Will Panama Plug Leaks at Yahoo!?

Unfortunately, Yahoo! (Nasdaq: YHOO  ) can't beat Google (Nasdaq: GOOG  ) at its own game. The search-engine pioneer came up short in last night's first-quarter report, missing bottom- and top-line analyst targets.

Yahoo! was able to grow its revenue before traffic acquisition costs by 9% to $1.18 billion. However, a 16% dip in operating profits ultimately led to earnings of just $0.10 a share, a penny below last year's showing. Wall Street was expecting $0.11 a share in net income on $1.21 billion.

There was improvement in several areas, but let's highlight a few items:

  • Free cash flow was up 8%.
  • Gross profit inched 5% higher.
  • Marketing revenue and fees revenue were up 6% and 9%, respectively.
  • Non-GAAP profitability clocked in at $0.17 per share, a 6% gain.

They are steps in the right direction, but Yahoo! is supposed to be a big, fat, sweaty growth stock. Anemic, single-digit percentage baby steps aren't going to woo investors. Even if you back out the company's stake in Yahoo! Japan, the stock is trading at too rich a multiple for this type of uninspiring performance.

It's a hat, it's a Van Halen song, it's a work in progress
Shareholders have been willing to give Yahoo! the benefit of the doubt, in part because of recent improvements to its paid search product. Project Panama, hyped as a way for Yahoo! to close the gap with faster growing Google, rolled out earlier this year after several months of delays.

Instead of Yahoo!'s original bid-for-placement system, where the highest-paying bidder for a specific keyword got top placement on search engine result pages, Panama follows Google's lead by adjusting priorities based on ad quality.

It's just common sense. If an ambulance-chasing attorney places a $0.50-per-click ad under "chocolate chip muffins," the text ad won't be very popular. When's the last time that you slipped on a muffin and fell? Really? Oh, it was a blueberry muffin? Big difference, my friend. We're talking chocolate chip here.

But let's get back to the muffin man. If a $0.20-per-click ad for muffin recipes gets clicked on five times as much as the lawyer ad, it's actually twice as lucrative for Yahoo! if it gets better placement. Why? Because Yahoo! gets paid mostly on clickthroughs for its contextual marketing service. It also makes for a less jarring cybersurfing experience to see relevant ads alongside search and content pages.

It may be wrong to pin too much hope on a search enhancement that has been gradually phased in, but Yahoo!'s investors have been hungry for too long. After posting lower profits in four of the past five quarters, Panama was supposed to be a feast. Instead, it was a Happy Meal bag with a hole in the bottom.

Plan B for Yahoo!
The next few quarters will reveal if Panama is a dud or not. Unfortunately, impatient shareholders may not give Yahoo! the luxury of more time. CEO Terry Semel's necktie is feeling more like a noose.

Panama may not be the problem. Yahoo!'s ad inventory may be the real troublemaker here. If Google has a broader, superior roster of sponsors, Yahoo! is really just trying new ways to milk an inferior cow.

If so, the solution is to make it up in volume. Yahoo! needs to win over more traffic and a fatter Rolodex. Here are a few potential acquisition targets that would expand the company's billable ad space while broadening its list of advertisers.

  • CNET (Nasdaq: CNET  ) -- Yahoo! has been a rumored suitor of CNET for years. It has even moved into areas like consumer tech and food in which CNET has a dominant position. With its broad portfolio of Web properties, CNET draws 85 million daily page views, ultimately attracting 136 million unique monthly visitors.
  • Marchex (Nasdaq: MCHX  ) -- With roughly 200,000 domains under its belt, Marchex is just starting to cash in on its valuable real estate. Between the 75,000 ZIP Codes and valuable addresses like resorts.org and debts.com, Marchex is embarking on a monetization strategy, but Yahoo! has the tools to populate a site with content even quicker thanks to its ads, Yahoo! Answer, and Flickr offerings.
  • National CineMedia (Nasdaq: NCMI  ) -- Yahoo!'s rivals are moving beyond online ads, acquiring stakes in marketers that sell spots for radio time and within video games. Let's get Yahoo! into the movies. National CineMedia recently went public. The company provides a popular service that delivers in-theater ads digitally. Big G or Mr. Softy will find their way here eventually so now is the time to snap up a market leader.
  • Facebook -- Negotiations for the popular coed social networking site has been running hot and cold for some time. A traffic-hungry Yahoo! isn't in a very good bargaining position, but letting Facebook go to someone else may send a negative signal to Wall Street.
  • The Knot (Nasdaq: KNOT  ) -- It's hard to beat the allure of the best branded wedding planning site. Sure, you have a short window of time with a visitor -- no one subscribes to Bride -- but you are getting them at a vulnerable moment, ready to spend a ton of money on the perfect wedding. Yahoo! could use a class act like The Knot, and the online registry business offers even more untapped potential.
  • ValueClick (Nasdaq: VCLK  ) -- If Google gets DoubleClick, ValueClick could be the next online advertiser down the aisle. It would be a good catch. ValueClick is growing quickly and its strengths in multimedia ads and affiliate marketing are areas where Google will get even stronger if it seals the $3.1 billion deal for DoubleClick.

Yahoo! shouldn't rush off and burn through its greenbacks if the asking prices aren't fair, but I would be shocked if Yahoo! didn't have a big deal or two to announce later this year. Now that Yahoo! has the Panama stamp on its passport, investors want to travel somewhere else with a better view. 

Yahoo! is a Stock Advisor recommendation. The Knot and CNET Networks are Rule Breakers newsletter service recommendations. If you can't join Yahoo! on its likely buying spree, save your money by going for a free 30-day trial subscription to either stock research service.  

Longtime Fool contributor Rick Munarriz has been to Panama before. He didn't buy a hat or a Van Halen CD there, but he did purchase an Indian-made mola. He does not own shares in any of the companies in this story. He is also part of the Rule Breakers newsletter research team, seeking out tomorrow's ultimate growth stocks a day early. The Fool has a disclosure policy.


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