Everyone has their own take on the state of online advertising, but I never saw it getting this bad for Yahoo! (Nasdaq: YHOO). Wednesday's announcement of a catastrophic profit warning and the loss of CEO Tim Koogle came as a shock to us here at Rule Maker Central. This just goes to show that even the investments we're most confident in can sometimes go sour. It's all part of the risk (and potential reward) of running a focused portfolio, as we do here with the Rule Maker.

The popped dot-com bubble has now collided with a slowing overall economy. The result is a truly dreadful environment for Yahoo!'s advertising business. First-quarter revenues will be only $170 million to $180 million, fully 25% below its already reduced guidance. To put this into perspective, consider that Q1 revenues are likely to come in at levels not seen since the second half of 1999. With one small difference: Yahoo! was solidly profitable back in 1999, whereas now with an expanded level of staff and overhead, the company expects to only break even for both the current quarter and all of 2001.

A profit warning of this magnitude is bad enough, but it's especially disturbing in light of Tim Koogle's sudden evacuation of the chief executive suite (although he will remain chairman of the board). This marks the loss of a great manager and leader. Since May 1995, Koogle built Yahoo! from its pre-IPO, no-business-plan days to become a consistently profitable Internet leader.

As I've followed Yahoo!'s progress for the past two years, listening to every quarterly conference call since Q1 '99, I've always admired Koogle's unwavering vision for the company -- to build Yahoo! into the only place in the world that anyone would have to go to find or get connected to anything or anybody. Koogle often quipped that his goal was for Yahoo! to become increasingly interwoven into people's lives.

And Koogle has most certainly executed upon his vision of creating an addictive service. Yahoo! now has 185 million unique users, of which 60 million are "active registered users," defined as anyone who logs into one or more of Yahoo!'s registered services at least once a month. A recent Salomon Smith Barney report helps put these numbers into perspective:

Yahoo!'s core active registered user base is about the same size as the newspaper industry's total daily circulation (and newspapers generate $40B+ in ad revenue/year). Yahoo!'s global user base is roughly twice the size of the U.S. cellular telephone industry (again, $40B+ in annual revenue). Yahoo! reaches more people in a month than do the top 10 magazines in the United States (more than $5B in annual sales).

And the numbers continue to grow strongly. In Wednesday's conference call, COO Jeff Mallett reported that global page view consumption has increased by 10% since December. That news hardly takes the sting out of the current profit slump, but there's a definite silver lining here. The growing consumer addiction to Yahoo!'s services represents real option value for the company that will someday be monetized -- somehow, some way.

The jury's out on whether the bulk of this monetization will happen directly through premium consumer services or indirectly through advertising. I tend to think the indirect strategy holds the most potential. The strategy of addicting users with an ever-expanding array of free consumer services was all part of Koogle's original master plan to indirectly monetize Yahoo!'s huge audience.

But Yahoo! is actively exploring the direct monetization route as well. In Wednesday's conference call, the company reiterated its intention of rolling out premium consumer services at some point in the near future. Jeff Mallett knows that, on average, when a user signs up for 2.8 of Yahoo!'s services, that user is an addict. As Mallett and his team watch the numbers, they will know when it's the optimal time to transition some of the business to a direct monetization model. 

Consider the possibilities: If Yahoo! were able to charge $5 a month for a bundle of its services -- say, My Yahoo!, Yahoo! Finance, and Yahoo! Mail -- that could instantaneously create $360 million in annual operating profit (assuming that 10% of the 60 million active registered users sign up). I, for one, would pay in a heartbeat. (Would you? Please let us know in this quick poll.) But again, I think most of Yahoo!'s opportunity will continue to be tied to its advertising services.

Granted, Internet advertising in its current form is pretty much dead. But -- but -- I do think the online medium's advertising potential lives on. My premise today is that Internet advertising offers too much profit potential for it not to eventually be successful. The fact is that consumers are gradually spending more and more time on the Internet, and that comes at the expense of other media such as TV and newspapers. Eventually, the marketing dollars will follow the eyeballs -- as Koogle has always said.

One recent step in the right direction has been the reform of Internet advertising standards. On Feb. 26, the Internet Advertising Bureau (IAB) released a new set of online advertising guidelines, including five designs -- all of which are, most notably, larger in size. For example, you may have already seen some of the "skyscraper" vertical tiles on the right side of the page here on the Fool site. Another example is over on CNET, where they have their large rectangular "messaging units."

These larger formats are much more eye-catching and allow marketers the space to be creative with their message. I have no doubt that technical and creative innovation will continue to improve the effectiveness of Internet advertising. The profit potential of the online medium is just too large for these innovations not to happen -- eventually.

So, with our sights set at least five years into the future, we in the Rule Maker Portfolio will continue to hold our Yahoo! shares. Investors with a shorter time horizon may wind up disappointed. I don't expect a near-term turnaround, and the stock could drop another 25% from current levels upon any worsening news. That's a reality we're willing to live with -- and that we must live with as stock market investors. We're holding on for what most of us on the Rule Maker team believe will be a bright future for this young company. With $1.7 billion in the bank, a world-class brand, an immense global user base, and sophisticated capabilities in its marketing services, Yahoo! has the pieces in place to grow into a large and very profitable global consumer business.

[For another Foolish take on Yahoo!, check out today's Fool on the Hill article, "Yahoo! and the Limits of Fundamentals."]

Matt Richey is co-manager of the Rule Maker Portfolio. He holds shares of Yahoo!, and has held shares of Yahoo! through most of the ups and downs of the past two years. He also holds shares of eBay and really wishes Yahoo! had bought out eBay this past summer. What a beautiful acquisition that could've been. (Matt specializes in hindsight.) The Motley Fool is investors writing for investors.