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 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

 

 

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!’s mission is to connect people to their passions, their communities, and the world’s knowledge. Yahoo! seeks to provide Internet services that are essential and relevant to its global audience of users and its advertisers. To its global audience of users, Yahoo! provides its owned and operated online properties and services (the “Yahoo Properties”). To its advertisers, Yahoo! provides a range of tools and marketing solutions designed to enable businesses to reach its community of users through the Yahoo! Properties and to also reach the users of its distribution network of third-party entities (referred to as “affiliates”) who have integrated the Company’s search and/or display advertising offerings into their websites.

 

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 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 and eliminates inconsistencies in 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

 

YAHOO! INC.

 

Notes to Condensed Consolidated Financial Statements — (Continued)

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 on its financial position, cash flows, and 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). For the three months ended March 31, 2006 and 2007, approximately 83 million and 132 million options to purchase common stock, respectively, were excluded from the calculation, as they were anti-dilutive. See Note 9 — “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):

 

 

 

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

 

YAHOO! INC.

 

Notes to Condensed Consolidated Financial Statements — (Continued)

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 March 31, 2007, the Company held an approximate 10 percent ownership interest in Gmarket, with an investment cost base totaling $69 million.

 

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 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.

 

YAHOO! INC.

 

Notes to Condensed Consolidated Financial Statements — (Continued)

 

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

 

Other Acquisitions — Asset Acquisitions.  During the quarter ended March 31, 2007, the Company acquired two companies which were accounted for as asset acquisitions. The total purchase price for these acquisitions was $45 million and consisted of $8 million in cash consideration, $36 million in equity consideration and $1 million of direct transaction costs. The total cash consideration of $8 million less cash acquired of $3 million resulted in net cash outlay of $5 million. For accounting purposes, approximately $61 million was allocated to amortizable intangible assets, $20 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 expense over the next three years.

 

 

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

 

 

Equity Investment in Alibaba.  On October 23, 2005, the Company acquired approximately 46 percent of the outstanding common stock of Alibaba, 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 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 March 31, 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 be further diluted to 40 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.

 

YAHOO! INC.

 

Notes to Condensed Consolidated Financial Statements — (Continued)

 

As of March 31, 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 months ended March 31, 2007, these transactions were not material.

 

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. 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 $60 million and $78 million for the three months ended March 31, 2006 and 2007, 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 billion as of March 31, 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.

 

YAHOO! INC.

 

Notes to Condensed Consolidated Financial Statements — (Continued)

 

The following table presents Yahoo! Japan’s condensed financial information, as derived from the Yahoo! Japan financial statements for the three months ended December 31, 2005, and 2006 and as of September 30, 2006 and December 31, 2006 (in thousands):

 

 

 

 

 

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

 

 

The changes in the carrying amount of goodwill for the three months ended March 31, 2007 are as follows (in thousands):

 

 

 

 

YAHOO! INC.

 

Notes to Condensed Consolidated Financial Statements — (Continued)

 

 

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

 

 

 

 

For both the three months ended March 31, 2006 and 2007, the Company recognized amortization expense for intangible assets of $56 million. 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: nine months ending December 31, 2007: $156 million; 2008: $155 million; 2009: $50 million; 2010: $32 million; 2011: $7 million and cumulatively thereafter: $13 million.

 

 

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

 

 

Investment gains (losses), net include realized investment gains, realized investment losses and foreign exchange transaction gains and losses.

 

YAHOO! INC.

 

Notes to Condensed Consolidated Financial Statements — (Continued)

 

 

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 2008, resulting 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 March 31, 2007, $4 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 March 31, 2007, the market price condition for convertibility of the Notes was satisfied with respect to the fiscal quarter beginning on April 1, 2007 and ending on June 30, 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.

 

YAHOO! INC.

 

Notes to Condensed Consolidated Financial Statements — (Continued)

 

As of March 31, 2007 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.

 

 

Stock Options.  The Company’s 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 1996 Directors’ Stock Option Plan for the three months ended March 31, 2007 is summarized as follows (in thousands, except per share amounts and as noted):

 

 

 

 

As of March 31, 2007, there was $541 million of unamortized stock-based compensation expense related to unvested stock options which is expected to be recognized over a weighted average period of 3.4 years.

 

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 three months ended March 31, 2007 is summarized as follows (in thousands, except per share amounts):

 

 

As of March 31, 2007, there was $400 million of unamortized stock-based compensation cost related to unvested restricted stock awards which is expected to be recognized over a weighted average period of 2.1 years.

 

YAHOO! INC.

 

Notes to Condensed Consolidated Financial Statements — (Continued)

 

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 the Company’s Chief Executive Officer (“CEO”). For each of the years 2006 to 2008, the CEO is 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. During the first quarter of 2007, $2 million of stock-based compensation expense was recognized in connection with the potential 2007 award. As of March 31, 2007, there was $7 million of unamortized stock-based compensation cost related to the 2007 portion of this award which is expected to be recognized over the remainder of 2007.

 

 

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 three months ended March 31, 2007, the Company repurchased 19.9 million shares of common stock directly at an average price of $29.91 per share. Total cash consideration for the repurchased stock was $595 million. These repurchased shares are recorded as part of treasury stock. Treasury stock is accounted for under the cost method.

 

As of March 31, 2007, there was an outstanding $250 million structured stock repurchase transaction which was entered into in the first quarter of 2007 and will mature in the third quarter of 2007. On the maturity date, if the market price of the Company’s common stock is above $33.00, the Company will have its investment returned with a premium and if the market price of its common stock is at or below such pre-determined price, the Company will repurchase 8.4 million shares of its common stock at an effective buy-back price of $29.80 per share. This outstanding transaction is recorded in stockholders’ equity in the condensed consolidated balance sheets.

 

See Note 15 — “Subsequent Events” for additional information.

 

YAHOO! INC.

 

Notes to Condensed Consolidated Financial Statements — (Continued)

 

 

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 March 31, 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 March 31, 2007, these commitments totaled $9 million of which $8 million will be payable in the remainder of 2007 and $1 million will be payable in 2008.

 

Intellectual Property Rights.  In February 2007, the Company committed to invest up to $200 million through July 2008 to acquire rights to intellectual property. License payments associated with the acquired rights will be amortized 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 or invasion of privacy, arising in connection with the Company’s e-mail, message boards, auction sites, shopping services and other communications and community features.

 

YAHOO! INC.

 

Notes to Condensed Consolidated Financial Statements — (Continued)

 

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, the Company 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 November 4, 2005, the Court issued an order denying the plaintiff’s summary judgment motions as to interactivity and willful infringement. The trial in this matter began on April 16, 2007. On April 27, 2007 the jury returned a unanimous verdict in favor of LAUNCH, finding no liability. The plaintiff may file a notice of appeal within 30 days after the judgment is entered.

 

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 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. Overture accepted a proposal for the settlement and release of claims against the issuer defendants, including Overture. The settlement was presented to the Court in June 2004. On February 15, 2005, the Court issued an order granting conditional preliminary approval of the settlement proposal. On August 31, 2005, the Court issued an order confirming preliminary approval of the settlement. On April 24, 2006, the Court held a fairness hearing in connection with the motion for final approval of the settlement. The Court has yet to issue a ruling on the motion for final approval. The settlement remains subject to a number of conditions, including final approval of the Court. On December 5, 2006, the Court of Appeals for the Second Circuit reversed the Court’s October 2004 order certifying a class in six test cases that were selected by the underwriter defendants and plaintiffs in the coordinated proceeding and on April 6, 2007 denied a petition for rehearing of its order. Overture is not one of the test cases and it is unclear what impact this will have on the class in Overture’s case. If the settlement does not occur, and litigation against Overture continues, the Company intends to defend the case vigorously.

 

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.

 

YAHOO! INC.

 

Notes to Condensed Consolidated Financial Statements — (Continued)

 

 

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, 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 months ended March 31, 2006 and 2007.

 

YAHOO! INC.

 

Notes to Condensed Consolidated Financial Statements — (Continued)

 

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

 

 

 

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 $622 million in total unrecognized tax benefits.

 

The total unrecognized tax benefits of $622 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 carryforwards attributable to the exercise of employee stock options in prior years. These amounts have been netted against the related deferred tax assets. The remaining $192 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 $622 million at January 1, 2007 comprised $445 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.

 

The Company recorded an increase of its unrecognized tax benefits of approximately $7 million during the quarter ended March 31, 2007.

 

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 adoption of FIN 48 and at March 31, 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 to which the Company is subject. The Company does not anticipate that its total unrecognized tax benefits will significantly change due to the settlement of examinations or the expiration of statutes of limitations during the next twelve months.

 

 

Stock Repurchase Transactions.  Subsequent to March 31, 2007, the Company repurchased approximately 10 million shares of its common stock at an average price of $28.31 per share, for a total of $276 million.

 

YAHOO! INC.

 

Notes to Condensed Consolidated Financial Statements — (Continued)

 

Right Media acquisition.  On April 28, 2007, the Company entered into an agreement to acquire Right Media Inc. (“Right Media”), an online advertising exchange. The Company currently owns approximately twenty percent of the outstanding equity interests in Right Media. Under the terms of the agreement, the Company will acquire all of the remaining outstanding equity interests (including all outstanding options and restricted stock units) in Right Media for an aggregate consideration of approximately $680 million comprised of cash and Yahoo! common stock subject to the determination of the measurement date. Right Media stockholders will be paid in approximately equal parts cash and Yahoo! common stock, and outstanding options and restricted stock units will be assumed and become exercisable for Yahoo! common stock. The exact number of shares of Yahoo! common stock to be issued in the merger to the Right Media stockholders will be based on the number of shares of Right Media stock outstanding as of the completion of the merger and on the volume weighted average closing price of Yahoo! common stock for a specified period ending two trading days prior to the completion of the merger, subject to a collar. The outstanding options and restricted stock units of Right Media will be assumed by Yahoo! based on the stock exchange ratio established for the merger. The Company currently expects the transaction to close in the second or third calendar quarter of 2007, subject to the satisfaction of customary closing conditions.

 

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. Our mission is to connect people to their passions, their communities, and the world’s knowledge. We seek to provide Internet services that are essential and relevant to our global audience of users and advertisers. To our global audience of users, we provide our owned and operated online properties and services (the “Yahoo! Properties”). To our advertisers, we provide a range of tools and marketing solutions designed to enable them to reach our community of users through the Yahoo! Properties and our distribution network of third-party entities (referred to as “affiliates”) who have integrated our search and/or display advertising offerings into their websites.

 

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 the 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 the 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 our properties 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.

 

As we announced in December 2006, we are reorganizing our structure and management to align our operations with our key customer groups. Under the new structure, we have two customer-focused groups: the

Audience Group and the Advertiser & Publisher Group. Each of these groups is supported by the Technology Group. We believe having a more customer-focused organization, supported by robust technology, will speed the development of leading-edge offerings for our most valuable audience segments and the provision of marketing services to our advertisers.

 

First Quarter Performance 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 the Yahoo! Properties. In the fourth quarter of 2006, we launched a new search marketing system, referred to as Project Panama, and we completed our migration plan for our active advertisers in the United States on to the new system in the first quarter of 2007 and will begin transitioning our advertisers in international markets in the second quarter of 2007. 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 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 increase our revenues for the remainder of 2007 over 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):

 

 

 

 

Marketing Services Revenue.  Marketing services revenue for the first quarter of 2007 increased by $88 million, or 6 percent, as compared to the same period in 2006. Our marketing services revenue for the first quarter of 2007 was impacted by declining revenues from our relationship with Microsoft Corporation (“Microsoft”), which completed the transition of its United States search business in-house during the quarter ended September 30, 2006. Despite this impact, marketing services revenue for the first quarter of 2007 showed year over year growth which can be attributed to a combination of factors that have driven increased marketing services revenue across the Yahoo! Properties both domestically and internationally. These included an increase in our user base and activity levels on the Yahoo! Properties, which contributed to a higher volume of search queries, page views and click-throughs.

 

On the Yahoo! Properties, our number of unique users worldwide as of March 31, 2007 was approximately 19 percent higher than the number of unique users as of March 31, 2006. Unique users refer to our internal estimates of the number of people who visited the Yahoo! Properties in a given month.

 

The combined number of page views (which includes searches) on the Yahoo! Properties and searches performed on our affiliate network sites (excluding the impact of content match links) increased by approximately

19 percent in the first quarter of 2007, as compared to the same period in 2006. The increase in the volume of page views and searches can be attributed to an increased number of users, an increased number of affiliates, and an expanded offering of properties. The combined average revenue per page view and search decreased by approximately 9 percent in the first quarter of 2007, compared to the same period in 2006, due to relatively large growth in the volume of page views and searches, compared to the growth in marketing services revenue.

 

We believe our growing number of users, advertisers and inventory, both on and off our network, has been driving this increase in our marketing services revenues. We believe our expanding offerings as well as our enhanced algorithmic search technology contribute to our growing number of users. As our user base increases, we generate a higher number of page views, which we view as inventory, and process a higher number of search queries which potentially result in a higher number of impressions and paid clicks. We also believe that our growing audience of users makes the Yahoo! Properties more attractive to advertisers and increases their spending on marketing services. Further, we believe the growth in users on the Yahoo! Properties and on the Internet overall reflects the increasing acceptance, importance and dependence of users on the Internet. As a result of the increasing online audience, we believe advertisers are shifting a greater percentage of their spending from traditional media to the Internet to reach this growing audience.

 

Fees Revenue.  Fees revenue for the first quarter of 2007 increased $17 million, or 9 percent, as compared to the same period in 2006. The year over year growth is associated with an increase in the number of paying users for our fee-based services, which numbered 16.5 million as of March 31, 2007, compared to 13.3 million as of March 31, 2006, an increase of 24 percent. Our increased base of paying users was due to growth in users across most of our offerings, with the largest growth generated from new Internet broadband users. Our fee-based services include Internet broadband services, sports, music, games, personals, and premium mail offerings, as well as our services for small businesses. Average monthly revenue per paying user slightly decreased to the lower end of our $3.00 to $4.00 range for the first quarter of 2007, compared to that of the same period in 2006. The decline in average monthly revenue per paying user reflects the continued growth of paying users in our services with lower fees.

 

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

 

 

 

 

Stock-based compensation expense was allocated as follows (in thousands):

 

 

See Note 10  — “Stock-Based Compensation” in the condensed consolidated financial statements as well as our Critical Accounting Policies, Judgments and Estimates for additional information about stock-based compensation.

 

Cost of Revenues.  Cost of revenues consists of traffic acquisition costs (“TAC”) and other expenses associated with the production and usage of the Yahoo! Properties. TAC consists of payments made to affiliates who have integrated our search and/or display advertising offerings into their websites and payments made to companies that direct consumer and business traffic to the Yahoo! Properties. Other cost of revenues consists of fees paid to third parties for content included on our online media properties, Internet connection charges, data center costs, server equipment depreciation, technology license fees, amortization of acquired intellectual property rights and developed technology, and compensation related expenses (including stock-based compensation expense).

 

Cost of revenues was as follows (dollars in thousands):

 

 

 

 

Cost of revenues for the first quarter of 2007 increased $56 million, or 8 percent, as compared to the same period of 2006. The year over year increase included $9 million of additional TAC, as well as an increase of $46 million in other cost of revenues.

 

The year over year increase in TAC of 2 percent for the first quarter of 2007 was mainly driven by our 6 percent growth in marketing services revenues compared to the same period of 2006, offset by reduced TAC related to our relationship with Microsoft, which completed the transition of its United States search business in-house during the quarter ended September 30, 2006.

 

The year over year increase in other cost of revenues included increases of $24 million in the depreciation of server equipment, information technology assets and maintenance cost, $8 million in Internet connection charges and data center costs, and $4 million in amortization of developed technology and intellectual property rights acquired through acquisitions.

 

The increase in the depreciation of server equipment, information technology assets and maintenance costs resulted from our continued investments in information technology assets and server equipment. Increased Internet connection charges and data center costs supported our growing audience of users, traffic, and new offerings on Yahoo! Properties. The increase in the amortization of developed technology and intellectual property rights acquired resulted from our continued investments in, and acquisitions of, businesses and technology.

 

Sales and Marketing.  Sales and marketing expenses consist primarily of advertising and other marketing related expenses, compensation related expenses (including stock-based compensation expense), sales commissions and travel costs. Sales and marketing expenses for the first quarter of 2007 increased $36 million, or 11 percent, as compared to the same period of 2006.

 

The year over year increase in sales and marketing expenses for the first quarter of 2007 was largely due to increase in compensation expense. Compensation expense increased approximately $29 million, including an additional $11 million of stock-based compensation expense, due to increases in our sales and marketing headcount as we expanded our presence in certain territories to support our growing advertiser base.

 

Sales and marketing expenses as a percentage of revenues were 22 percent (including 3 percent related to stock-based compensation expense) and 21 percent (including 2 percent related to stock-based compensation expense) for the first quarter of 2007 and 2006, respectively.

 

Product Development.  Product development expenses consist primarily of compensation related expenses (including stock-based compensation expense) incurred for the development of, enhancements to and maintenance of the Yahoo! Properties, classification and organization of listings within the Yahoo! Properties, research and development, and Yahoo!’s technology platforms and infrastructure. Depreciation expense and other operating costs are also included in product development.

 

Product development expenses for the first quarter of 2007 increased $22 million, or 10 percent, as compared to the same period of 2006. Approximately $29 million of the increase was related to compensation expense including an additional $11 million of stock-based compensation expense. The increased compensation expense reflected our continued hiring of engineering talent to further develop and enhance new and existing offerings and services on the Yahoo! Properties. Our increased compensation expense for the first quarter of 2007 was partially offset by our increased capitalization of development costs.

 

Product development expenses as a percentage of revenues were 14 percent (including 3 and 2 percent related to stock-based compensation expense) for the first quarter of 2007 and 2006, respectively.

 

General and Administrative.  General and administrative expenses consist primarily of compensation related expenses (including stock-based compensation expense) and fees for professional services.

 

General and administrative expenses for the first quarter of 2007 increased $27 million, or 21 percent, compared to the same period of 2006. The year over year increase was primarily due to an increase of $19 million in compensation expense (including an additional $9 million of stock-based compensation expense). Additionally, our facility related expense increased $7 million mainly due to our new and expanded facilities.

 

General and administrative expenses as a percentage of revenues were 9 percent (including 2 percent related to stock-based compensation expense) and 8 percent (including 2 percent related to stock-based compensation expense) for the first quarter of 2007 and 2006, respectively.

 

Amortization of Intangibles.  We have purchased, and expect to continue purchasing, assets and/or businesses, which may include the purchase of intangible assets. Amortization of developed technology and acquired intellectual property rights is included in the cost of revenues and not in amortization of intangibles.

 

Amortization of intangibles was approximately $27 million for the first quarter of 2007, compared to $31 million for the same period of 2006. Amortization of intangibles was 2 percent of revenues for both the first quarter of 2007 and 2006. The year over year decrease in amortization of intangibles was primarily the result of intangible assets being fully amortized during the quarter ended December 31, 2006. As of March 31, 2007, we had net intangible assets of $413 million on our condensed consolidated balance sheet, including acquired intellectual property rights and developed technology which are amortized in cost of revenues.

 

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

 

 

Other income, net was $35 million for the first quarter of 2007, which was consistent with the level of the same period in 2006. Interest and investment income for the first quarter of 2007 increased as higher average interest rates more than offset the lower average invested balances, compared to the same period in 2006. Average interest rates were approximately 4.6 percent in the first quarter of 2007, compared to 3.6 percent in the same period of 2006. This increase was offset by an increase in our foreign currency losses incurred during the first quarter of 2007. Other income, net may fluctuate in future periods due to realized gains and losses on investments, impairments of investments, changes in our average investment balances, and changes in interest and foreign exchange rates.

 

Income Taxes.  The effective tax rate for the first quarter of 2007 was 45 percent, compared to 43 percent for the same period in 2006. The provisions for income taxes for both the first quarter of 2007 and 2006 differ from the amounts computed by applying the federal statutory income tax rate primarily due to state taxes, foreign income taxed at different rates, and non-deductible stock-based compensation expense.

 

We adopted the provisions of Financial Accounting Standards Board (“FASB”) Interpretation No. 48, “Accounting for Uncertainty in Income Taxes,” (“FIN 48”) on January 1, 2007. See Note 14 — “Income Taxes” in the condensed consolidated financial statements for additional information.

 

Earnings in Equity Interests.  Earnings in equity interests for the first quarter of 2007 was $29 million, compared to $26 million for the same period of 2006. Earnings in equity interests consists of our share of the net income or loss of our equity investments in Yahoo! Japan and Alibaba. See Note 4 — “Investments in Equity Interests” in the condensed consolidated financial statements for additional information.

 

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 the subsidiaries in which we hold a majority, but less than 100 percent, ownership interest and consolidate the subsidiaries’ results in our consolidated financial statements. Minority interests in operations of consolidated subsidiaries were $1 million for the first quarter of 2007, compared to less than $1 million for the same period in 2006. Minority interests recorded for the first quarter of 2007 and 2006 were related to our Yahoo! 7 joint venture arrangement completed in the first quarter of 2006. See Note 3 — “Acquisitions” in the condensed consolidated financial statements for additional information.

 

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, 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, amortization and stock-based compensation expense. Management believes that segment operating income before depreciation, amortization and stock-based compensation expense 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 in the United States (“GAAP”).

 

Summarized information by segment was as follows (dollars 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 for the first quarter of 2007 or 2006.

 

United States.  United States revenues for the first quarter of 2007 increased $4 million, as compared to the same period in 2006. Our year over year increase in revenues was a result of growth in advertising across most of the Yahoo! Properties and in our fee-based services. Our expanding user base which has been attracting more advertisers has been contributing to our growth in our advertising revenues. Our growth for the first quarter of 2007 was impacted by declining revenues from our relationship with Microsoft which completed the transition of its United States search business in-house during the quarter ended September 30, 2006. The growth in our fee-based services is due to the increase in our paying users for both existing and new offerings.

 

International.  International revenues for the first quarter of 2007 increased $101 million, or 22 percent, compared to the same period of 2006. Most of the international revenue increase came from marketing services revenue for the first quarter of 2007. The year over year growth in international marketing services revenue can be attributed to our increased penetration into existing markets, coupled with continued growth of the global online advertising marketplace and our affiliate network.

 

International revenues accounted for approximately 34 percent of total revenues in the first quarter of 2007, compared to 30 percent in the same period in 2006. The strong performance of our international operations has increased our exposure to foreign currency fluctuations. Revenues and related expenses generated by our international subsidiaries are generally denominated in the currencies of the local countries. Primary currencies include Euros, British Pounds, Japanese Yen, Korean Won, and Australian Dollars. The statements of income of our international operations are translated into United States dollars at the average exchange rates in each applicable period. To the extent the United States 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 United States dollar weakens against foreign currencies. Using the average foreign currency exchange rates for the first quarter of 2006, our international revenues for the first quarter of 2007 would have been lower than we reported by approximately $26 million.

 

Critical Accounting Policies, Judgments and Estimates

 

Our discussion and analysis of our financial condition and results of operations is based upon our condensed consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these condensed consolidated financial statements requires us to make estimates, judgments and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and the 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 estimate is made, and if different estimates that reasonably could have been used, or changes in the accounting estimate that are reasonably likely to occur, could materially impact the condensed consolidated financial statements. We believe that the following critical accounting policies reflect the more significant estimates and assumptions used in the preparation of the condensed 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 advertisements, display of text based links to the advertiser’s websites, 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 may enter into certain sales transactions that involve multiple element arrangements (arrangements with more than one deliverable). 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 tax planning 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, we would make an adjustment to the valuation allowance which would reduce the provision for income taxes.

 

We establish reserves for tax-related uncertainties based on estimates of whether, and the extent to which, additional taxes will be due. These reserves are established when we believe that certain positions might be challenged despite our belief that our tax return positions are supportable. Effective January 1, 2007, we adopted the provisions of FIN 48. See Note 14 — “Income Taxes” in the condensed consolidated financial statements for additional information.

 

Goodwill and Other Intangible Assets.  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, and 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 5 — “Goodwill” in the condensed consolidated financial statements for additional information. Based on our 2006 impairment test, there would have to be a significant unfavorable change to our assumptions used in such calculations for an impairment to exist.

 

We amortize other intangible assets over their estimated useful lives. We record an impairment charge on these assets when we determine that their carrying value may not be recoverable. The carrying value is not recoverable if it exceeds the undiscounted future cash flows resulting from the use of the asset and its eventual disposition. When there is existence of one or more indicators of impairment, we measure any impairment of intangible assets based on a projected discounted cash flow method using a discount rate determined by our management to be commensurate

with the risk inherent in our business model. Our estimates of future cash flows attributable to our other intangible assets require significant judgment based on our historical and anticipated results and are subject to many factors. Different assumptions and judgments could materially affect the calculation of the fair value of our other intangible assets which could trigger impairment.

 

Investments in Equity Interests.  We account for investments in entities in which we can exercise significant influence but do not own a majority equity interest or otherwise control using the equity method. In accounting for these investments we record our proportionate share of these entities’ net income or loss, one quarter in arrears.

 

We review all of our investments in equity interests for impairment whenever events or changes in business circumstances indicate that the carrying amount of the investment may not be fully recoverable. The impairment review requires significant judgment to identify events or circumstances that would likely have a significant adverse effect on the fair value of the investment. Investments identified as having an indication of impairment are subject to further analysis to determine if the impairment is other-than-temporary and this analysis requires estimating the fair value of the investment. The determination of the fair value of the investment involves considering factors such as the following: the stock prices of public companies in which we have an equity investment, current economic and market conditions, the operating performance of the companies including current earnings trends and undiscounted cash flows, quoted stock prices of comparable public companies, and other company specific information including recent financing rounds. The fair value determination, particularly for investments in privately-held companies, requires significant judgment to determine appropriate estimates and assumptions. Changes in these estimates and assumptions could affect the calculation of the fair value of the investments and the determination of whether any identified impairment is other-than-temporary.

 

Stock-Based Compensation Expense.  Effective January 1, 2006 we adopted Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”), and under the fair value recognition provisions of SFAS 123R, we recognize stock-based compensation net of an estimated forfeiture rate and therefore only recognize compensation cost for those shares expected to vest over the service period of the award.

 

Calculating stock-based compensation expense requires the input of highly subjective assumptions, including the expected term of the stock-based awards, stock price volatility, and the pre-vesting option forfeiture rate. We estimate the expected life of options granted based on historical exercise patterns, which we believe are representative of future behavior. We estimate the volatility of our common stock on the date of grant based on the implied volatility of publicly traded options on our common stock, with a term of one year or greater. We believe that implied volatility calculated based on actively traded options on our common stock is a better indicator of expected volatility and future stock price trends than historical volatility. Therefore, expected volatility for the three months ended March 31, 2007 and 2006 was based on a market-based implied volatility. The assumptions used in calculating the fair value of stock-based awards represent our best estimates, but these estimates involve inherent uncertainties and the application of management judgment. As a result, if factors change and we use different assumptions, our stock-based compensation expense could be materially different in the future. In addition, we are required to estimate the expected forfeiture rate and only recognize expense for those shares expected to vest. We estimate the forfeiture rate based on historical experience of our stock-based awards that are granted, exercised and cancelled. If our actual forfeiture rate is materially different from our estimate, the stock-based compensation expense could be significantly different from what we have recorded in the current period. See Note 10 — “Stock-Based Compensation” in the condensed consolidated financial statements for additional information.

 

Recent Accounting Pronouncements

 

In September 2006, the FASB issued 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 and eliminates inconsistencies in guidance found in various prior accounting pronouncements. SFAS 157 will be effective for us on January 1, 2008. We are currently evaluating the impact of adopting SFAS 157 but do not believe that the adoption of SFAS 157 will have any material impact on our 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 us on January 1, 2008. We are currently evaluating the impact of adopting SFAS 159 on our financial position, cash flows, and results of operations.

 

Liquidity and Capital Resources