Yahoo!’s (YHOO) CEO Marissa Mayer on Q3 2014 Results – Earnings Call Transcript

I’m Bianna Golodryga again. I would be moderating today’s earnings event. Here with me are Marissa Mayer, Yahoo!’s Chief Executive Officer; and Ken Goldman, Yahoo!’s Chief Financial Officer.

Today, we bring you prepared remarks from both Marissa and Ken around Yahoo!’s third quarter performance. Later, they will be answering your questions submitted via email. Institutional investors were encouraged to submit questions and we have selected a few questions that were representative of the group.

I’d like to now turn it over to Marissa to discuss Yahoo!’s third quarter business update. Marissa?

Marissa Mayer – Chief Executive Officer

Thank you for joining us on today’s call. We had a good solid third quarter. We delivered $1,094 million in revenue ex-TAC and $1,148 million in GAAP revenue. This represents 1% growth in revenue ex-TAC and 1% growth in GAAP.

We achieve this revenue growth with strong momentum in our new areas of investments; mobile, social, native and video, despite industry headwinds in some of our large legacy businesses. Our results were outside and above the top of our guidance range by $34 million on revenue ex-TAC and $48 million on GAAP revenue.

For my segment of today’s call I will cover our quarter then Alibaba. Then return to our strategy for the core business for M&A and for managing expenses. We’re turning now to Q3. We see strength in search and mobile.

Our investment businesses of social, mobile, native and video are collectively growing 80% year-over-year, and we are gaining momentum in the four key areas of our strategy, search, communications, digital magazines and video. Our results in display are mix within new investment areas growing triple digits, but with legacy PC display more than offsetting that growth.

Turning now to search, our search business continues to be strong showing 6% growth year-over-year on an ex-TAC basis. With our search click driven up 17% based largely on strong PPC trends and clicks flat year-over-year.

This quarter represents our 11th quarter of search revenue growth year-over-year on a revenue ex-TAC basis. Our price-per-click is up in almost all regions as we continue to find ways to enhance the performance of our search ads through better user interfaces and higher quality traffic and as advertisers ultimately find our search ads more valuable.

In terms of clicks the story is more regional. We saw a strong click growth in the Americas for example, where clicks grew 9% year-over-year. However we saw fewer Clicks year-over-year in our Asia Pacific region, in total resulting in flat clicks year-over-year.

Social across both PC and mobile continues to be a highlight where we see a lot of momentum and opportunity. Speaking of mobile, I’m delighted to report you today that our revenue and mobile is now material. In Q3 we saw mobile revenues in excess of $200 million on a GAAP basis.

Further, we estimate that our gross revenues in mobile will exceed $1.2 billion in revenue this year. This maps to GAAP revenue of more than $700 million in 2014. We’ve invested deeply in mobile and those investments are paying off.

Our mobile revenue more than doubled year-over-year, not only our mobile products attracting praise and engagement from users and industry awards, they are generating meaningful revenue for Yahoo! Fundamentally, we are moving from a company that makes web pages and monetizes them through banner ads to a company that makes mobile apps and monetizes them through native ads.

We have effected this transformation remarkably quickly with 44% of our display ads now being native and are material — and our mobile revenue now being material. And as we continue to think about growth, we know that we’ll say strong here. Mobile remains the minority of our traffic. And as our mobile traffic grows, we anticipate so will the associated revenue given the effectiveness of our mobile native ads.

Our display business continues to show some weakness with revenue down 6% year-over-year. But we will certainly like to display business grow, we see some very encouraging trends and anticipate we will see growth in the next year.

For instance, the number of ads sold is up 24% year-over-year. This really represents an increase in our user engagement especially on mobile. Our price per ad decline to 24% year-over-year and we would like both price-per-ad and ad sold to be positive.

If we were to have one positive and one negative, in my view its always better to have more things to sell and then subsequently focus on building greater demand, value and an improved pricing strategy. We feel the pricing on our mobile in particular will improve over time with better targeting and increased advertiser demand.

And while our display revenue has been flat to down, the components of our display have not been. Traditional PC advertising is a sector of advertising and is in decline across the industry. That decline has been steep here at Yahoo! with legacy PC display advertising creating a drag on the business of $60 million or more per quarter.

However on the flip side, our native advertising offer through our Gemini platform has becoming credible strong. This product didn’t even exist six quarters ago. In Q3 native ads had revenues across mobile and desktop of more than $65 million.

In Q4 we anticipate native ads will approach $80 million of revenue. Native ads have been experiencing triple-digit year-over-year growth. And have moved from being an idea and the prototype to being a nearly $250,000 [quarter of billion dollar] business.

The advertising industry is constantly changing and the fact that we are able to response to this trend so quickly and meaningfully is a testament to our teams. This growth in native ads used on social and mobile has worked to offset the declines in traditional PC display.

As Gemini native ads and programmatic ads sold through Yahoo! Ad Management Plus gain momentum. We believe that their growth will overpower the declines in traditional PC display. In fact already in Q3 setting aside PC display and revenue classified as other our core revenue at 8% on a GAAP basis and 10% on a revenue ex-TAC basis.

This summarizes the key pieces of our core business in Q3. Obviously one of the biggest events for our company in Q3 was the Alibaba IPO on September 19. I’d like complement Jack Ma, Joe Tsai, the Alibaba management team and the underwriters on a very successful IPO.

I’d also like to complement our Founder Jerry Yang, on his foresight to invest in Alibaba where he has now joined the board. I want to use the next part of the call to discuss that actions that Yahoo!’s Management and Board have take to capture additional value from our Alibaba stake.

In May 2012 prior to the current management’s arrival at Yahoo! myself included Yahoo! entered into the agreement with Alibaba regarding the sale of our shares. The May 2012 agreements specified a numbers of things including one the immediate sell of approximately 520 million shares of Alibaba at a $35 billion market valuation.

Two, the sale of 262 million shares in the IPO, and three, the lockup of those shares not sold in the IPO approximately 262 million shares for one year after the IPO. Upon current management’s arrival in Q3 2012, we immediately recognized two things.

Alibaba had the potential to appreciate considerably in value and also that we need to improve the relationship between the two companies. Unable to modify or revisit the agreement at that time, we focus on rebuilding the relationships.

I immediately directed my team to begin healing years of tension and hard feelings. I sign Jackie Reses to the Board of Alibaba and Ken Goldman to the Board of Yahoo! Japan, our Joint Venture with SoftBank. Jackie and Ken have done a tremendous job, building the bridges between Yahoo! and our very important Asian allies. In fact, long-term Yahoo! shareholders will recall that as a result Alibaba allowed us to reduce the number of shares we sold in the IPO in two different instances. These reductions were made with no direction concessions on our side, and stemmed from better relationships between the companies.

Ultimately our management team negotiated to an outcome of selling 140 shares in the IPO. As you can see on this slide, this reduction in shares sold in the IPO netted nearly an additional $2.5 billion to Yahoo! on a pretax basis.

The first sale completed in 2012, the other $4.3 billion to the company and after tax proceeds. In September 2012, we promise to return $3 billion of those proceeds to shareholders. Over the past two years through Q2, 2014 we went on to return $6.2 billion to shareholders, more than double our commitment.

In Q3 and Q4 to-date we returned an additional $1.6 billion bringing the total to more than $7.7 billion in capital returned during Ken’s and my tenure. To facilitate these buybacks we went beyond our committed $3 billion amount from the Alibaba sale.

We utilized free cash flow from the core business, raised $1.4 billion in convertible debt to facilitate further buybacks as well as use the proceeds from a well-timed hedged on the Japanese yen. All-in-all we bought back 24% of the Company’s share and have done so continuously from the stock price on the day I started $15.65 to today.

On the share sold into the IPO we have already discuss the $2.5 billion of additional shareholder value captured by reducing the number of share sold. The IPO sales netted approximately $6 billion and after taxes to the company. We have committed to return at least half of that capital, approximately $3 billion to shareholders. And in Q3 we undertook an accelerated share repurchase as part of that return.

Today our share count stands at approximately 976 shares down from over $1.2 billion two years ago. On the remaining stake we continue to hold 384 shares of Alibaba valued at $34 billion on a pretax basis. These shares are subject to a one year lockup agreement. We worked hard to negotiate and achieved more favorable terms on that agreement.

Those terms allow us to communicate our intensions and take preparatory actions during the intervening year. Though there are some restrictions on what we can say today. Many have pointed out the value accretion that would occur at this final tranche were to be taxed upon sales at a lower rate than the previous sales. We are acutely aware of this.

We have the best tax experts in the country working intensively on structures to maximize the value to our shareholders of our remaining stake in Alibaba. Further, we are pleased with these efforts to-date and our considering promising alternatives that we are optimistic would maximize value.

We continue to refine our thinking on our approach and will report back to shareholders by our next earnings release in January. Management is committed to being a good steward of capital. The board is also committed to this stewardship and is and will be appropriately involved with the return of capital and investment decisions.

We are proud of our accomplishments to-date on capital allocation and the yield they’ve had for our shareholders. To recap, we have bought back 293 million shares for $7.7 billion with an average price of $26.37 and we’ve been executing these purchases continuously over the past 27 months.

We worked hard to build our relationships with Alibaba and SoftBank to reduce our sales in the IPO as we felt that would be immediately accretive to shareholder value. And we used cash from retiring Japanese Yen hedges and issued convertible debt to access cash to continue to buyback shares.

Further these actions were dramatically accretive to our earnings per share. EPS is up 52% year-over-year. On capital allocation we have gone far beyond any publicly committed amount of return and we’ve done so due to our commitment to shareholder value and because we believe deeply in the future potential of Yahoo! and the transformation we are pursuing to bring an iconic company back to greatness.

Turning back to the core Yahoo! We have a great confidence in the strength of our business and in the opportunities within. Our focus has been on sustainable market share gaining growth and on building value for our shareholders.

Our business has four interdependent pillars. Search, communications, digital magazines and video that operate as a network monetize through advertising. We are product-oriented company and we believe in attracting new users, advertisers and publishers to our ecosystem through quality products and great experiences.

We are incredibly proud that many things that we build over the past two years, the new looking feel across our products, the new Yahoo! mail. Yahoo! screen, the digital magazines, new search experiences and features, the Apple design award winning, Yahoo! news digest, the Yahoo! weather app and new versions of Flickr for mobile and PC.

Just this past quarter we launch Yahoo! Style led by industry maven Joe Zee, Yahoo! health and earlier this week we launch Yahoo! DIY, a digital magazine for do-it-yourselfers, over the course of Q3 Yahoo! Live broadcast more than 90 live concerts to million of users through our exclusive partnership with Live Nation.

And we launch Yahoo! Recommends bringing Yahoo!’s Leading personalization technology to leading publishers. The list goes on and on and I couldn’t be proud of how we’ve update and upgraded our products to better serve our users.

An engagement has steadily grown as results. Today the number of monthly active users on Yahoo! and Tumblr exceeds 1 billion users. That’s up at least 6% over the last year and our mobile traffic has grown even faster.

Across Yahoo! and Tumblr on a device basis we now see more than 0.5 billion, 550 million monthly active users on mobile. This is a different metric than we’ve reported on in the past combined with Tumblr and device-based.

So for reference and continuity we believe mobile monthly active users are approximately 17% from a year ago showing strong growth on an already large user base. Further mobile monthly active users have more than double since the beginning of our mobile investment.

Now I’d to show a few charts on mobile. These chart show our growth in mobile monthly users, user time spend and revenue. As I’ve laid out many times on previous calls, we intent to invest in new areas primarily mobile in order to achieve growth and exceed that of the industry rate and of our historical growth rate.

In these charts you can see Yahoo!’s actual trend line in purple. With the yellow circles denoting when our mobile efforts were formed in October 2012. You can clearly see here that our actual growth from October 2012 to present exceed our historical growth rate denoted in blue, modeled as a continuation of our previous trajectory and the industry growth rate denoted in yellow taken from reliable third-party sources from monthly users in revenue and from Flurry for time spend.

Our mobile investments have meet of goal of growing market share, and are achieving material revenue on mobile this quarter indicates our team has successfully completed the first lap around the virtuous circle we’ve talked about so many times here before, people, products, traffic, revenue.

Hire great people, they will build great products that generate increase traffic and ultimately increased revenue. I’d also like to update you on Tumblr. We acquired Tumblr a little more than 15 months ago. Over the past 15 months they have seen strong growth.

Their audience grew 40% from 300 million to more than 420 million users. The number of register blogs nearly doubled from 105 million to 206 million, mobile monthly users of their mobile app grew by 50% and perhaps most impressively Tumblr time spend grew from 22 minutes to 28 minutes per Tumblr’s and Tumblr dashboard sessions.

The engagement numbers on Tumblr continue to be really impressive. This year Tumblr has also focus on revenue growth. Today more than 260 of the world’s top brands not only have a presence on Tumblr but also advertising spend on the platform, and that number grows everyday.

We launched Tumblr’s sponsored post this summer to great effect. Marketers really like the content marketing format and how it helps them express their messages and reach audience in a way that the audience is in the way they feels very nature.

Tumblr’s revenue is growing nicely and we anticipate them achieving more than $100 million in revenue as well as positive EBITDA in 2015. The Internet sector is incredibly competitive and inquisitive industry to build products that compete and successfully attract users and accelerating engagement revenue, acquisitions have not been a choice for Yahoo! in my view but rather a necessity.

We think about acquisitions in three groups; talent acquisitions, building block acquisitions and larger strategic acquisitions. I’d like to talk more about our acquisition philosophy and how we think about capital deployment in this area.

Let’s start with talent acquisitions. In our virtual cycle in order to build beautiful inspiring products, grow engagement and ultimately revenue everything starts with having the best people. So we need to attract great inspiring entrepreneurial people to work at Yahoo! to help us accelerate our transformation in mobile and other growth areas.

When I first arrived Yahoo! was a very different place attracting top talent in July 2012 in the wake up years of corporate turbulence and high efficient in core areas was challenging to say the least. Talent acquisitions were the best way for us to gain functioning teams in key areas for accomplish, responsible, accountable, collaborative and visionary and to do so quickly. Our strategy of using talent acquisitions in this manner works brilliantly.

The people we gain from those acquisitions now hone our efforts in mobile, video, native, digital magazines and more. They drive and are directly responsible for the growth we are seeing in mobile engagement, mobile revenue and native apps.

We will continue to do thoughtful appropriate talent acquisition in the future when that is the right strategy to bring great people to the company. When I call building block acquisitions, our larger M&A deals that tend to be about people and a key technology, as a result we only look at building block acquisitions that aligned with one of four pillars, search, communications, digital magazines and video.

It isn’t worth the integration overhead, if a technology does not support one of our strategic pillars. To-date we have done six building block transactions. Aviate for search in order to build our contractual mobile search, Xobni and IQ engines for communications in order to improve our understanding of contacts and images, Rockmelt and Summly for digital magazines to help us create beautiful rich media experiences and Raydee for video to improve our video streaming transcoding.

Because Yahoo! is legacy technology it’s quite aged. It’s important for us to look for opportunities to bring more modern, more cost effective, more efficient and more updatable technology into the mix. We will continue look at building block acquisitions that modernize our technology and our alignment with one of our four strategic areas.

The third area of acquisitions is what I call strategic acquisitions. That’s not to say the talent acquisitions and building block acquisitions aren’t strategic. They are strategic for all the reasons that I just covered. However we refer to large acquisitions that accelerate us in key areas of investment as strategic acquisitions. To-date we have done two such strategic acquisitions, Tumblr and Flurry. While small in number these acquisitions makeup the vast majority of dollars we have spent through M&A since I joint the company.

We have spent just over $1.6 billion on acquisitions during my time here. And these two acquisitions are 80% of that spent approximately $1.3 billion. Strategic acquisition should not only build on the four core pillars of our business, search, communications, digital magazines and video, but also go much deeper in our areas of investment, mobile, social, native and video.

Further because of their size they are almost always immediately accretive and meaningful to the company in terms of revenues and earnings. These are acquisition that we consider carefully with management and our Board. In terms of process we have sophisticate business models, detailed integration plans and work extensively with the other company in preparation for the merger.

Across talent acquisitions, building blocks and strategic acquisitions we have funneled our resources directly into mobile, social, native and video and we’ve grown users, traffic and revenue tremendously. Our recent acquisitions have been instrumental in replacing and will eventually outpace our declining legacy revenues.

From a capital allocation perspective, I want to call out that we have spent $1.6 billion on acquisitions where we have returned more than $7.7 billion through share repurchases during that same time period underscoring that the bulk of our capital allocation plan has been devoted to share repurchases and that these repurchases have been accomplished at very accretive prices.

In summary, we have a clear M&A strategy and a principled process for reviewing M&A opportunities. We will continue to seek opportunities here and we will be smart about. While Ken usually covers cost related item in his section, I also wanted to touch on this topic in mind.

Our focus has been on efficiency, effectiveness and excellence. We’ll look for ways to drive new efficiencies in our business continuously and intensively. Essentially finding costs and investments that used to make sense and no longer do.

We’ve taken an exhaustive look at our locations, the locations of our operations and we have closed 8 offices to-date including Cairo; Rolle, Switzerland, Amman, Jordan; Seoul, Korea; Oshkosh, Wisconsin; Boca Raton; Denver and Carlsbad. We’ve also work to consolidate offices and teams where we had multiple offices in the single city like New York or Bangalore. We have generally consolidated to one.

We have moved, relocated and reassessed hundreds of roles to make sure we have people working on not only the most important things, but working on those important areas from the right places. We’ve also taken a more rigorous approach to performance including the quarterly performance for reviews that I’ve discussed on past calls.

The culture has responded well to the sharpen view of performance and this sharpen view of performance allows us to reward the best performers as well as work with those who are challenge by either finding them the different role for them at Yahoo! or by coaching them to move on from Yahoo!

To-date we have had nearly 2,000 performance related departures in the company during by tenure and retention of our top performing talent has been at the highest level in years. We’ve also exceeded more than 65 tertiary product lines. Retiring these products help us achieve greater focus and also freeze up significant additional energy to allocate to growth drivers.

All of these decisions enable us to remix and restructure our business to fund investment and future growth. The net is we have higher performing talent in the right locations working on the most important growth drivers for the company.

And we are committed to making these improvements on a continuous basis. In fact earlier this year and as part of an ongoing effort we brought outside advisers to get fresh perspectives and insights on how to drive further efficiencies. While we endeavor to improve earnings primarily through revenue growth, we are committed to managing costs.

We all came here to return an iconic company to greatness and I’m so proud of what we’ve have achieve not only in terms of product excellence, traffic increases and modest revenue growth, but also in terms of efficiency and effectiveness of our organization, capital allocation and employee moral, especially when you consider the broader ecosystem of our industry, the rapid technical change, fierce competition for talent, greater emphasis on scale and shifting markets.

We’ve come really far, really fast. We’ve build a truly excellent team is up to the task. That team, our board and I have and will continue to be careful stewards of shareholders money. This team is now been in place for two years and we’ve achieve much more than many people realize. We have delivered significant shareholder value.

We’ve completed share repurchases of $7.7 billion within average price of $26.37 to buyback 24% of our outstanding shares. We’ve gained mobile market share and made mobile a material part of our business with 2014 gross revenue in excess of $1.2 billion. We build $1.25 billion business in native ads from nothing six quarters ago. We maintained search is a strong source of growth in our quarter for 11 quarters in a row. We found and invested in both organically and inorganically the key growth trends of mobile, social, native and video. And we’ve remixed and restructured our business for an improved focus, execution and excellence setting aside legacy businesses we’ve achieved 8% GAAP growth and 10% revenue ex-TAC growth.

Q3 was a strong quarter for Yahoo! However one quarter does not a year make, like any company in transition we will have our ups and down, we have in the past and we will in the future we will continue our relentless pursuit of a path to return this iconic company to greatness while always working just as hard to create shareholder value. And now, I like to hand it over to Ken who will discuss our financial results in further detail.

Ken Goldman – Chief Financial Officer

Thanks, Marissa and thanks to all of you for joining us today. We are in the midst of a comprehensive transformation of the business. There is clear momentum and I have full faith that we continue to create value for shareholders. It’s been two years since I joined Yahoo!, this represents interestingly my ninth earnings call as a CFO, so like most I wanted to take a step back and quickly highlight on the many areas of progress we have made as a company, as a management team.

We also recognize that much work remains to be done and I am confident that we are up to the challenge. So let me summarize with the status update for the first two years. And I will cover five main points. First on capital allocation. I have said before there were good stores of capital, let me expand on that. Since July of 2012, we have been aggressively buying back our stock. We have repurchased 293 million shares totaling $7.7 billion or representing 24% of the Q3 2012 share base at an average price of $26.37.

These aggressive repurchases were also another way for us to capture some of the upside in the all above evaluation over this time period, given our sale of half of our position in 2012. As a part of these buybacks we entered into an accelerated share repurchase agreement in September as we brought back 23.5 million shares for $933 million with final settlement completed in October. While we were returning nearly 8 billion to shareholders we also spent 1.6 billion in M&A primarily for two operating companies and smaller others to accelerate our development efforts.

We allocate nearly five times in a month and return of capital to shareholders. In summary, compared to the $3 billion we committed to return to shareholders in September of 2012, this team has significantly over delivered on that promise of capital return. Second, shareholder value, we were opportunistic in identifying market conditions to raise $1.4 billion in convertible debt late last year with very attractive terms including a zero coupon interest rate. We realized $482 million through timely hedges on Japanese Yen, hedging our balance sheet investment of Yahoo! Japan to the benefit of shareholders.

And cummatively over this period, we have monetized patents and IP for total cash value of approximately $540 million which will be realized over a number of years. These transactions provide even more capital for potential share holder return, investment in our core business to drive value for shareholders. And of course there is Alibaba. Though committed by a prior government to sell shares and IPO we twice proactively requested and achieved a lower number of shares to be sold in the IPO, ultimately ending up at a 140 million shares down from the original 262 million which translates as Marissa said to roughly $2.2 billion of additional pre tax value.

This not only allowed us to take advantage of perspective gains in the Alibaba stock value in excess to the IPO price but also any potential tax strategies we may pursue. As part of the IPO we entered into a one year lock up agreement for our remaining Alibaba shares. As Marissa noted, there are limitations of what we can disclose in the short term, however, I am optimistic about the promising structures we are working on with our financial advisors. To sum up, we have repeatedly shut out, equated and delivered enormous value to our shareholders.

Third, free cash. Once again, we generated a strong free cash flow over $212 million in Q3. Since July of 2012, we have generated a total of 2.4 billion of free cash flow, which would suggest for cash tax payment of 2.3 billion related to the sale of Alibaba group shares in Q3 of 2012. We continue to effect balance sheet working capital efficiencies such as remaining payables, payment terms and enhancing collection rates throughout the year.

We deferred an estimated 3.3 billion tax payment related to the Alibaba IPO proceeds to Q1 of next year which will result in additional interest income and a stronger balance sheet in the interim. We have continued to improve our tax planning which has resulted in lower cash tax payments for federal state and local further improving free cash flow, such that year-to-date cash excess are down two thirds from 2013.

We reduced capital expenses from historical run rates in 2013 and 2014 by introducing stronger controls for our capital spend. Fourth, managing expenses. Management and cost structure is important to us and as with capital return as we receive continuous intention. We have thoughtfully managed our cost structures, we identified opportunities for improvements. Initially we increased costs to support improvement in the work place environment for our employees consistent with peer companies, while enhancing our conservative expense capitalization policies. We have locked value in our IPO assets with patent sales and licensing programs, they have resulted in a $143 million in total cost benefits. This also resulted in transaction compared to license fee revenue of approximately $40 million to be recognized over several years.

We early on, revised the company’s global approval matrix to more vigorously cover expenses, headcount, capital and contracts. For example, our review for capital spending is leading to low depreciation costs. We also improved other management processes such as instituting quarterly goals and more disciplined employee performance reviews.

And as noted, our location strategy review led to eight office closures and consolidation of functions in our remaining locations which will create more collaboration in key regional offices. In conjunction with this, we engage a top tier management consulting firm to help us achieve cost and structural efficiencies we are benchmarking and implementing best practices. We continuously look to find efficiencies to our business structure that will enable improve performance for our shareholders and fifth, revenue growth. Revenue engagement growth remains a top operational goal as a management team.

For Q3, we are reporting revenue above our guidance range as we saw continuous surge strength in our core business in improvements on fee revenue. We reinvested much of the cost efficiencies into our key initiatives to drive future growth. For example, we increased our mobile headcount to over 500 and as noted I am proud of the more than 200 million mobile GAAP revenue achieved in Q3. Considering especially of that significantly smaller mobile presence a number of mobile products two years ago.

M&A has been critical to rebuild our core business through our investments and mobile social native and video. In summary, led by Marissa the management team has provided stability and renewed pride throughout our company. Our employees are energized and focused as we are able to retain high performance and to attract top talent to develop the best products which we expect will ultimately to revenue growth. I have great confidence in the strength of our business as we continue through this transformation to a sustainable market share growth and further value equation for our shareholders.

With that, let’s go through our third quarter financial results. Once again I will focus most of the discussion around non-GAAP results which exclude stock-based compensation expense of $106 million and restructuring charges of $8 million. I will note though, while we exclude stocks based compensation from non-GAAP financial results, we take the stock dilution seriously, including shares granted and the resulting compensation expense.

And as a reminder you can find complete reconciliation between GAAP and non-GAAP results in our earnings slides in our Investor Relations website. So now starting with the financial highlights for Q3 as seen on Slide 5. Q3 GAAP revenue was $1.148 billion and revenue ex-TAC was $1.094 billion well above our guidance. Looking at our search and display businesses, the combined core revenue ex-TAC was flat versus prior year. Other revenue was up 6% as Alibaba related fees and patent license revenue more than offset declines in leads and listings.

We are pleased to see continuous strong performance in our four investment areas as noted Mobile, social, net and video with approximately 80% GAAP revenue growth and the aggregate for those four areas year-over-year. Adjusted EBITDA was $206 million in the quarter which was also above our guidance range has improved revenue performance flow through and we managed cost ahead of our guidance.

Non-GAAP operating income was $156 million. Earnings and equity interest of $399 million grew 71% year-over-year driven by the strong Alibaba Group Q2 financial results in which we recorded our share on a one quarter lag. Non-GAAP EPS was $0.52, up 52% year-over-year and our Q3 average fully diluted share count decreased year-over-year by 3% to [$1.08] billion and was down $7 million from Q2. Our ending diluted share count was 993 million and since the end of Q3, through today, we have repurchased an additional 17 million shares of which 8.4 million was from the ASR. Free cash flow was $212 million for the quarter marginally down versus prior year as we had decreased capital spending to support company growth initiatives.

In our cash of marketable securities balance was $12.3 billion resulting primarily from receipt of the Alibaba pre tax IPO proceeds of $9.4 billion. Lastly, our headcount at the end of the quarter approximately 12,500. Let’s take a couple of minutes to go through the financial results in a bit more detail. And beginning with search, GAAP search revenue grew 4% and revenue ex-TAC grew 6%, once again without the benefit of the RPS guarantee. Similar to the last quarter, the search strength resulted from PPC improvement of 17% year-over-year.

We continue to see favorable traffic mix come from higher monetizing segments of the Americas revenue, Americas region and the Yahoo! properties. Paid clicks were flat year-over-year compared to a strong Q3 of 2013 that experienced 21% year-over-year click growth. In the Americas region as noted, we achieved 9% click volume growth, while the majority of negative impact came from Asia Pacific. This underlying operating matrix delivered a 17% year-over-year increase in search, click driven revenue. Once again, strong double-digit growth in the matrix that we believe best measures the health of this business.

Mobile search GAAP revenue continues to more than double year-over-year. Now moving to display. GAAP display revenue declined 5% and revenue ex-TAC declined 6% year-over-year. Sequentially GAAP revenue was up 3% driven by a new formats including native ads, premium programs and and fancy football. Additionally we expect completion of the U.S. migration of audience campaign through a yen plus platform this month.

Growth in a number of ads sold held strong in Q3 at 24% as we continue to build our native and mobile inventory. The PPA decline of 24% offset the volume increases in Q3 as we saw increased contribution from our native ads. For revenue detail by region, please refer to slide 12.

Let me now move on to expenses. Traffic acquisition costs were down 7% compared to prior year, while up 24% quarter-on-quarter as we saw more growth on display network. Non-GAAP total operating expenses were up 3% versus prior year driven by work force expenses as we continue to invest in our tactical workforce and increased marketing spend for premium programs, while managing to lower other costs, such as data center consolidation and T&E.

On a sequential basis cost were up primarily through the patent sale contra expense that we had in Q2 and increased marketing. As noted we ended the quarter with approximately 12,500 employees nearly half of which are now in tactical functions and focus on creating the kind of strong products that attract consumers and ultimately grow revenues. However our total workforce including contract is down 11% versus the prior year, because we have aggressively reduced our contract workers by more than 1600 over the last year.

EBITDA was $306 million in Q3 with a margin of 28% based on revenue ex-TAC basis compared to $331 million in Q3 of 2013. Non-GAAP operating income was $156 million for the quarter resulting in a margin of 14% on a revenue ex-TAC basis. D&A remained consistent over the past several quarters at approximately $150 million. Rounding out the income statement other income includes our $10.3 billion pre tax gain on the Alibaba IPO. We received cash proceeds of $9.4 billion and recorded additional gain reflecting our proportionate share of the new stock issued by Alibaba net of our original basis.

We estimate that we will pay approximately $3.3 billion in cash taxes in the first quarter of 2015 related to these proceeds. Earnings and equity interest grew 71% to $299 million. The increase was primarily driven by one time gains recognized by Alibaba in Q2 relates to its equity investments.

Now let me turn to the balance sheet, at the end of Q3 we had $12.3 billion in cash and marketable securities, equivalent to $9.4 billion for the proceeds of Alibaba IPO. These shares were sold out of our Hong Kong subsidiary. Under U.S. tax law, such gain is fully taxable, regardless of where the cash is domiciled. Cash taxes related to sale are expected to be $3.3 billion and will be paid in Q1 of 2015.

As part of our commitment at least 50% of after tax Alibaba IPO proceeds showed us we have repurchased 1.4 billion of our shares to date. As we move to a class – treatment for Alibaba group our remaining investments now reflected on our balance sheet and mark-to-market at $34 billion as of September 30. The change in cash balance from Q2 to Q3 was primarily driven by strong cash flow — free cash flow of $212 million, the Alibaba proceeds of $9.4 billion, acquisitions net of the cash acquired of $292 million, which was primarily for Flurry, and share repurchase activity of $1.4 billion.

We bought back approximately 8 million shares for $282 million through September. And on September 30th we prepaid $1.1 billion under our ASR. We received additional deliver of 15 million shares under this agreement during the quarter with final settlement occurring in October resulting in repurchasing from an additional 8.5 million shares for a total repurchase of 23.5 million shares under the ASR for net $33 million.

Now let’s me turn over to guidance. As we look to the last quarter of the year and going forward, we are committed to sustainably growing our business. I’m pleased with the sense of urgency that we have operated within Q3 and I expect that our EBITDA levels at a low point and we expect to see improvements with revenue growth in 2015 and beyond.

Our guidance assumed that we continue to make steady progress in our core business into Q4 with the following assumptions. Post the Alibaba IPO we will recognize remaining portion of the September 2012 one-time TPA payment through September 2015 for approximately $17 million revenue per quarter, but we’ll have no other royalty revenue going forward.

Short-term expenses expect to be approximately flat sequentially as we look for module leverage in Q4. For our Q4 guidance we expect the following; GAAP revenue range of $1.2 to $1.24 billion, revenue ex-TAC in the range of $1.14 to $1.18 billion, EBITDA in the range of $340 million to $380 million, with short-term operating expenses roughly flat at $800 million and non-GAAP operating income in the range of $190 million to $230 million.

Thanks again for your time. In closing we remain committed to building a strong core business creating of returning value to our shareholders and warranting your continue support and trust in our leadership as effective stewards of your company.

With that, Marissa and I would be glad to take your questions and I will go to Bianna.

 

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