of $27 million and $987 million, respectively, related to the sale of non-strategic marketable equity security investments.  These gains have been included in other income, net on the condensed consolidated statements of operations.

 

On October 23, 2005, we acquired an approximate 46 percent interest in the outstanding common stock of Alibaba which represents an approximate 40 percent interest on a fully diluted basis, in exchange for $1 billion in cash, the contribution of Yahoo! China and direct transaction costs of $8 million.  Pursuant to the terms of a shareholders agreement, we have an approximate 35 percent voting interest in Alibaba, with the remainder of our voting rights subject to a voting agreement with Alibaba management.  We will account for this investment using the equity method of accounting.  Following the acquisition date, our consolidated financial results will include our share of the results of Alibaba together with amortization expense relating to any acquired intangible assets identified.  We will record our share of the results of Alibaba, and any related amortization expense, one quarter in arrears within earnings in equity interests.  Following the acquisition date, Yahoo! China will no longer be consolidated in our results but included within earnings in equity interests to the extent of our continued ownership interest in Alibaba.  The revenues and operating income of Yahoo! China were not material to our consolidated results for the year ended December 31, 2004 and the nine months ended September 30, 2005.  In connection with the transaction, we also expect to record a non-cash gain based on the difference between Yahoo! China’s fair value and its carrying value, adjusted for our continued ownership interest in the newly combined entity.  We currently estimate a non-cash pre-tax gain of $300 - $350 million in the fourth quarter of 2005.

 

We continue to believe the search queries, page views, click-throughs and the related marketing services and fees revenues that we generate are correlated to the number of users and the amount of time that these users are spending on our network.  By providing a platform for our users that brings together our search technology, content, and community while allowing for personalization and integration across devices, we seek to increase our share of users, become more essential to our users and deepen their engagement with our products and services.  We believe this deeper engagement of new and existing users, coupled

 

20



 

with the expansion of the online advertising market as advertisers shift their spending from traditional media to the Internet, will continue to increase our revenues for the remainder of 2005 over 2004.  We also believe that our operating expenses for the remainder of 2005 will continue to increase over 2004 as we make additional investments in all areas of our business and will incur a full year of costs in 2005 related to acquisitions completed in 2004 as well as incur additional costs for new acquisitions completed this year.

 

Results of Operations

 

The following table sets forth selected information on our results of operations as a percentage of revenues for the periods indicated:

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2004

 

2005

 

2004

 

2005

 

 

 

 

 

 

 

 

 

 

 

Revenues

 

100

%

100

%

100

%

100

%

Cost of revenues

 

37

 

39

 

37

 

39

 

Gross profit

 

63

 

61

 

63

 

61

 

Operating expenses:

 

 

 

 

 

 

 

 

 

Sales and marketing

 

21

 

20

 

22

 

20

 

Product development

 

10

 

11

 

10

 

10

 

General and administrative

 

8

 

6

 

8

 

6

 

Stock compensation expense

 

1

 

1

 

1

 

1

 

Amortization of intangibles

 

4

 

3

 

4

 

3

 

 

 

 

 

 

 

 

 

 

 

Total operating expenses

 

44

 

41

 

45

 

40

 

Income from operations

 

19

 

20

 

18

 

21

 

Other income, net

 

14

 

5

 

6

 

29

 

 

 

 

 

 

 

 

 

 

 

Income before income taxes, earnings in equity interests and minority interests

 

33

 

25

 

24

 

50

 

Provision for income taxes

 

(8

)

(8

)

(8

)

(20

)

Earnings in equity interests

 

3

 

2

 

3

 

2

 

Minority interests in operations of consolidated subsidiaries

 

 

 

 

 

Net income

 

28

%

19

%

19

%

32

%

 

Revenues.  Revenues by groups of similar services were as follows (dollars in thousands):

 

 

 

Three Months Ended September 30,

 

Percent

 

Nine Months Ended September 30,

 

Percent

 

 

 

2004

 

(1)

 

2005

 

(1)

 

Change

 

2004

 

(1)

 

2005

 

(1)

 

Change

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Marketing services(2)

 

$796,568

 

88

%

$1,159,572

 

87

%

46

%

$2,184,319

 

87

%

$3,278,669

 

87

%

50

%

Fees(2)

 

110,147

 

12

%

170,357

 

13

%

55

%

312,481

 

13

%

477,999

 

13

%

53

%

Total revenues

 

$906,715

 

100

%

$1,329,929

 

100

%

47

%

$2,496,800

 

100

%

$3,756,668

 

100

%

50

%

 

(1)           Percent of total revenues.

 

(2)           For the three and nine months ended September 30, 2004, we have reclassified previously reported Marketing Services revenues of $6 million and $16 million, respectively as Fees in order to refine our alignment of revenue sources with these classifications.

 

Marketing Services Revenue.  Marketing Services revenue for the third quarter of 2005 increased by $363 million, or 46 percent as compared to the same period in 2004.  Marketing Services revenue for the nine months ended September 30, 2005 increased by $1,094 million, or 50 percent as compared to the same period in 2004.  The year over year growth in our marketing services revenue can be attributed to a combination of factors that are driving increased advertising revenue across the entire Yahoo! Network, including an increase in our user base and activity levels on the Yahoo! Network, including a higher volume of

 

21



 

search queries, page views and click-throughs.  As a result of our increased user audience, we continued to attract new advertisers to our portfolio of marketing solutions and increased the average spending per advertiser over the prior year periods.

 

On the Yahoo! Network, our number of unique users worldwide as of September 30, 2005 was approximately 26 percent higher than the number of unique users as of September 30, 2004.  Unique users are the estimated number of people who visited the Yahoo! Network in a given time period.

 

The combined number of page views and searches, including those from our affiliate network, increased by approximately 38 percent and 39 percent, respectively, in the three and nine months ended September 30, 2005 compared to the same periods in 2004.  These increases can be attributed to an increased number of users, an increased number of affiliates, an expanded offering of properties which increased our inventory of page views and greater market acceptance of new sponsored search offerings.  The combined average revenue per page view and search increased by approximately 5 percent and 8 percent, respectively, in the three and nine months ended September 30, 2005 compared to the same periods in 2004.  Our combined revenue per page view and search is influenced by sales mix changes period to period as we expand our offerings on the Yahoo! Network and introduce new inventory with differing yields.

 

Fees Revenue.  Fees revenue for the third quarter of 2005 increased $60 million, or 55 percent, as compared to the same period in 2004, of which $15 million is attributable to acquisitions.  Fees revenue for the nine months ended September 30, 2005 increased $166 million, or 53 percent, as compared to the same period in 2004, of which $42 million is attributable to acquisitions.  The remainder of the increase was primarily associated with an increase in the number of paying users for our fee-based services, which were approximately 11.4 million as of September 30, 2005 compared to 7.6 million as of September 30, 2004, an increase of 50 percent.  Our increased base of fee paying users was due to growth in users across most of our offerings that were available in the prior year as well as from our acquisition of Musicmatch in the fourth quarter of 2004.  Our fee-based services include Internet broadband and dial-up services, sports, music, personals and premium mail offerings as well as our services for small businesses.  Average monthly revenue per paying user has remained consistent at approximately $4 for the third quarter of 2005 and the same period in 2004.

 

Costs and Expenses:  Operating costs and expenses were as follows (dollars in thousands):

 

 

 

Three Months Ended September 30,

 

Percent

 

Nine Months Ended September 30,

 

Percent

 

 

 

2004

 

(1)

 

2005

 

(1)

 

Change

 

2004

 

(1)

 

2005

 

(1)

 

Change

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cost of revenues

 

$332,333

 

37

%

$520,238

 

39

%

57

%

$911,421

 

37

%

$1,459,433

 

39

%

60

%

Sales and marketing

 

$192,950

 

21

%

$265,714

 

20

%

38

%

$551,120

 

22

%

$742,639

 

20

%

35

%

Product development

 

$97,033

 

10

%

$141,616

 

11

%

46

%

$261,162

 

10

%

$386,509

 

10

%

48

%

General and administrative

 

$69,215

 

8

%

$77,733

 

6

%

12

%

$189,930

 

8

%

$232,708

 

6

%

23

%

Stock compensation expense

 

$6,111

 

1

%

$13,524

 

1

%

121

%

$25,823

 

1

%

$33,938

 

1

%

31

%

Amortization of intangibles

 

$36,968

 

4

%

$41,047

 

3

%

11

%

$103,588

 

4

%

$122,664

 

3

%

18

%

 

(1)           Percent of total revenues.

 

Cost of Revenues.  Cost of revenues consists of traffic acquisition costs (“TAC”) and other expenses associated with the production and usage of the Yahoo! Network.  TAC consists of payments made to affiliates that have integrated our sponsored search offerings into their websites and payments made to companies that direct consumer and business traffic to the Yahoo! website.  Other cost of revenues consists of fees paid for content included on our online media properties, Internet connection charges, facilities costs, server equipment depreciation, technology license fees and compensation related expenses.

 

 

 

Three Months Ended September 30,

 

Percent

 

Nine Months Ended September 30,

 

Percent

 

 

 

2004

 

(1)

 

2005

 

(1)

 

Change

 

2004

 

(1)

 

2005

 

(1)

 

Change

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Traffic acquisition costs (“TAC”)

 

$251,314

 

76

%

$397,814

 

76

%

58

%

$682,108

 

75

%

$1,128,686

 

77

%

65

%

Other costs of revenues

 

81,019

 

24

%

122,424

 

24

%

51

%

229,313

 

25

%

330,747

 

23

%

44

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Costs of revenues

 

$332,333

 

100

%

$520,238

 

100

%

57

%

$911,421

 

100

%

$1,459,433

 

100

%

60

%

 

(1)           Percent of cost of revenues.

 

22



 

Cost of revenues for the third quarter of 2005 increased $188 million, or 57 percent, as compared to the same period of 2004.  The increase included $147 million of additional TAC which represents the largest component of cost of revenues, as well as an increase of $26 million in content costs and depreciation.  This year over year increase in TAC of 58 percent was driven by our 46 percent growth in marketing services revenues over the same period in 2004 and a product mix change toward revenue streams that have associated TAC.  Cost of revenues for the nine months ended September 30, 2005 increased $548 million, or 60 percent, as compared to the same period of 2004.  The increase included $447 million of additional TAC as well as an increase of $69 million in content costs and depreciation.  This 65 percent year over year increase in TAC was driven by our 50 percent growth in marketing services revenues over the same period in 2004 and a product mix change toward revenue streams that have associated TAC.  Cost of revenues, as a percent of revenue, has increased from 37 percent for the three and nine months ended September 30, 2004 to 39 percent for the three and nine months ended September 30, 2005.  This trend is the result of a product mix shift and our increase in spending on content for the Yahoo! Network.

 

Sales and Marketing.  Sales and marketing expenses consist primarily of advertising and other marketing related expenses, compensation related expenses, sales commissions and travel costs.

 

Sales and marketing expenses for the third quarter of 2005 increased $73 million, or 38 percent, as compared to the same period of 2004.  Sales and marketing expenses for the nine months ended September 30, 2005 increased $192 million, or 35 percent, as compared to the same period of 2004.  Approximately one-half of the increases, $37 million and $102 million, for the three and nine month periods, respectively, related to compensation expense as we increased our headcount to expand our presence in certain territories to service our expanding advertising business as well as support our growing advertiser base in existing regions. Additionally, year over year spending on marketing and distribution increased by $20 million and $51 million for the three and nine months ended September 30, 2005, respectively, as we continued to invest in product branding and develop our distribution channels.

 

Product Development.  Product development expenses consist primarily of compensation related expenses incurred for enhancements to and maintenance of the Yahoo! Network, classification and organization of listings within Yahoo! properties and research and development as well as depreciation expense and other operating costs.

 

Product development expenses for the third quarter of 2005 increased $45 million, or 46 percent, as compared to the same period of 2004.  Product development expenses for the nine months ended September 30, 2005 increased $125 million, or 48 percent, as compared to the same period of 2004.  Approximately $31 million and $84 million of the increases for the three and nine month periods ended September 30, 2005, respectively, related to increased compensation expenses as we continued to hire engineers to further develop and build new properties and services on the Yahoo! Network.  Additionally, approximately $4 million and $17 million of the increases for the three and nine months ended September 30, 2005 respectively, related to increased depreciation expense arising from our additional investments in property and equipment to support further product development.

 

General and Administrative.  General and administrative expenses consist primarily of compensation related expenses and fees for professional services.

 

General and administrative expenses for the third quarter of 2005 increased $9 million, or 12 percent, as compared to the same period of 2004.  General and administrative expenses for the nine months ended September 30, 2005 increased $43 million, or 23 percent, as compared to the same period of 2004.  For both the three and nine months September 30, 2005, the increases were primarily due to compensation related expenses, which reflects the expansion of our team to support increased compliance and infrastructure needs.

 

Stock Compensation.  Stock compensation expense relates to the amortization of the intrinsic value of Yahoo! stock options issued and assumed in connection with acquisitions and other equity-based awards.  This expense is generally being amortized using the accelerated amortization method in accordance with FASB Interpretation No. 28 “Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans”.

 

The increases in stock compensation expense for the three and nine months ended September 30, 2005 were primarily a result of the amortization of newly issued equity-based awards partially offset by decreased costs associated with options assumed in acquisitions.  The amortization of options assumed in acquisitions has declined as the accelerated amortization method results in declining amortization of awards over their vesting periods and as we have not assumed a significant amount of options in our recent acquisitions.

 

Amortization of Intangibles.  We have purchased, and expect to continue purchasing, assets or businesses, which may include the purchase of intangible assets.  Amortization of intangibles for the third quarter of 2005 was $41 million compared to $37 million for the same period of 2004.  Amortization of intangibles for the nine months ended September 30, 2005 was

 

23



 

$123 million compared to $104 million for the same period of 2004.  The year over year increases in amortization of intangibles in the three and nine months ended September 30, 2005 were the result of our continued acquisition activity which has resulted in an increased balance of amortizable intangible assets.

 

Other Income, Net.  Other income, net was as follows (in thousands):

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2004

 

2005

 

2004

 

2005

 

 

 

 

 

 

 

 

 

 

 

Interest and investment income

 

$14,962

 

$37,676

 

$40,978

 

$88,548

 

Investment gains (losses), net

 

110,268

 

26,948

 

107,780

 

995,231

 

Other

 

(1,949

)

1,371

 

2,080

 

11,946

 

Total other income, net

 

$123,281

 

$65,995

 

$150,838

 

$1,095,725

 

 

Other income increased due to sales of non-strategic marketable equity security investments which generated investment gains of $105 million in the three and nine months ended September 30, 2004 and $27 million and $987 million for the three and nine months ended September 30, 2005.  In addition, interest and investment income earned in both the three and nine months ended September 30, 2005 was higher than the income during the same periods in 2004 as a result of larger invested balances, as well as higher yields on our investment portfolio.

 

Income Taxes.  The effective tax rate for the three and nine months ended September 30, 2004 was 23 percent and 34 percent, respectively, compared to 34 percent and 40 percent, respectively, for the three and nine months ended September 30, 2005.  For all periods, the provision for income taxes differs from the amount computed by applying the statutory federal income tax rate due to state taxes and foreign losses for which no tax benefit is provided.  Additionally, for the three and nine months ended September 30, 2004 the tax rate was reduced due to the utilization of previously unbenefited capital losses against the capital gain on the sale of an equity investment.  For the three months ended September 30, 2005, the tax rate was reduced primarily due to the realignment of our year-to-date tax provision based on a lower than previously expected annual effective tax rate, as well as the receipt of foreign tax refunds.

 

Earnings in Equity Interests.  Earnings in equity interests for the third quarter of 2005 was $32 million compared to $26 million for the same period of 2004.  Earnings in equity interests for the nine months ended September 30, 2005 was $95 million compared to $70 million for the same period of 2004.  The increases in both the three and nine months ended September 30, 2005 resulted from increased net income earned by Yahoo! Japan.

 

Minority Interests in Operations of Consolidated Subsidiaries.  Minority interests in operations of consolidated subsidiaries represents the minority holders’ percentage share of income or losses from such subsidiaries in which we hold a majority ownership interest, but less than 100 percent, and consolidate the subsidiaries’ results in our consolidated financial statements.  Minority interests in income from operations of consolidated subsidiaries were $1 million and $6 million for the three and nine months ended September 30, 2005 compared to $1 million and $3 million in both the three and nine months ended September 30, 2004.

 

24



 

Business Segment Results

 

We manage our business geographically.  Our primary areas of measurement and decision-making are the United States and International.  Management relies on an internal management reporting process that provides revenue and segment operating income before depreciation and amortization for making financial decisions and allocating resources.  Segment operating income before depreciation and amortization, includes income from operations before depreciation, amortization of intangible assets and amortization of stock compensation expense.  Management believes that segment operating income before depreciation and amortization is an appropriate measure for evaluating the operational performance of our segments.  However, this measure should be considered in addition to, not as a substitute for, or superior to, income from operations or other measures of financial performance prepared in accordance with generally accepted accounting principles.

 

Summarized information by segment was as follows (dollars in thousands):

 

 

 

Three Months Ended September 30,

 

Percent

 

Nine Months Ended September 30,

 

Percent

 

 

 

2004

 

(1)

 

2005

 

(1)

 

Change

 

2004

 

(1)

 

2005

 

(1)

 

Change

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Revenues by segment:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

United States

 

$

654,985

 

72

%

$

922,860

 

69

%

41

%

$

1,878,417

 

75

%

$

2,611,103

 

70

%

39

%

International

 

251,730

 

28

%

407,069

 

31

%

62

%

618,383

 

25

%

1,145,565

 

30

%

85

%

Total revenues

 

$

906,715

 

100

%

$

1,329,929

 

100

%

47

%

$

2,496,800

 

100

%

$

3,756,668

 

100

%

50

%

 

(1)           Percent of total revenues.

 

 

 

Three Months Ended
September 30 ,

 

Percent

 

Nine Months Ended
September 30,

 

Percent

 

 

 

2004

 

2005

 

Change

 

2004

 

2005

 

Change

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Segment operating income before depreciation and amortization:

 

 

 

 

 

 

 

 

 

 

 

 

 

United States

 

$223,260

 

$306,031

 

37

%

$612,879

 

$867,690

 

42

%

International

 

36,444

 

79,091

 

117

%

91,808

 

230,934

 

152

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total segment operating income before depreciation and amortization

 

$259,704

 

$385,122

 

48

%

$704,687

 

$1,098,624

 

56

%

Depreciation and amortization

 

(81,488

)

(101,541

)

25

%

(225,108

)

(285,909

)

27

%

Stock compensation expense

 

(6,111

)

(13,524

)

121

%

(25,823

)

(33,938

)

31

%

Income from operations

 

$172,105

 

$270,057

 

57

%

$453,756

 

$778,777

 

72

%

 

Revenue is attributed to individual countries according to the international online property that generated the revenue.  No single foreign country accounted for more than 10 percent of revenues in the three and nine months periods ended September 30, 2005 or 2004.

 

United States.  United States revenues in the third quarter of 2005 increased $268 million, or 41 percent as compared to the same period in 2004.  United States revenues for the nine months ended September 30, 2005 increased $733 million, or 39 percent as compared to the same period in 2004.  The year over year growth can be attributed to strong growth in advertising across the entire Yahoo! Network, as well as growth from our fee-based services.  The advertising growth can be attributed to our expanding user audience which is allowing us to attract more advertisers and deepen their spending on Internet marketing solutions.  United States segment operating income before depreciation and amortization increased $83 million, or 37 percent from the third quarter of 2004 to the third quarter of 2005.  United States segment operating income before depreciation and amortization for the nine months ended September 30, 2005 increased $255 million, or 42 percent as compared to the same period in 2004.  The year over year increases for both the three and nine months ended September 30, 2005 were primarily as a result of the increased revenues.

 

International.  International revenues in the third quarter of 2005 increased $155 million, or 62 percent as compared to the same period in 2004.  International revenues for the nine months ended September 30, 2005 increased $527 million, or 85 percent as compared to the same period in 2004.  The year over year growth can be attributed to our continued expansion into new markets, as well as our increased penetration into the markets in which we operate coupled with the continued expansion of the online advertising marketplace on a worldwide basis.  In 2005, the revenue growth rate has also been favorably impacted by foreign

 

25



 

currency rates.  International segment operating income before depreciation and amortization increased $43 million, or 117 percent from the third quarter of 2004 compared to the third quarter of 2005.  International segment operating income before depreciation and amortization for the nine months ended September 30, 2005 increased $139 million, or 152 percent as compared to the same period in 2004.  The increases for both the three and nine months ended September 30, 2005 were primarily as a result of the increase in revenues, as well as continued efforts to control discretionary spending and our ability to generate revenue without a commensurate increase in costs.

 

International revenues accounted for 31 percent and 30 percent of total revenues during the three and nine months ended September 2005, respectively, as compared to 28 percent and 25 percent during the three and nine months ended September 30, 2004.  The growth in our international operations has increased our exposure to foreign currency fluctuations.  Revenues and related expenses generated from our international subsidiaries are generally denominated in the functional currencies of the local countries.  Primary currencies include Euros, British Pounds, Japanese Yen, Korean Won, Chinese Yuan and Australian Dollars.  The income statements of our international operations are translated into U.S. dollars at the average exchange rates in each applicable period.  To the extent the U.S. dollar strengthens against foreign currencies, the translation of these foreign currency denominated transactions results in reduced revenues, operating expenses and net income for our International segment.  Similarly, our revenues, operating expenses and net income will increase for our International segment if the U.S. dollar weakens against foreign currencies.  Changes in foreign currencies increased international revenues in the three and nine months ended September 30, 2005 by approximately $9 million and $44 million, respectively, when translated at the average foreign currency exchange rates in effect during the corresponding periods in 2004.

 

Critical Accounting Policies, Judgments and Estimates

 

Our discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States.  The preparation of these consolidated financial statements requires us to make estimates, judgments and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities.  We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources.  Actual results may differ from these estimates.

 

An accounting policy is considered to be critical if it requires an accounting estimate to be made based on assumptions about matters that are highly uncertain at the time the estimates are made, and if different estimates that reasonably could have been used, or changes in the accounting estimates that are reasonably likely to occur, could materially impact the consolidated financial statements.  We believe the following critical accounting policies reflect the more significant estimates and assumptions used in the preparation of the consolidated financial statements.

 

Revenue Recognition.  Our revenues are generated from marketing services and fees.  Marketing services revenue is generated from several offerings including: the display of textual, rich media and graphical advertisements, display of text based links to advertisers’ listings, listing based services, and commerce based transactions.  Fees revenue includes revenue from a variety of consumer and business fee-based services.  While the majority of our revenue transactions contain standard business terms and conditions, there are certain transactions that contain non-standard business terms and conditions.  In addition, we have certain sales transactions that involve multiple element arrangements (arrangements with more than one deliverable) that may include placement on specific properties and content integration.  We also enter into arrangements to purchase goods and/or services from certain customers.  As a result, significant contract interpretation is sometimes required to determine the appropriate accounting for these transactions including: (1) whether an arrangement exists; (2) how the arrangement consideration should be allocated among potential multiple elements; (3) when to recognize revenue on the deliverables; (4) whether all elements of the arrangement have been delivered; (5) whether the arrangements should be reported gross as a principal versus net as an agent; and (6) whether we receive a separately identifiable benefit from purchase arrangements with our customers for which we can reasonably estimate fair value.  In addition, our revenue recognition policy requires an assessment as to whether collection is reasonably assured, which inherently requires us to evaluate the creditworthiness of our customers.  Changes in judgments on these assumptions and estimates could materially impact the timing or amount of revenue recognition.

 

Deferred Income Tax Asset Valuation Allowance.  We record a valuation allowance to reduce our deferred income tax assets to the amount that is more likely than not to be realized.  In evaluating our ability to recover our deferred income tax assets we consider all available positive and negative evidence, including our operating results, ongoing prudent and feasible tax planning strategies and forecasts of future taxable income on a jurisdiction by jurisdiction basis.  In the event we were to determine that we would be able to realize our deferred income tax assets in the future in excess of their net recorded amount, an adjustment to the valuation allowance would likely increase stockholders’ equity as substantially all of our net operating losses result from employee stock option deductions.

 

26



 

Goodwill and Other Intangible Assets.  Our long-lived assets include goodwill and other intangible assets and as of September 30, 2005 had a net balance of $3.0 billion.  Goodwill is tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis and between annual tests in certain circumstances.  Application of the goodwill impairment test requires judgment, including the identification of reporting units, assigning assets and liabilities to reporting units, assigning goodwill to reporting units, and determining the fair value of each reporting unit.  Significant judgments required to estimate the fair value of reporting units include estimating future cash flows, determining appropriate discount rates, growth rates and other assumptions.  Changes in these estimates and assumptions could materially affect the determination of fair value for each reporting unit which could trigger impairment.  See Note 4—”Goodwill” in the condensed consolidated financial statements for additional information.  Based on our 2004 impairment test, there would have to be a significant unfavorable change to our assumptions used in such calculations for an impairment to exist.