Counting on Yahoo! and Google

Investors are looking to the search titans for stellar second-quarter numbers, after disappointing results from some tech bellwethers

A dour outlook for much of the technology industry has yet to dampen enthusiasm for Yahoo! (YHOO) and Google (GOOG), the Web-search giants that report second-quarter results this week. Analysts are betting both companies will match, if not exceed, Wall Street's rosy expectations.

Optimism is in short supply for tech's biggest players of late. Concerns over a host of issues—from rising oil prices to product delays to an economic slowdown—are prompting analysts to revisit forecasts for such bellwether firms as Dell (DELL), Apple (AAPL), and IBM (IBM) (see, 7/17/06, "You Too, Big Blue?").

But there's good reason for a sanguine view toward the marquee Internet companies—namely, 25% to 30% annual growth in online advertising. "It's pretty difficult to see this kind of growth in another industry," says Ben Schachter, an Internet analyst with UBS Securities.


  Yahoo on July 18 is expected to report that sales jumped 30% in the three months that ended in June. Google, due to release results on July 20, is likely to say revenue surged 84%.

While double-digit growth is nothing new for Google and Yahoo, there's added reason to expect more of the same from the companies. The simple explanation is that people are spending more time online, and that's only increasing as a wider swath of the population logs on to the Internet using high-speed connections. The latest data from market researcher comScore shows search engine queries rose 24% in May from the previous month. "The majority of the growth has come from volume, and so that is where a lot of the current excitement is," says Mark May, an analyst at Needham & Co.

The added online activity means higher ad rates for Google and Yahoo. Search engine ad rates have swelled about 20% in the past three years, May says. Because both Google and Yahoo primarily make money from the number of clicks ads receive, the larger online traffic has led to more clicks and, thus, more revenue. Down the road, high traffic could even create additional revenue streams by enabling the search engines to offer some subscription services, says analyst Rob Sanderson of American Technology Research. For example, Google could charge subscription fees for an application such as Google Earth. Yahoo has similar opportunities with Yahoo Maps and Yahoo Finance.


  There's even reason to hope for additional ad dollars, as Google and Yahoo expand advertising operations to allow more types of online ads and better targeted advertising. In their efforts to keep up with Google, both Yahoo and Microsoft's (MSFT) MSN plan to unveil improved advertising programs. Yahoo will unveil its project, code-named "Panama," by the end of the year (see, 5/8/06, "The Counterattack on Google").

New algorithms in these ad programs could account for factors such as the popularity of the ad and the characteristics of the individual searching, as well as ad cost, when choosing ads to highlight. That's likely to entice even more companies to choose online advertising. "Right now there is a very strong secular trend driving advertising online, and I think people are excited about these stocks because, even in a slower economic environment, they might do quite well," says Marianne Wolk, an analyst at Susquehanna Financial Group. New ad programs are also likely to address click-fraud problems that have dogged search engines in the past.

Wolk recently upgraded her predictions for Yahoo this month, forecasting $1.15 billion in net revenue, up from $1.14 billion. The World Cup, she believes, likely tempered the cooling effect of summer on Internet searches. The Yahoo-sponsored soccer championship likely drove people to Yahoo's Web sites to see its World Cup-related content. Justin Post, senior research analyst with Merill Lynch, predicts that any slowdown will disappear by fall. "You see a broad slowdown in Internet usage in the summer, especially in Europe, and sometimes you get a cautious tone," Post says. "Generally, it picks up again in September and October."


  Despite the positive outlook for the search engines, there are challenges on the horizon. Competitive pressure to spend increasing amounts on developing new search engine capabilities could cut into profit margins down the road, particularly when additional search engines enter the profitable market. "Google has said that they do expect margins will go down," says UBS's Schachter.

There is also concern that the problems affecting the rest of the tech industry could spill over into the search engines. Although there could be a short-term advertising bump as companies fight to reinvigorate apathetic or wary consumers, a major slowdown in consumer spending will eventually hurt growth for all tech sectors. "If there are bigger problems, it will filter through for sure," says Amtec's Sanderson. "It gets harder for everybody then, including these guys."

But that's all theoretical for now. "The Internet's promise is finally being fulfilled," said Safa Rashtchy, a net and media analyst with Piper, Jaffray. "It has finally come around to be a big industry with demand increasing."

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