Tech Investing July 21, 2009, 9:00PM EST

Yahoo: Too Early to Call a Turnaround

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"An O.K. Quarter"

Yet investors are clearly disappointed that Yahoo still doesn't see light at the end of the tunnel. Investors have driven up Yahoo shares about 30% since the start of the year. But Wall Street had hoped for better operating earnings, which fell 25% from a year ago, to $101 million, below analysts' forecasts. "It is an O.K. quarter," says Sandeep Aggarwal, an analyst with financial services firm Collins Stewart (CLST.L). "But in the changing landscape of display ads, Yahoo has been lagging a bit."

Revenues from display (pictorial and video) ads on Yahoo's own sites—the company's core business—dropped 14% from a year ago, a little worse sequentially than a 13% drop in the first quarter. Marketers have been heavily cutting back on their buying of display ads used for branding in favor of more direct-response advertising such as textual search ads. "The display market is very soft right now," says David Hallerman, senior analyst with market researcher eMarketer, which forecasts a 5% drop in banner ads this year, to $4.7 billion. "A lot of the money that's been going into display has been in three main areas hit hard by the downturn: financial services, retail, and automotive," he says.

In addition, Yahoo's search ad revenues fell 15%, far worse than Google's 3% growth in its second quarter. Yahoo has continued to lose ground in search to leader Google, whose 65% share of search queries dominates the field. At the same time, Microsoft's Bing search engine has garnered generally positive reviews and eked out a small market-share gain, likely at Yahoo's expense.

Dropping Downscale Ads

Making matters worse, Yahoo's third-quarter forecast was less than what investors had hoped for. One reason is that Yahoo plans to revamp the type of advertising it runs on its site. "It's no secret that many of our users are put off by a few irritating ads" that run over and over, Bartz said. Cutting out those ads, often pushing mortgages or weight loss aids, will cost Yahoo about $75 million in the third quarter. But Bartz hopes the eventual result will be better ads that more people will view or click on more often.

Another reason for the disappointing outlook is that Yahoo now has started hiring again after a series of layoffs in the past year. Two-thirds of those new hires are in engineering and product development, with others in marketing and sales. Bartz said she hopes that will help Yahoo double-down on successful services such as Yahoo Mail and the photo-sharing site Flickr.

Some observers give Bartz credit for streamlining Yahoo's management and trying to focus its many services. On July 21, for instance, Yahoo unveiled a new home page that it says is simpler for users. But on the advertising front, some say Yahoo has further to go to make buying ads easier across the company's online properties. "Yahoo still has a lot of work ahead of it with regard to search and display integration," says Kevin Lee, CEO of digital marketing firm Didit.

The Specter of Microsoft

Looming over the earnings results is whether Yahoo will finally do a deal with Microsoft. Yahoo executives declined to address the issue, partly because no analysts asked about the talks during the conference call. "We're focused on running our business," Morse told BusinessWeek in response to a question on the impact of Microsoft deal speculation.

Analysts are wary of predicting whether a Microsoft-Yahoo deal will happen. But many say it's something both companies need if they're to have any hope of competing with Google on the Internet. "Yahoo needs the money," says eMarketer's Hallerman. "But Microsoft would benefit more from the deal." Microsoft's $100 million Bing marketing campaign "proves how much help Microsoft needs for its search efforts," he says.

For now, Yahoo's fate hangs on its own efforts, which clearly will take some time to show results.

Hof is BusinessWeek's Silicon Valley bureau chief.