On Second Look, Investors Aren't So Thrilled With Yahoo's Earnings

A lot can happen in a span of a week -- just ask shareholders of Yahoo (YHOO).

Last week, Carol Bartz's struggling Internet pioneer hit a 52-week high of $19.12 a share as investors pushed its stock upward in anticipation of decent organic growth in its first-quarter earnings.

But following the release of the quarterly results, investors pulled back and wiped away about 5% of the stock's value Wednesday, pushing it down to nearly 10% below its price on April 15, when it posted that high. Shares of Yahoo dipped as low as $17.30 in trading, and closed at $17.43.

What's the issue? Yahoo's profits, after all, soundly beat Wall Street's estimates, and while revenues weren't as high as analysts expected, the company still posted a meager gain over its year-ago figures and showed growth not displayed during the past five quarters.

"Somewhat Disappointed"

For starters, the additional benefits that were expected from the Microsoft (MSFT) search advertising deal are now expected to be reinvested into other operational expenses, such as a new advertising campaign for search. And while Yahoo expects to see revenue growth in its highly touted display advertising business, that area offers lower profit margins than its poorly performing search and and broadband fee businesses, analysts note.

"The stock has been performing well in recent months on the catalysts of higher EBITDA via contributions from the Microsoft search transaction (which now appears to be getting re-invested in 2010) and monetization of China Internet assets (which now looks to be a 2011 event at the earliest),"Jeetil Patel, a Deutsche Bank analyst, said in a research note. "However, these drivers now appear to be [second half of] 2011 events, leaving investors to rely on 1% revenue growth in 2010 and 4% EBITDA growth in 2010 (more importantly, down over 10% Y/Y without Microsoft payments)." Patel is maintaining his hold recommendation and $16 a share price target.

Ross Sandler, an RBC Capital Markets analyst who maintains his buy on the stock with $22 a price target, voiced similar concerns regarding the benefits of cost savings from the Microsoft integration this year.

"We were somewhat disappointed that the cost savings from the Microsoft integration are not flowing through to the bottom line based on re-investment and loss of revenue (fees/listings), but we think the company could be overly conservative on the guidance and the cost savings are likely to materialize in 2011," Sandler noted in his research report.

Don't Worry About Margins, Think About Profits

Going forward, what are the areas investors should follow?

One critical area to watch is the revenue from paid search advertisements and fees charged to folks such as broadband partners, in comparison to the advertising revenue from display ads.

Patel noted that while Yahoo's display advertising business far outperformed Wall Street's expectations, its profit margins are relatively low compared to those from such areas as search advertising and fees, which performed below expectations in the quarter. He added this will likely put pressure on profits.

But one major institutional investor, who asked to remain anonymous, said that's not an issue, because at the end of the day, the profits from both of Yahoo's businesses are blended. "Yahoo spends profits, not margin," quips the investor.

This investor also notes that Yahoo's 40% stake in Alibaba.com doesn't receive the credit it deserves as an asset and says five years from now, it shouldn't be surprising to see that investment worth more than Yahoo's current market capitalization.

Still Too Early to Tell If CEO Carol Bartz Fits

Whether Yahoo's CEO Bartz, who has five quarters with the company under her belt, is the right person to lead Yahoo in the next five years remains to be seen.

"I'm not a big fan of Carol's. I'm not sure she has the vision to take the company to the next level. Sure she cut a deal with Microsoft and can stabilize things but it's not clear she has a vision of where to take the company," the investor says. "The most important asset Yahoo has is display advertising, and that is driven by premium content. During this downturn, she could have been more aggressive scooping up content assets or building them internally."

Yahoo declined to comment on Bartz's fit as CEO, other than to note the 20% increase in first-quarter display advertising revenue.

Analysts say Yahoo is in the midst of a transition period that will likely last for a couple more years.

Trip Chowdhry, an analyst with Global Equities Research, says Yahoo will likely continue to experience downward pressure on its profits for a while as cost-cutting and the transfer of search technology to Microsoft continue, but after four years, he would expect to see Yahoo capturing strong revenue growth.