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Searching for greatness
Investors have high hopes for Yahoo! and Google earnings. Are they unreasonably high?
October 14, 2005: 3:21 PM EDT
By Paul R. La Monica, CNN/Money senior writer
Searching for love: Shares of Yahoo! and Google have been hit by a summer slump due to 2Q results that didn't live up to lofty expectations.
Searching for love: Shares of Yahoo! and Google have been hit by a summer slump due to 2Q results that didn't live up to lofty expectations.

NEW YORK (CNN/Money) Let's get the blatantly obvious out of the way.

Yahoo! and Google, both due to report their third-quarter earnings soon, are going to post spectacular numbers, results that are the envy of most companies in the tech sector.

Thanks to booming demand for Internet search advertising, Yahoo! (Research) is expected to report sales, excluding ad revenues shared with partners known as traffic acquisition costs (TAC), of $918 million, up 40 percent from last year. And analysts are forecasting an earnings increase of 56 percent from a year ago, to 14 cents a share.

For Google (Research), the numbers should be even better. Analysts predict that sales, excluding TAC, will surge 87 percent from a year ago to $940 million. And earnings excluding the cost of stock compensation and other charges are expected to nearly double, to $1.37 a share.

Summer sluggishness?

But will mere greatness be enough when everyone's expecting flawlessness? Both companies disappointed investors when they reported second-quarter results in July, even though they posted blockbuster results, and the stocks have yet to recover. Some fear a repeat scenario.

"I think there's more room for disappointment than upside with both companies. And any disappointment could lead to volatility," said Philip Remek, an analyst with Guzman & Co., a Miami-based investment bank.

With that in mind, unless the two companies report numbers that are much better than expected, investors could be in for a rerun of what happened in July. Although Yahoo! reported a 63 percent increase in per-share earnings excluding one-time items, profits merely matched expectations and the stock plunged 11 percent the day after the announcement.

And for Google, beating earnings estimates by a mere 12 percent apparently was not enough to satisfy Wall Street. The stock fell nearly 4 percent following the release of its second-quarter numbers.

"In this sector, valuation is not a factor as long as there's outperformance in the numbers. But when you have a quarter when you don't outperform, it becomes an issue," said Scott Devitt, an analyst with Legg Mason.

Analysts say it might be tough for either company to beat Wall Street's estimates since the third quarter, which covers the dog days of summer (at least in the northern Hemisphere), tend to be the weakest for Internet companies.

Devitt said that both companies should report "good, but not great" numbers considering how high expectations are.

Concerns about a bidding war for a stake in AOL could also weigh on the companies' shares in the near-term. People close to the situation told CNN/Money this week that Google is considering making a minority investment in AOL, and on Friday, reports surfaced that Yahoo! is also weighing a minority purchase in AOL.

Looking to the fourth quarter

Investors will also be looking for clues in Yahoo!'s and Google's earnings conference calls about how demand for online advertising is shaping up in the fourth quarter and perhaps 2006.

If history is any guide, Yahoo! should give an update about its fourth-quarter sales outlook when it reports its third-quarter numbers. Currently, analysts expect revenue excluding TAC of $1.06 billion and earnings of 17 cents a share.

Google, however, has tended in its short history as a public company to not be as forthcoming about its guidance. Analysts expect revenue of $1.1 billion and earnings of $1.59 a share for the quarter.

But Google has taken some steps to appease Wall Street lately, such as saying explicitly in a filing for its recent secondary offering that it expected its sales growth rate to decline over time and that its operating margins would come under pressure as well.

In addition, Google said recently that it would specifically report an earnings number that backs out the stock compensation costs and other charges that analysts exclude when devising their earnings estimates.

Moves like this have led to hopes that Google will be less cagey during its third-quarter conference call. And that is important because some think Google is a riskier bet than Yahoo! because there is less certainty about what Google has planned for the future.

Greg Gorbatenko, an analyst with Marquis Investment Research, an independent firm based in Chicago, said one problem he has with Google's stock, as opposed to Yahoo!'s, is that there are too many question marks about Google's strategy.

Recently, there has been speculation about Google looking to build a free wireless network for San Francisco, for example, in addition to the talk that the company is looking to team up with cable firm Comcast to buy a minority stake in AOL. Both AOL and CNN/Money are owned by Time Warner (Research).

"What exactly is Google trying to do? Are they buying fiber? Are they getting into voice? Do they want to be a media company, a telecom company or just a search company?" said Gorbatenko. "Google's technology has definitely changed the Internet but they may be prematurely thinking that they have the Midas touch and that anything they start working on is going to be successful."

Yahoo!, on the other hand, continues to make concrete efforts to lessen its reliance on advertising and bolster its fee-based businesses. The company launched an online music store in May and a co-branded digital subscriber line (DSL) broadband service with Verizon in August, for example.

For this reason, Gorbatenko said he thinks Yahoo! is a safer bet than Google.

Valuations may still be too steep

But that's all relative. Both stocks may be too much of a gamble to buy heading into the quarterly earnings reports. Even though the stocks have been sluggish performers the past three months, neither is exactly a value play, reflecting investors' heady confidence about this quarter and beyond.

Google trades at about 40 times consensus 2006 earnings estimates and Yahoo! has a P/E of 45. And Yahoo! is valued at nearly 10 times 2006 revenue projections while Google sports a price-to-sales ratio of 15.

By way of comparison, traditional media companies like Walt Disney (Research), News Corp. (Research) and Viacom (Research) trade at about 15 times next year's earnings estimates and less than 2 times projected sales.

"Both stocks are expensive on any traditional value measures," said Guzman's Remek.

Of course, the projected growth rates for "old" media companies are a lot lower than those of Yahoo! and Google.

But Devitt said that as long as investors' hopes for the two online giants are excessively high, the stocks are very risky. He thinks that expectations are getting closer to reality but are probably still too optimistic.

For a look at more Internet stocks, click here.

AOL is in vogue again. Find out why.

Analysts quoted in this story do not own shares of the companies mentioned and their firms have no investment banking ties to the companies.

The reporter of this story owns shares of Time Warner through his company's 401(k) plan.  Top of page

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