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Will Microsoft Yahoo?
Microsoft's search moves could hurt the Internet giant, despite what should be a great 3Q report.
October 8, 2003: 5:57 AM EDT
By Paul R. La Monica, CNN/Money Senior Writer

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NEW YORK (CNN/Money) - Yahoo! will likely post third quarter results on Wednesday that would make most tech CEOs yodel out of sheer joy.

The Internet media giant is expected to report an earnings increase of 80 percent from a year ago and sales growth of nearly 36 percent. But will that be enough?

Yahoo! reported an earnings increase of 137 percent in its second quarter but the stock fell nearly 8 percent on the news. Why? The company merely met Wall Street's consensus estimate.

Investors tend to play the buy on the rumor and sell on the news game with Yahoo! To wit, the stock ran up 8 percent in the first few days of July leading up to the second quarter report.

And guess what? In the first four trading days of October, Yahoo! (YHOO: Research, Estimates) has surged more than 12 percent.

So unless Yahoo! smashes third quarter earnings estimates of 9 cents a share and sales projections of $338 million, a similar pullback is possible Thursday. Investors will be also hoping to see Yahoo! raise guidance for the fourth quarter and perhaps for 2004 as well.

Along those lines, the most crucial piece of information for long-term Yahoo! fans will be what the company has to say about the dynamics of the lucrative sponsored search business, which gives advertisers the ability to have their ads tied to specific keywords.

Despite moves to bolster fee-based businesses such as personals, games and other premium services like a DSL offering that is co-branded with Baby Bell SBC Communications, Yahoo! is still highly dependent on advertising for the bulk of its sales and earnings. Ad sales accounted for 68 percent of the company's total revenue in the second quarter.

Rumbling in Redmond

Investors have reason to be concerned about Yahoo!'s future growth prospects in this business. On Monday after the closing bell, search company LookSmart announced that its biggest customer -- Microsoft's MSN Internet -- would not renew its licensing agreement with LookSmart, which provided paid search listings to MSN.

Microsoft appears intent on building its own search capabilities and in doing so, there's the chance that it will eventually dump other partners as well. That could be bad news for Yahoo! since it is set to complete its deal for Overture Services, another sponsored search provider that lists Microsoft as one of its top two customers.

"MSN walking away outright from LookSmart creates some headline risk for Yahoo!," said Youssef Squali, an analyst with First Albany. He estimates that about a third of Overture's sales come from Microsoft. In addition, Microsoft is a customer of Inktomi, the search engine technology company that Yahoo! acquired earlier this year.

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So far Microsoft has made no mention of terminating its contracts with either Inktomi or Overture but that might only be because Microsoft is not ready to launch its own full-fledged search product just yet.

Mark Zadell, an analyst with Blaylock & Partners, said it's no secret that Microsoft is planning on building search capabilities into its next version of the Windows operating system, currently code named Longhorn.

Longhorn isn't expected to hit the market until late 2004 and at that point, Yahoo! might find itself losing a valued customer and gaining a significant competitor at the same time. "Ultimately it wouldn't surprise me if Microsoft's search business had nothing to do with Yahoo!" said Zadell.

Due for a pullback

Now don't get me wrong. Nobody is predicting that Microsoft's entry into the search market will relegate Yahoo! to the Internet dust bin alongside Netscape. But it has led some to wonder whether Yahoo! is worth its current valuation of 80 times 2004 earnings estimates.

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By Paul R. La Monica

Squali has a "Neutral" rating on Yahoo! and added that the company would need to raise earnings targets for 2004 substantially to justify the current price. He thinks that is unlikely given the integration issues that Yahoo! will have to deal with regarding Overture.

And Zadell, who has a "Hold" rating on the stock, said that the Microsoft issue raises "question marks that will persist for awhile."

Investors supposedly hate uncertainty. Yahoo! appears to have a fair share of it.

Analysts quoted in this story do not own shares of Yahoo! and their firms have no investment banking relationship with the company.


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Most stock quote data provided by BATS. Market indices are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer. Morningstar: © 2018 Morningstar, Inc. All Rights Reserved. Factset: FactSet Research Systems Inc. 2018. All rights reserved. Chicago Mercantile Association: Certain market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. Dow Jones: The Dow Jones branded indices are proprietary to and are calculated, distributed and marketed by DJI Opco, a subsidiary of S&P Dow Jones Indices LLC and have been licensed for use to S&P Opco, LLC and CNN. Standard & Poor's and S&P are registered trademarks of Standard & Poor's Financial Services LLC and Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC. All content of the Dow Jones branded indices © S&P Dow Jones Indices LLC 2018 and/or its affiliates.