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Searching for love
When Yahoo! and Google report their 1Q earnings, will investors find what they're looking for?
April 18, 2005: 3:10 PM EDT
By Paul R. La Monica, CNN/Money senior writer
Search slump: Shares of Google and Yahoo! have hit a rough patch in the past three months.
Search slump: Shares of Google and Yahoo! have hit a rough patch in the past three months.

NEW YORK (CNN/Money) - Search engine leaders Yahoo! and Google find themselves in a bit of an unusual position as they get ready to report first quarter earnings later this week: underachievers.

Despite expectations for robust earnings and sales growth thanks to the continued strength in online advertising, shares of Google (Research) and Yahoo! (Research) are down 7.5 percent and 12 percent respectively in the past three months.

Weakness in the overall tech sector has hurt the companies, as well as concerns about the effect that increased competition in online advertising could have on profits.

Google and Yahoo! have been engaged in a fierce battle for Internet users during the past year. When Google launched a free e-mail service with more storage space than most of the competition, Yahoo! quickly countered by increasing storage for its own free e-mail service.

The two companies have also introduced various competing services in the areas of comparison shopping, blogging and local search. In addition, both firms also have to contend with a third major player in the online world: Microsoft (Research) has stepped up its efforts lately with a new version of its MSN search engine.

Finally, some analysts have expressed concerns that keyword pricing for Web searches are starting to come down, which could put pressure on margins.

Investors find reasonable expectations

But because of these doubts, shares of Yahoo!, which will release its first quarter results on Tuesday, and Google, set to report its numbers Thursday, might have a better chance of giving Wall Street a pleasant surprise. That's because expectations don't appear to be as high for these two as they have been in the past.

"Sentiment going into the numbers is muted to mixed on both Yahoo! and Google. Just look at what's happened with the stock prices," said Mark Mahaney, an analyst with American Technology Research. "So for the stocks to trade up, you need a clean beat and my sense is that you will get it with both companies."

For Yahoo!, analysts are expecting earnings of 11 cents per share, up 57 percent from a year ago. Sales, excluding the advertising revenues that the company shares with partners (known as traffic acquisition costs or TAC), are expected to surge 45 percent to $795.5 million.

Google's quarter should be even better. Consensus estimates call for a 74 percent surge in earnings (excluding expenses for equity compensation and other charges) to 93 cents per share. And revenues, excluding TAC, should increase 92 percent, to $729.8 million.

But Martin Pyykkonen, an analyst with Janco Partners, said that estimates for the first quarter are in line with reality. What's more, he said that second quarter projections also appear to be rational.

Analysts currently expect a 5 percent sequential sales increase in revenues, excluding TAC, to $767.3 million for Google and a 6 percent bump in sales from the first quarter for Yahoo!, to $842.3 million.

Fears of a slowdown overdone?

And even though there are some concerns about soft online ad pricing, Pyykkonen said any weakness should be outweighed by the fact that search activity is increasing.

"It's really volume driven. There are more and more search queries so growth should continue on the ad front," Pyykkonen said.

Another analyst thinks that investors overreacted to reports of lower keyword prices earlier this year, saying that there usually is a bit of a slowdown in January, following a period of heavy advertising leading up to the holidays.

"There was some early quarter seasonal softness that may have been interpreted as a fundamental change in the appetite for online advertising," said Derek Brown, an analyst with Pacific Growth Equities. "But the question isn't how does pricing change week to week, but what is the broader demand over an extended period of time."

Of course, both stocks are still pricey, which is a concern. Google trades at 47 times 2005 earnings estimates while Yahoo! has a P/E of 62.

And because of these heady valuations, both stocks do risk getting sold off if they miss numbers or if Yahoo!'s guidance is uninspiring. Google does not give guidance to Wall Street about sales or earnings so investors will closely scrutinize any second quarter forecast from Yahoo!

"The stocks are not cheap, so any hiccup could hurt," Pyykkonen said.

Still, Brown said he sees little chance that the companies will disappoint Wall Street.

"Both Yahoo! and Google will discuss very favorable trends in the first quarter with a continuation of the online migration of ad dollars. We saw no discernible change in ad behavior during the first quarter," said Brown.

And Mahaney argues that the stocks deserve these multiples because long-term earnings growth is expected to drastically outpace the market. Analysts are predicting an annual growth rate of 30 percent a year over the next five years for both companies.

For a look at more Internet stocks, click here.

For a rundown of key earnings news, click here.

Analysts quoted in this story do not own shares of the companies mentioned and their firms have no investment banking relationships with the companies.  Top of page

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