The Yahoo Firewall?

Everyone knows that Yahoo is the leading Web portal, but many Internet investors this week are hoping the company enters the firewall business.

After Tuesday’s market close, Yahoo will release its much-awaited third quarter earnings report. How well YHOO does, especially against expectations, and how the market responds may go a long way toward determining the direction ‘Net tickers will take this fall and beyond.

So far that direction has been due south, as a spate of Q3 earnings warnings has further shaken investor confidence in Internet stocks.

Long regarded as a blue-chip Internet company, Yahoo is profitable and routinely beats street estimates for revenue and earnings. Consensus expectations for Q3 are earnings of 12 cents per share and revenue of $281 million, with upper sales estimates reaching $285 million.

But legitimate market concerns about declining online advertising spending by battered ‘Net companies is fueling fears that portals such as Yahoo, heavily dependent on such ads for revenue, will seriously hamper growth and threaten profitability.

Yahoo has been aggressively trying to broaden its revenue base. On Monday, for example, the company announced it would build customized portals for four corporate clients, each of which will pay YHOO a license fee and yearly maintenance costs. But advertising still comprises 80% of the portal leader’s revenue.

Clearly this leaves Yahoo vulnerable to softness in the Internet advertising market. If that weakness shows up in the numbers, it could have a disastrous effect on YHOO shares and ‘Net stocks in general.

Right now, Yahoo is pricey compared to other leading ‘Net companies. With a market capitalization of $47 billion, it is trading at 55x trailing 12 months’ revenue of $854.7 million. Among the top ‘Net revenue generators, only chipmaker Broadcom is a more expensive stock.

However, should Yahoo meet Q3 revenue forecasts, its valuation, based on the $47 billion market cap, will drop to 48x TTM revenue. That’s exactly half the valuation YHOO had one year ago.

Judging by Monday’s trading results, in which Yahoo rose 3% from its 52-week low closing price of $81.25, investors appear optimistic that Yahoo will deliver the goods later Tuesday.

If YHOO’s numbers shatter estimates, shares should rise and could possibly halt, or at least slow down, the freefall gripping ‘Net tickers.

If Yahoo’s Q3 results fail to meet the bar set by Wall Streetwell, let’s just say that won’t be a good thing, unless you’re into short-selling.

What I think is most likely is Yahoo’s Q3 numbers will meet, and perhaps slightly exceed, forecasts. That won’t do much for the market, and also could push down Yahoo shares even further, as happened after the company’s Q1 report came out in April.

Should that scenario play out, it might be time for those (like myself) who have considered Yahoo to be too expensive over the past year to take a hard look at this Internet blue chip.

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