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A Big Boo for Yahoo!

By Ben Elgin Investors hammered Yahoo!'s stock in afterhours trading on July 19 after it posted tepid second-quarter financial results. The Internet giant has consistently blown past analyst's top-line estimates, but this time it notched second-quarter net sales of $875 million -- nearly 1% below consensus expectations of $882 million.

Disappointed investors pounded the stock, shaving its shares by 10%, to $33.89.

RISE AND FALL. The news wasn't all bad for Yahoo (YHOO). The Sunnyvale (Calif.)-based company notched net profits of $192 million, not including a sizable one-time investment gain. The bottom-line total matched analyst estimates and represented a 70% gain over the year-ago quarter.

Even its lackluster sales bested year-ago totals by 44%. And the number of subscribers paying for Yahoo features has jumped 58% in the same period, to 10.1 million. "We're in a position of strength, as rapid adoption of the Internet continued among users and advertisers," Yahoo CEO Terry Semel told financial analysts on a conference call.

Before Tuesday's afterhours shellacking, Yahoo's stock had climbed 14%, to $37.73, over the previous three months, giving it a market capitalization of $53 billion.

CLICKS AND TRACKS. Yahoo trades at a multiple that's neck-and-neck with key competitor Google (GOOG) -- lower when looking at projected free-cash flow, higher when examining price-to-earnings, according to Jefferies & Co.

Yahoo's ability to maintain such a price point could depend on a couple of budding initiatives. One is a new algorithm designed to better rank the ads that appear alongside its search results. Such search ads generate nearly half of Yahoo's sales, yet users click on Google's search ads at a more frequent rate -- a concern for many analysts.

In addition, Yahoo two months ago unleashed a trial music-subscription program, dubbed Yahoo! Music Unlimited, which dramatically undercuts the pricing of its competitors. Yahoo execs, however, remained largely mum on both endeavors during the analyst call.

GOOGLE'S LEAD. A more effective algorithm for Yahoo's search ads could be especially critical. Yahoo has traditionally ranked search-engine ads by the amount advertisers pay for keywords, while Google uses a combination of payment amount and the relevance of an ad. If an advertiser pays the most, yet few people click on the ad, it will drop down the order.

Clearly, Google's method has worked better. Its click-through rates for ads in the U.S. stand at 18%, vs. 11% for Yahoo, according to comScore Media Metrix. "Yahoo needs to close the gap in search monetization," says Jefferies analyst Youssef Squali.

Yahoo has been working on a new algorithm for its search ads, but its launch isn't considered imminent. Several analysts predict it will be unveiled late this year or in early 2006. But with Google's share of search queries growing faster than Yahoo's, according to numerous researchers, it becomes a more pressing issue. Semel acknowledged that Yahoo is working on and testing such an algorithm, but wouldn't comment on the timing of its launch.

MUSICAL MOVEMENT. Yahoo also provided little detail about its two-month-old foray into music subscriptions. Its unlimited download service caused a stir with its pricing of $7 per month, roughly half the price of many comparable offerings. Yahoo has not provided the financial details behind the deal, but competitors decried it as a money-losing attempt to grab attention.

Still, analysts have been encouraged by Yahoo's attempts to diversify its business and aggressive foray into the crowded online-music field. Yahoo declined to offer specific information about its number of music subscribers or the service's profitability.

Such endeavors will only increase in importance as Yahoo attempts to bounce back from its first disappointing quarter in quite some time. Elgin is a correspondent in BusinessWeek's San Mateo bureau

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