UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

 

Form 10-Q

 

 

Commission file number 0-28018

 

 

 

 

YAHOO! INC.

(Exact name of Registrant as specified in its charter)

 

 

701 First Avenue

Sunnyvale, California 94089

(Address of principal executive offices, including zip code)

 

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

 

 

 

 

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed 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 þ     No o

 

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer þ     Accelerated filer o     Non-Accelerated filer 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 þ

 

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

 

 

YAHOO! INC.

 

Table of Contents

 

 

PART I — FINANCIAL INFORMATION

 

 

YAHOO! INC.

 

Condensed Consolidated Statements of Income

 

 

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

YAHOO! INC.

 

Condensed Consolidated Balance Sheets

 

 

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

YAHOO! INC.

 

Condensed Consolidated Statements of Cash Flows

 

 

YAHOO! INC.

 

Condensed Consolidated Statements of Cash Flows — (Continued)

 

 

 

See Note 3 — “Acquisitions” for additional information.

 

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

YAHOO! INC.

 

Notes to Condensed Consolidated Financial Statements
(unaudited)

 

 

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! is focused on powering its communities of users, advertisers and publishers by creating indispensable experiences built on trust. To its users, Yahoo! provides its owned and operated online properties and services (“Yahoo Properties” or “Owned and Operated sites”), as well as access to third-party content and services. To its advertisers and publishers, Yahoo! provides a range of marketing solutions and tools that enable businesses to reach users who visit the Yahoo! Properties and to reach the users of its distribution network of third-party entities (referred to as “affiliates”) who have integrated the Company’s advertising offerings into their websites (referred to as “Affiliate sites”) or their other offerings.

 

Basis of Presentation.  The condensed consolidated financial statements include the accounts of Yahoo! and its majority-owned or otherwise controlled subsidiaries. All significant intercompany accounts and transactions have been eliminated. Investments in entities in which the Company can exercise significant influence, but does not own a majority equity interest or otherwise control, are accounted for using the equity method and are included as Investments in equity interests on the condensed consolidated balance sheets. The Company has included the results of operations of acquired companies from the closing date of the acquisition. Certain prior period amounts have been reclassified to conform to the current period presentation.

 

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 periods.

 

The preparation of condensed consolidated financial statements in conformity with generally accepted accounting principles in the United States (“GAAP”) 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, investments in equity interests, income taxes, and contingencies. In addition, the Company uses assumptions when employing the Black-Scholes option valuation model to calculate the fair value of stock-based awards granted. 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.

 

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, 2006. Certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations. The condensed consolidated balance sheet as of December 31, 2006 was derived from the Company’s audited financial statements for the year ended December 31, 2006, but does not include all disclosures required by GAAP. However, the Company believes the disclosures are adequate to make the information presented not misleading.

 

Recent Accounting Pronouncements

 

In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value Measurements” (“SFAS 157”), which clarifies the definition of fair value, establishes guidelines for measuring fair value, and expands disclosures regarding fair value measurements. SFAS 157 does not require any new fair value measurements but eliminates inconsistencies in

 

YAHOO! INC.

 

Notes to Condensed Consolidated Financial Statements — (Continued)

 

guidance found in various prior accounting pronouncements. SFAS 157 will be effective for the Company on January 1, 2008. The Company is currently evaluating the impact of adopting SFAS 157 but does not believe that the adoption of SFAS 157 will have a material impact on its financial position, cash flows, or results of operations.

 

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”), which permits entities to choose to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value. SFAS 159 will be effective for the Company on January 1, 2008. The Company is currently evaluating the impact of adopting SFAS 159 but does not believe that the adoption of SFAS 159 will have a material impact on its financial position, cash flows, or results of operations.

 

 

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 and restricted stock units, collectively referred to as “restricted stock awards” (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). Potentially dilutive securities representing approximately 117 million and 134 million shares of common stock for the three months ended September 30, 2006 and 2007, respectively, and 98 million and 125 million shares of common stock for the nine months ended September 30, 2006 and 2007, respectively, were excluded from the computation of diluted earnings per share for these periods because their effect would have been antidilutive. Potentially dilutive securities include outstanding stock options, shares to be issued under the employee stock purchase plan, and restricted stock awards.

 

See Note 9 — “Short-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):

 

 

YAHOO! INC.

 

Notes to Condensed Consolidated Financial Statements — (Continued)

 

 

Transactions completed in 2006

 

Seven.  On January 29, 2006, the Company and Seven Network Limited (“Seven”), a leading Australian media company, completed a strategic partnership in which the Company contributed its Australian Internet business, Yahoo! Australia and New Zealand (“Yahoo! Australia”), and Seven contributed its online assets, television and magazine content, an option to purchase its 33 percent ownership interest in mobile solutions provider m.Net Corporation Ltd, and cash of $7 million. The Company believes this strategic partnership and the contribution of the respective businesses with their rich media and entertainment content has created a comprehensive and engaging online experience for local users and advertisers. The Company obtained a 50 percent equity ownership interest in the newly formed entity, which operates as “Yahoo! 7.” Pursuant to a shareholders agreement and a power of attorney granted by Seven to vote certain of its shares, the Company has the right to vote 50.1 percent of the outstanding voting interests in Yahoo! 7 and has control over the day-to-day operations and therefore consolidates Yahoo! 7, which includes the operations of Yahoo! Australia. For accounting purposes, the Company is considered to have acquired the assets contributed by Seven in exchange for 50 percent of the ownership of Yahoo! Australia. Accordingly, the Company accounted for this transaction in accordance with SFAS No. 141, “Business Combinations.” The total purchase price was $35 million including direct transaction costs of $2 million.

 

The allocation of the purchase price of the Company’s share of the assets acquired and liabilities assumed based on their fair values was as follows (in thousands):

 

 

The amortizable intangible assets have useful lives not exceeding seven years and a weighted average useful life of seven years. No amounts have been allocated to in-process research and development and approximately $16 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.

 

As a result of this transaction, the Company’s ownership in Yahoo! Australia, which is now part of Yahoo! 7, decreased to 50 percent. The Company effectively recognized a non-cash gain of approximately $30 million representing the difference between the fair value of Yahoo! Australia and its carrying value adjusted for the Company’s continued ownership in Yahoo! 7. This non-cash gain was accounted for as a capital transaction and recorded as additional paid-in capital because of certain future events that could affect actual realization of the gain. The Company also recorded a minority interest of $7 million related to its reduced ownership of Yahoo! Australia and Seven’s retained interest in their contributed net assets.

 

Investment in Gmarket Inc.  During the year ended December 31, 2006, the Company acquired shares in Gmarket Inc., a leading retail e-commerce provider in South Korea, for $61 million, including direct transaction costs of approximately $1 million. During the quarter ended March 31, 2007, the Company acquired additional shares in Gmarket for $8 million. As of September 30, 2007, the Company held an approximate 10 percent ownership interest in Gmarket, with an investment cost base totaling $69 million.

 

YAHOO! INC.

 

Notes to Condensed Consolidated Financial Statements — (Continued)

 

Other Acquisitions — Business Combinations.  During the year ended December 31, 2006, the Company acquired three other companies which were accounted for as business combinations. The total purchase price for these three acquisitions was $42 million and consisted of $41 million in cash consideration and $1 million of direct transaction costs. The total cash consideration of $41 million less cash acquired of $1 million resulted in net cash outlay of $40 million. Of the purchase price, $27 million was allocated to goodwill, $21 million to amortizable intangible assets and $6 million to net assumed liabilities. In connection with these business combinations, the Company also issued stock-based awards valued at $23 million that will be recognized as compensation expense over the next three years. 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 Company also completed immaterial asset acquisitions that did not qualify as business combinations during the year ended December 31, 2006.

 

Transactions completed in 2007

 

Right Media.  On July 11, 2007, the Company acquired Right Media Inc. (“Right Media”), an online advertising exchange. The Company believes the acquisition of Right Media builds upon the Company’s leadership in online advertising and is a key step in executing the Company’s long term strategy to transform how online advertisers and publishers connect to their target audience. The purchase price exceeded the fair value of net tangible and intangible assets acquired from Right Media and as a result, the Company recorded goodwill in connection with this transaction. Under the terms of the agreement, the Company acquired all of the remaining equity interests (including all outstanding options and restricted stock units) in Right Media. Right Media stockholders were generally paid in approximately equal parts cash and shares of Yahoo! common stock (approximately 8 million shares) and outstanding Right Media options and restricted stock units were assumed. Assumed Right Media options and restricted stock units will be settled in Yahoo! common stock. The acquisition followed the Company’s 20 percent investment in Right Media in October 2006.

 

The total purchase price of $526 million consisted of $246 million in cash consideration, $237 million in equity consideration, $40 million for the initial 20 percent investment, and $3 million of direct transaction costs. The $246 million of total cash consideration less cash acquired of $16 million resulted in a net cash outlay of $230 million. In connection with the acquisition, the Company issued stock-based awards valued at $177 million which will be recognized as stock-based compensation expense as the awards vest over a period of up to four years.

 

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

 

 

The amortizable intangible assets have useful lives not exceeding seven years and a weighted average useful life of six years. No amounts have been allocated to in-process research and development and $437 million has been

 

YAHOO! INC.

 

Notes to Condensed Consolidated Financial Statements — (Continued)

 

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.

 

Other Acquisitions — Asset Acquisitions.  During the nine months ended September 30, 2007, the Company acquired four companies which were accounted for as asset acquisitions. The total purchase price for these acquisitions was $58 million and consisted of $20 million in cash consideration, $36 million in equity consideration, $1 million of incurred liabilities, and $1 million of direct transaction costs. The total cash consideration of $20 million less cash acquired of $3 million resulted in net cash outlay of $17 million. For accounting purposes, approximately $80 million was allocated to amortizable intangible assets, $26 million to net assumed liabilities, primarily deferred income tax liabilities, $1 million to tangible assets, and $3 million to cash acquired. In connection with these acquisitions, the Company also issued stock-based awards valued at $19 million that will be recognized as stock-based compensation expense over the next three years.

 

Other Acquisitions — Business Combinations.  During the nine months ended September 30, 2007, the Company acquired two other companies which were accounted for as business combinations. The total purchase price for these two acquisitions was $108 million and consisted of $106 million in cash consideration and $2 million of direct transaction costs. The total cash consideration of $106 million less cash acquired of $5 million resulted in net cash outlay of $101 million. Of the purchase price, $74 million was allocated to goodwill, $33 million to amortizable intangible assets, $5 million to tangible assets, $5 million to cash acquired, and $9 million to net assumed liabilities.

 

Pro forma results of operations have not been presented for the acquisitions completed during the three and nine months ended September 30, 2006 and 2007 as results of the acquired companies, not already consolidated, either individually or in aggregate were not material to the Company’s consolidated financial results before the acquisitions.

 

See Note 15 — “Subsequent Events” for additional information related to the Company’s acquisitions of Zimbra, Inc. and BlueLithium, Inc.

 

 

The following table summarizes the Company’s investments in equity interests (dollars in thousands):

 

 

Equity Investment in the Alibaba Group.  On October 23, 2005, the Company acquired approximately 46 percent of the outstanding common stock of Alibaba Group Holding Limited (“Alibaba” or “the Alibaba Group”), which represented approximately 40 percent on a fully diluted basis, in exchange for $1.0 billion in cash, the contribution of the Company’s China based businesses, including 3721 Network Software Company Limited (“Yahoo! China”) and direct transaction costs of $8 million. Pursuant to the terms of a shareholder 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. Other investors in Alibaba include SOFTBANK Corp. (“SOFTBANK”). The investment in Alibaba is being accounted for using the equity method, and the total investment, including net tangible assets, identifiable intangible assets and goodwill, is classified as part of Investments in equity interests on the Company’s condensed consolidated balance sheets. The Company records its share of the

 

YAHOO! INC.

 

Notes to Condensed Consolidated Financial Statements — (Continued)

 

results of Alibaba and any related amortization expense, one quarter in arrears, within earnings in equity interests on the condensed consolidated statements of income.

 

Through this transaction, the Company has combined its leading search capabilities with Alibaba’s leading online marketplace and online payment system and Alibaba’s strong local presence, expertise and vision in the China market. These factors contributed to a purchase price in excess of the Company’s share of the fair value of Alibaba’s net tangible and intangible assets acquired resulting in goodwill.

 

The purchase price was based on acquiring a 40 percent equity interest in Alibaba on a fully diluted basis. As of September 30, 2007, the Company’s ownership interest in Alibaba was 44 percent, an approximate 2 percent decrease from the initial investment, primarily as a result of the conversion of Alibaba’s outstanding convertible debt in April 2006. The Company’s ownership interest in Alibaba may now be further diluted to 39 percent upon exercise of Alibaba’s employee stock options. The Company will recognize non-cash gains if and when such further dilution to its ownership interest in Alibaba occurs, as such reduction in interest results in an incremental sale of Yahoo! China. In allocating the excess of the carrying value of its investment in Alibaba over its proportionate share of the net assets of Alibaba, the Company allocated a portion of the excess to goodwill to account for the estimated reductions in the carrying value of the investment in Alibaba that may occur as the Company’s equity interest is diluted to 40 percent.

 

As of September 30, 2007, the difference between the Company’s carrying value of its investment in Alibaba and its proportionate share of the net assets of Alibaba is summarized as follows (in thousands):

 

 

The amortizable intangible assets have useful lives not exceeding seven years and a weighted average useful life of approximately 5 years. No amount has been allocated to in-process research and development. Goodwill is not deductible for tax purposes.

 

The Company also has commercial arrangements with Alibaba to provide technical, development, and advertising services. For the three and nine months ended September 30, 2007, these transactions were not material.

 

See Note 15 — “Subsequent Events” for additional information related to the Company’s investment in the Alibaba Group.

 

Equity Investment in Yahoo! Japan.  During April 1996, the Company signed a joint venture agreement with SOFTBANK, which was amended in September 1997, whereby Yahoo! Japan Corporation (“Yahoo! Japan”) was formed. Yahoo! Japan was formed to establish and manage a local version of Yahoo! in Japan. During the nine months ended September 30, 2006 and 2007, the Company received cash dividends from Yahoo! Japan in the amounts of $13 million and $15 million, before taxes, respectively, which were recorded as reductions in the Company’s investment in Yahoo! Japan. The Company also has commercial arrangements with Yahoo! Japan, consisting of services, including algorithmic search services and sponsored search services and the related traffic acquisition costs and license fees. The net cost of these arrangements was approximately $64 million and $41 million for the three months ended September 30, 2006 and 2007, respectively. The net cost of these

 

YAHOO! INC.

 

Notes to Condensed Consolidated Financial Statements — (Continued)

 

arrangements was approximately $183 million and $199 million for the nine months ended September 30, 2006 and 2007, respectively. As of December 31, 2006 and September 30, 2007, the Company has a net payable balance to Yahoo! Japan of approximately $10 million and a net receivable balance from Yahoo! Japan of approximately $77 million, respectively.

 

The investment in Yahoo! Japan is being accounted for using the equity method and the total investment is classified as a part of the Investments in equity interests balance on the condensed consolidated balance sheets. The Company records its share of the results of Yahoo! Japan one quarter in arrears within earnings in equity interests on the condensed consolidated statements of income. The fair value of the Company’s approximate 34 percent ownership interest in Yahoo! Japan, based on the quoted stock price, was approximately $7.7 billion as of September 30, 2007.

 

Prior to and during 2001, Yahoo! Japan acquired the Company’s equity interests in certain entities in Japan for total consideration of approximately $65 million, paid partially in shares of Yahoo! Japan common stock and partially in cash. As a result of the acquisition, the Company increased its investment in Yahoo! Japan, which resulted in approximately $41 million of goodwill to be amortized over seven years. The amortization ceased upon the adoption of SFAS No. 142, “Goodwill and Other Intangible Assets,” on January 1, 2002. The carrying amount of the Company’s investment in Yahoo! Japan differs from the amount of the underlying equity in net assets of Yahoo! Japan primarily as a result of this goodwill.

 

The following table presents Yahoo! Japan’s condensed financial information, as derived from the Yahoo! Japan financial statements for the three and nine months ended June 30, 2006 and 2007, respectively, and as of December 31, 2006 and June 30, 2007, respectively (in thousands):

 

 

 

 

 

The differences between generally accepted accounting principles in the United States and Japan did not materially impact the amounts reflected in the Company’s financial statements.

 

On August 31, 2007, the Company completed the sale of Overture Japan to Yahoo! Japan for cash consideration of approximately $20 million, subject to certain adjustments which are expected to be finalized in the fourth quarter of 2007. The transaction was accounted for as a sale of assets. In connection with the transaction, in the third quarter of 2007, the Company recorded a pre-tax gain of $6 million in Other income, net. The Company also entered into a commercial arrangement with Yahoo! Japan in which the Company will provide

 

YAHOO! INC.

 

Notes to Condensed Consolidated Financial Statements — (Continued)

 

advertising and search marketing services to Yahoo! Japan for a service fee beginning on September 1, 2007. Accordingly, the Company will no longer recognize marketing services revenue and traffic acquisition costs for the delivery of sponsored search results and payments to affiliates in Japan as Yahoo! Japan is responsible for the fulfillment of all advertiser and affiliate services. Beginning in September 2007, the Company will record marketing services revenue from Yahoo! Japan for the provision of search marketing services based on a percentage of advertising revenues earned by Yahoo! Japan for the delivery of sponsored search results.

 

 

The changes in the carrying amount of goodwill for the nine months ended September 30, 2007 are as follows (in thousands):

 

 

 

 

 

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

 

 

 

 

For the three months ended September 30, 2006 and 2007, the Company recognized amortization expense for intangible assets of $71 million and $68 million, respectively, including $38 million in cost of revenues for both periods. For the nine months ended September 30, 2006 and 2007, the Company recognized amortization expense for intangible assets of $185 million and $182 million, respectively, including $87 million and $100 million in cost of revenues, respectively. Based on the current amount of intangibles subject to amortization, the estimated amortization expense for the remainder of 2007 and each of the succeeding years is as follows: three months ending December 31, 2007: $59 million; 2008: $208 million; 2009: $102 million; 2010: $71 million; 2011: $35 million and cumulatively thereafter: $42 million.

 

During the three and nine months ended September 30, 2007, the Company acquired $55 million and $75 million, respectively, of patents and intellectual property rights, included in the “Developed and acquired technology and intellectual property rights” category of the intangible assets balance as of September 30, 2007.

 

YAHOO! INC.

 

Notes to Condensed Consolidated Financial Statements — (Continued)

 

 

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

 

 

 

 

Investment gains (losses), net includes realized investment gains, realized investment losses, foreign exchange transaction gains and losses and impairment charges related to declines in values of publicly traded and privately held companies judged to be other than temporary.

 

 

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

 

 

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

 

 

 

In April 2003, the Company issued $750 million of zero coupon senior convertible notes (the “Notes”) due April 1, 2008, resulting in net proceeds to the Company of approximately $733 million after transaction fees of

 

YAHOO! INC.

 

Notes to Condensed Consolidated Financial Statements — (Continued)

 

$17 million, which have been deferred and are included on the condensed consolidated balance sheets in other current assets. As of September 30, 2007, $1.7 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, 2007, the market price condition for convertibility of the Notes was satisfied with respect to the fiscal quarter beginning on October 1, 2007 and ending on December 31, 2007. 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, 2007 the fair value of the Notes was approximately $1 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. To the extent that holders of the Notes do not exercise their conversion rights prior to the maturity date of April 1, 2008, the Company will be obligated to pay in cash the principal amount of any such Notes that remain outstanding on such maturity date. Consequently, the Notes have been classified as short-term debt in the condensed consolidated balance sheet as of September 30, 2007.

 

 

Stock Options.  The Company’s Amended and Restated 1995 Stock Plan and other stock-based award plans assumed through acquisitions are collectively referred to as the “Plans”. Stock option activity under the Company’s Plans and the Amended and Restated 1996 Directors’ Stock Plan for the nine months ended September 30, 2007 is summarized as follows (in thousands, except per share amounts):

 

 

 

 

As of September 30, 2007, there was $578 million of unrecognized stock-based compensation cost related to unvested stock options which is expected to be recognized over a weighted average period of 3.10 years.

 

YAHOO! INC.

 

Notes to Condensed Consolidated Financial Statements — (Continued)

 

The fair value of option grants was estimated using the Black-Scholes option pricing model with the following weighted average assumptions:

 

 

 

Restricted stock awards activity for the nine months ended September 30, 2007 is summarized as follows (in thousands, except per share amounts):

 

 

As of September 30, 2007, there was $477 million of unrecognized stock-based compensation cost related to unvested restricted stock awards which is expected to be recognized over a weighted average period of 1.76 years.

 

Executive Retention Compensation Arrangement.  During 2006, the Compensation Committee of the Company’s Board of Directors approved a three year performance and retention compensation arrangement with Terry Semel, the Company’s then Chief Executive Officer (“CEO”). For each of the years 2006 to 2008, as the CEO, Mr. Semel was eligible to receive a discretionary annual bonus payable in the form of a fully vested non-qualified stock option for up to 1 million shares with an exercise price equal to the closing trading price of the Company’s common stock on the date of the grant.

 

On June 18, 2007, the executive retention compensation arrangement was terminated due to Mr. Semel’s resignation as the CEO of the Company. During the second quarter of 2007, $16 million of stock-based compensation expense recorded through March 31, 2007 related to forfeitures of equity awards previously granted to Mr. Semel was reversed.

 

YAHOO! INC.

 

Notes to Condensed Consolidated Financial Statements — (Continued)

 

 

In March 2005, the Company’s Board of Directors authorized a stock repurchase program for the Company to repurchase up to $3.0 billion of its outstanding shares of common stock over the next five years, dependent on market conditions, share price and other factors. The Company had substantially completed the $3.0 billion authorized stock repurchase program as of September 30, 2006.

 

In October 2006, the Company’s Board of Directors authorized a new stock repurchase program allowing it to repurchase up to $3.0 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. Repurchases may take place in the open market or in privately negotiated transactions, including derivative transactions, and may be made under a Rule 10b5-1 plan.

 

In the nine months ended September 30, 2007, the Company repurchased 49.1 million shares of common stock directly at an average price of $27.77 per share. Total cash consideration for the repurchased stock was $1,363 million.

 

In addition, upon the vesting of certain restricted stock awards during the nine months ended September 30, 2007, 70,000 shares of such vested stock were reacquired by the Company to satisfy tax withholding obligations. These repurchased shares were recorded as $2 million of treasury stock and accordingly reduced the number of common shares outstanding by 70,000.

 

During the three months ended September 30, 2007, a $250 million structured stock repurchase transaction, which was entered into in the first quarter of 2007, matured and settled. On the maturity date, the Company received 8.4 million shares of its common stock at an effective buy-back price of $29.80 per share.

 

Treasury stock is accounted for under the cost method.

 

 

Operating Lease Commitments.  The Company leases office space and data centers under operating lease agreements with original lease periods of up to 23 years, expiring between 2007 and 2027.

 

A summary of gross and net lease commitments as of September 30, 2007 follows (in millions):

 

 

Affiliate Commitments.  In connection with contracts to provide sponsored search and/or display advertising services to affiliates, the Company is obligated to make payments, which represent traffic acquisition costs, to its affiliates. As of September 30, 2007, these commitments totaled $266 million, of which $10 million will be payable in the remainder of 2007, $84 million will be payable in 2008, $111 million will be payable in 2009, and $61 million will be payable in 2010.

 

YAHOO! INC.

 

Notes to Condensed Consolidated Financial Statements — (Continued)

 

Intellectual Property Rights.  In connection with the licensing of certain intellectual property, the Company is obligated to invest up to $141 million through July 2008. To the extent the licensed intellectual property will benefit future periods, the Company will capitalize such payments and amortize them over the useful life of the related intellectual property.

 

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 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 aggregate 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.

 

Contingencies.  From time to time, third parties assert patent infringement claims against Yahoo!. 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, trade secrets and other intellectual property rights, claims related to employment matters, and a variety of other claims, including claims alleging defamation, invasion of privacy, or similar claims arising in connection with the Company’s e-mail, message boards, auction sites, shopping services and other communications and community features.

 

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 Media, Inc. (“LAUNCH”) in the United States District Court for the Southern District of New York. The plaintiffs alleged, 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 sought declaratory and injunctive relief and damages for the alleged infringement. After the lawsuit was commenced, Yahoo! entered into an agreement to acquire LAUNCH, which closed in August 2001, and since that time LAUNCH has been a wholly owned subsidiary of Yahoo!. Because LAUNCH settled the LAUNCH litigation as to all other plaintiffs, BMG Music d/b/a/The RCA Records Label was the sole remaining plaintiff in this proceeding. On April 27, 2007, after a two week jury trial, the jury returned a unanimous verdict in favor of LAUNCH finding no liability. The plaintiff has filed a notice of appeal to the United States Court of Appeals for the Second Circuit.

 

On July 12, 2001, the first of several purported securities class action lawsuits was filed in the United States District Court, Southern District of New York against certain underwriters involved in Overture Services Inc.’s (“Overture”) 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

 

YAHOO! INC.

 

Notes to Condensed Consolidated Financial Statements — (Continued)

 

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 an omnibus 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. In June 2004, a stipulation of settlement and release of claims against the issuer defendants, including Overture, was submitted to the Court for approval. On August 31, 2005, the Court preliminarily approved the settlement. In December 2006, the appellate court overturned the certification of classes in the six test cases that were selected by the underwriter defendants and plaintiffs in the coordinated proceedings. Since class certification, a condition of the settlement, was not met, the parties stipulated to terminate the settlement. On June 25, 2007, the Court entered an order terminating the proposed settlement based upon this stipulation. Plaintiffs have filed amended master allegations and amended complaints in the six test cases. It is uncertain whether there will be any future settlement. If a settlement is not reached, and litigation against Overture continues, the Company intends to defend the case vigorously.

 

On May 11, 2007, the first of two purported securities class action lawsuits was filed against Yahoo! Inc. and certain of its officers and members of the Board of Directors. The first lawsuit was filed in the United States District Court, Central District of California by plaintiff Ellen Rosenthal Brodsky and the second lawsuit was filed in the United States District Court, Central District of California by plaintiff Manfred Hacker. The plaintiffs allege, among other things, violation of the Securities Exchange Act of 1934 sections 10(b) and 20(a), as well as Rule 10b-5. The plaintiffs generally claim that Yahoo! issued false, deceptive or misleading statements concerning its advertising business, financial results, and sales and growth potential between April 8, 2004 and July 18, 2006. The complaints seek unspecified compensatory damages, injunctive relief, costs and attorneys’ fees. The Company believes these cases are without merit and intends to defend them vigorously.

 

On May 15, 2007, the first of two shareholder derivative actions was filed in the Superior Court of Santa Clara County by plaintiff Greg Brockwell against certain officers and members of the Board of Directors of Yahoo! Inc. purportedly on behalf of Yahoo! Inc. The second derivative action was filed in the United States District Court for the Central District of California on June 14, 2007 by plaintiff Jill Watkins. The derivative actions, which include allegations of substantially identical facts to the purported securities class actions, attempt to state various claims under California law for trading by defendants on alleged material non-public information, and allegations of breaches of fiduciary duties relating to financial reporting, misappropriation of information, abuse of control and waste of corporate assets. The federal derivative action includes an additional claim for alleged violation of Section 10(b) of the Securities Exchange Act of 1934. The derivative actions seek unspecified damages, equitable and injunctive relief, including, among other things, changes to corporate governance and internal procedures, restitution and disgorgement of profits and compensation received by defendants, costs and attorneys’ fees.

 

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 such claims. In the event of a determination adverse to Yahoo! 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.

 

 

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, amortization and stock-based compensation expense for making financial decisions and allocating resources. Segment operating income before depreciation, amortization and stock-based compensation expense includes income from operations before depreciation,

 

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Notes to Condensed Consolidated Financial Statements — (Continued)

 

amortization and stock-based compensation expense. Management believes that segment operating income before depreciation, amortization and stock-based compensation expense 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 GAAP.

 

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

 

 

 

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, 2006 and 2007.

 

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Notes to Condensed Consolidated Financial Statements — (Continued)

 

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

 

 

 

During the three months ended September 30, 2007, the Company reduced its provision for income taxes primarily due to a benefit recorded during the quarter attributable to the release of deferred tax liabilities in connection with changes to its worldwide entity structure.

 

During the nine months ended September 30, 2007, the Company reduced its provision for income taxes primarily due to a benefit recorded in the second quarter of 2007 resulting from a reduction in nondeductible executive compensation expense and a benefit recorded in the third quarter of 2007 due to the release of deferred tax liabilities in connection with changes to its worldwide entity structure.

 

In addition, in the quarter ended September 30, 2007, the Company determined that income tax benefits of $76 million relating to acquired net operating losses should have been recognized instead of net operating losses resulting from the exercise of employee stock options. Accordingly, in the third quarter of 2007, the Company recorded a reduction of deferred tax assets and additional paid-in-capital in the balance sheet and reduced the amount that would have otherwise been recorded as excess tax benefits from stock-based awards in the statement of cash flows. There was no income statement effect for this item.

 

The Company adopted the provisions of FASB Interpretation No. 48, “Accounting for Uncertainty of Income Taxes” (“FIN 48”) on January 1, 2007. As a result of the implementation of FIN 48, the Company recognized a $46 million increase to the January 1, 2007 balance of retained earnings related to adjustments to certain unrecognized tax benefits. At January 1, 2007, the Company had approximately $620 million in total unrecognized tax benefits.

 

The total unrecognized tax benefits of $620 million include approximately $306 million related to a capital loss resulting from a subsidiary restructuring transaction and approximately $124 million related to research and development tax credit carry-forwards attributable to the exercise of employee stock options in prior years. These amounts have been netted against the related deferred tax assets. The remaining $190 million is recorded within deferred and other long-term tax liabilities on the Company’s condensed consolidated balance sheet as of January 1, 2007.

 

The total unrecognized tax benefits of $620 million at January 1, 2007 comprised $443 million that, if recognized, would reduce the effective income tax rate in future periods; $4 million that, if recognized, would result in a reduction to goodwill; $104 million that, if recognized, would result in a credit to additional paid-in capital; and $69 million related to federal tax benefit on state unrecognized tax benefits, if recognized. However, one or more of these unrecognized tax benefits could be subject to a valuation allowance if and when recognized in a future period, which could impact the timing of any related effective tax rate benefit.

 

During the three and nine months ended September 30, 2007, the Company recorded an increase in its total unrecognized tax benefits of approximately $16 million and $54 million, respectively.

 

YAHOO! INC.

 

Notes to Condensed Consolidated Financial Statements — (Continued)

 

The Company recognizes interest and/or penalties related to uncertain tax positions in income tax expense. To the extent accrued interest and penalties do not ultimately become payable, amounts accrued will be reduced and reflected as a reduction of the overall income tax provision in the period that such determination is made. The amount of interest and penalties accrued upon the adoption of FIN 48 and at September 30, 2007 was immaterial.

 

The Company files income tax returns in the United States (“U.S.”) on a federal basis and in many U.S. state and foreign jurisdictions. The tax years 1995 to 2006 remain open to examination by the major taxing jurisdictions in which the Company is subject to tax. Over the next twelve months, our existing tax positions are expected to generate an increase in total unrecognized tax benefits.

 

 

Zimbra.  On October 4, 2007, the Company completed the acquisition of Zimbra, Inc. (“Zimbra”), a provider of e-mail and collaboration software. The Company believes the acquisition of Zimbra will further strengthen its global leadership position in web mail and expand the Company’s presence in universities, businesses and internet service providers. Under the terms of the agreement, the Company acquired all of the equity interests (including all outstanding options and restricted stock units) in Zimbra for approximately $350 million. Zimbra shareholders were paid in cash and outstanding Zimbra options and restricted stock units were assumed and will be exercisable for, or settled in, shares of Yahoo! common stock.

 

BlueLithium.  On October 15, 2007, the Company completed the acquisition of BlueLithium, Inc. (“BlueLithium”), an online global advertising network. The Company believes that the acquisition of BlueLithium is a key element of the Company’s strategy to create the largest and most effective online advertising network. Under the terms of the agreement, the Company acquired all of the equity interests (including all outstanding options and restricted stock units) in BlueLithium for approximately $300 million. BlueLithium shareholders were paid in cash and outstanding BlueLithium options and restricted stock units were assumed and will be exercisable for, or settled in, shares of Yahoo! common stock.

 

Alibaba.com Ltd. Initial Public Offering.  As part of the November 6, 2007 initial public offering on the Hong Kong Stock Exchange of the Alibaba Group’s business-to-business e-commerce subsidiary, Alibaba.com Ltd., the Company purchased 57,481,000 shares, or approximately 1%, of Alibaba.com Ltd. for the total purchase price of approximately $100 million.

 

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-looking statements regarding our:

 

 

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 in Part II, Item 1A, “Risk Factors” of this Quarterly Report on Form 10-Q. 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 are focused on powering our communities of users, advertisers and publishers by creating indispensable experiences built on trust. To our users, we provide our owned and operated online properties and services (“Yahoo! Properties” or “Owned and Operated sites”), as well as access to third-party content and services. To our advertisers and publishers, we provide a range of marketing solutions and tools that enable businesses to reach users who visit Yahoo! Properties and to reach the users of our distribution network of third-party entities (referred to as “affiliates”) who have integrated our advertising offerings into their websites (referred to as “Affiliate sites”) or their other offerings.

 

We offer a broad range of innovative and high-quality Internet products and services that are designed to provide our users with the power to connect, communicate, create, access, and share information online. We seek to provide efficient and effective marketing services for advertisers to reach our global audience of users. Our focus is on engaging more deeply with users and increasing the user base on Yahoo! Properties, thereby enhancing value for our advertisers. We believe that we can increase our existing and potential user base and our users’ engagement on Yahoo! Properties not only by offering compelling Internet services, but also by effectively integrating search, community, personalization and content to create a more powerful user experience.

 

Many of our services are free to users. We generate revenues by providing marketing services to advertisers across a majority of Yahoo! Properties and on the websites of our affiliates and by charging our users for premium services. We classify these revenues as either marketing services or fees. The majority of our offerings are available globally in more than 20 languages. We manage and measure our business geographically. Our principal geographies are the United States and International.

Third Quarter Highlights

 

 

 

 

We believe the search queries, page views, click-throughs, and the related marketing services and fees revenues that we generate correlate to the number and activity level of users across our offerings on Yahoo! Properties and the activity level on our Affiliate sites. In the fourth quarter of 2006, we launched a new search marketing system, referred to as Project Panama, and we are nearing completion of our migration plan for our active advertisers worldwide on to the new system. We believe the new search marketing system, including the new ranking model which was launched in the United States in the first quarter of 2007, will enable us to provide a more relevant search experience to our users, more valuable customer leads to advertisers, and additional opportunities to our affiliate and distribution partners. 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 become more essential to, increase our share of, and deepen the engagement of, our users with our products and services. We believe this deeper engagement of new and existing users and our new search marketing system, coupled with the growth of the Internet as an advertising medium will enable us to increase our revenues for the remainder of 2007 compared to 2006.

Results of Operations

 

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

 

 

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