Yahoo's Tenuous Case for Independence

To justify repelling Microsoft's bid, the Web portal must show investors it can pump up growth and generate revenue from its search business

Yahoo!'s second-quarter financial results did little to bolster the case for why the company should remain independent. Executives of the widely used Internet portal reported July on 22 that profits fell 19%, to $131 million, in the three months ended in June, in large part because of spending cutbacks by online marketers in the face of a weakening U.S. economy. "We continue to see softness in finance, travel, and retail [advertising]—all areas impacted by recent economic events," Yahoo (YHOO) CFO Blake Jorgenson said during a conference call explaining the results.

Investors and analysts are scouring the company's numbers for evidence that Yahoo's efforts to reinvigorate growth are taking effect—and that the company was justified in repelling an unwelcome takeover offer from Microsoft (MSFT). They got little from a per-share profit figure that fell short of Wall Street's already low average forecast. "It is true that the economy is softening," says Forrester Research (FORR) analyst Shar VanBoskirk. "But Yahoo made some grandiose claims when they denied the Microsoft offer, and there is absolutely no way that they can fulfill them in their current state."

Microsoft-Yahoo vs. Google

While Yahoo didn't make its case for independence, its results didn't prove that it must join up with Microsoft either. Many investors had feared Yahoo would miss Wall Street's expectations by a wide margin, given the impact weakening demand for Internet advertising and technology products has had on other Internet giants. Microsoft reduced forecasts for 2009 earnings (, 7/18/08), saying it would need to invest more in its online efforts before they would become profitable. Google (GOOG) released disappointing results on July 18 as well (, 7/18/08), citing a more challenging economic environment. The same day, ValueClick (VALU), one of the largest online advertising networks, lowered its forecasts for Internet advertising revenue, too.

Yahoo, on the other hand, held fast to forecasts for the current quarter and full year. It expects revenue of $1.78 billion to $1.98 billion for the third quarter and sales of $7.35 billion to $7.85 billion for the full year. "The general thinking was that Yahoo was going to be pretty ugly," says American Technology Research analyst Rob Sanderson, adding that Yahoo results were better than some had anticipated. "Microsoft is the one that had the disaster." Yahoo shares rose 2.3% in extended trading.

Even though Microsoft isn't faring better than Yahoo online, some investors and analysts still see a combination with the software company as the best option if the two companies are to repel the threat from the online advertising leader, Google. "At the end of the day, after all the twists and turns in the road, I expect there is probably some combination with Microsoft," Sanderson says.

Mistake to sell search?

The market will get a better sense of Yahoo's fate after the Aug. 1 shareholder meeting where activist shareholder Carl Icahn and two directors of his choosing are expected to gain seats on the company's board (, 7/21/08). Icahn has insisted his goal is to sell all of Yahoo, or potentially just Yahoo's search business, to Microsoft. Yahoo CEO Jerry Yang and the current board have expressed willingness to do a deal at the previously rejected price of $33 per share.

A search-only deal with Microsoft, however, may not be the best option, given Yahoo's future strategy. Yahoo is banking on a new display advertising network that will let marketers more easily buy multimedia ads across Yahoo's network and search ads at the same time. "We will be in the position to unify the process of buying display and search," Yahoo President Sue Decker said during the earnings call.

Should Yahoo sell its search business, it would lose the ability to offer such a one-stop shop. "I think it would be a big mistake for them [to sell search] because the value that they bring to advertisers and to users is a combined experience," VanBoskirk says.

Report card: Needs improvement

The alternative, should Microsoft not want the whole business, is for Yahoo and Google to expand an agreement whereby Google places ads on Yahoo's pages. Although Yahoo announced that its new search advertising platform is delivering higher revenue per search, it still has not matched Google in profitability. "Google's monetization is head and shoulders above the rest," says Sanderson.

It's not clear whether the government would sign off on a closer collaboration between Yahoo and Google. Already, the U.S. Justice Dept. has announced that it will scrutinize the current partnership between the two companies for antitrust concerns.

For Yahoo to prove it truly deserves to be independent, it will likely need more than the promise of a continuing partnership with Google. It will need to show that, weak economy or not, it is capable of accelerating growth and generating more revenue from its search business. That requires Yahoo to do better than Wall Street's worst expectations.

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