Why Yahoo can’t afford to disappoint by Yi-Wyn Yen @FortuneMagazine April 22, 2008, 11:11 AM EDT E-mail Tweet Facebook Google Plus Linkedin Share icons By Yi-Wyn Yen Is Yahoo bluffing? Wall Street, which has spent weeks trying to read CEO Jerry Yang’s poker face, will finally get an answer when Yahoo YHOO shows its cards and reports earnings after the closing bell Tuesday. Expectations are high as Yahoo, Microsoft’s No. 1 takeover target, attempts to convince investors that it’s worth more than Microsoft MSFT is currently willing to pay. Yahoo has until Saturday to accept Microsoft’s $43 billion offer, which values the stock at slightly less than $30 per share, before Microsoft begins a hostile takeover. The Redmond, Wash. software giant will report its own numbers Thursday. In this high-stakes game, Yahoo can’t afford to disappoint. Some analysts say that truly terribly first-quarter earnings are unlikely; Yahoo has been talking up this quarter in an investor roadshow. Besides, for the past three months it’s steadily rebuffed Microsoft’s advances. If Yahoo were having serious problems, its board would likely have quickly accepted Microsoft’s original cash-and-stock offer, which was valued at $31 a share when it was made on Jan. 31. “If Yahoo! management does not have a reasonably good quarter’s performance in the bag at this point, even announcing a deal with Google at the last minute is unlikely to stave off investor pressure to close the Microsoft deal,” wrote Jeffrey Lindsay, an analyst with Bernstein Research, in a recent note to investors. In fact, any sign from the tarnished Internet portal that it’s doing better than expected should bolster its bargaining position. That shouldn’t be that difficult considering that Yahoo executives set such a low bar after its last quarterly earnings, forecasting revenue (excluding money the company shares with advertising partners) of between $1.28-1.38 billion. Analysts polled by Thomson Financial expect Yahoo to report first-quarter net revenues that are in line with their estimates of $1.33 billion and modest earnings of 9 cents per share. Other analysts have become more bullish on Yahoo in the wake of Google’s strong showing last week. Google’s paid-search profits rose 30% last quarter, a sign that could indicate that more ad dollars will continue to shift online. “GOOG has been seeing relatively higher growth from big advertisers. This means YHOO, which tends to have deeper relationships with big advertisers, should see continuation of growth reacceleration in its [owned and operated] display ad,” said Sandeep Aggarwal, a Collins Stewart analyst, in a note to clients. Though economists have argued that display advertising, which is the way that big brands prefer to spend their online ad dollars, is vulnerable in a recession, some industry watchers aren’t convinced. Digital ad spending in the United States, which includes display — or banner — advertising, is expected to rise 23% to $26 billion, according to research firm eMarketer. During Yahoo’s last earnings call, Yang promised that display advertising would grow by the second half of the year. Last year Yahoo bought ad exchange Right Media to compete with Google’s DoubleClick and ad network Blue Lithium to help sell its unsold ad inventory. The company also reorganized its sales team to refocus on display advertising, the company’s core business. “For an extended period of time last year, Yahoo had an unhealthy focus on their search business,” says Jeff Lanctot, the senior vice president of media for Microsoft’s online ad agency, Avenue A/Razorfish. “Their focus on returning to the display business has been noticeable this quarter.” Microsoft CEO Steve Ballmer will be watching closely on Tuesday to see if that paid off. In a letter to Yahoo shareholders, Ballmer cited economic conditions that have “weakened considerably” and suggested that Yahoo’s market share had fallen. Yahoo’s stock has traded 51% higher on average than when it last traded at $19.18 prior to Microsoft’s offer. Strong quarterly results could put pressure on Ballmer to raise his bid. “It was pretty clear that Microsoft was betting on Yahoo having a lousy quarter so it wouldn’t have to negotiate,” says Martin Pyykkonen, an analyst with Global Crown Capital. “Yahoo isn’t going to win or lose this hand, but Microsoft got a little aggressive.” Some analysts are expecting Microsoft to up the ante to $34-35 a share to close the deal. Microsoft has admitted that it cannot catch up with Google GOOG in the online ad space without Yahoo. Google owns a 59% share of the U.S. search market, while Yahoo and Microsoft’s MSN combined would command 30% of the market, according to Nielsen Online. Now, Microsoft must contend with a possible scenario in which Yahoo teams up with AOL, which is owned by Fortune’s parent company Time Warner TWX . Yahoo is also running Google’s search advertising in a limited test run that ends Wednesday. Will Microsoft raise its bid? Will Yahoo sit pat and trigger a proxy fight? The cards that Yahoo shows Tuesday afternoon could determine how this game plays out.