Analyzing Yahoo!’s Profit Warning

Two months ago I outlined a long Google/short Yahoo! paired trade as a way to play the possible p/e multiple convergence of the two leading Internet advertising companies. This week’s third quarter warning from Yahoo prompted an ugly sell-off in the name. Google shares were down for the day as well in sympathy, but it dropped far less than Yahoo!, which is exactly what the paired trade is supposed to capitalize on.

The question we have to answer now is, “What do we make of the Yahoo! shortfall?” There are two ways we can go here. One, the Yahoo! warning signals that the economy is slowing significantly and advertising clients are pulling back their ad budgets. This would hurt Google in the same way as Yahoo!. On the other hand, it could simply be that Yahoo! is becoming less and less relevant in the advertising space, and Google continues to steal market share.

Back in July when I first wrote about this trade I was in the latter camp. I remain there today. I think Yahoo! is getting beaten at the same game they once dominated. Google is dominant enough in domestic search that most of the market share gains have been made, but they still are doing better than Yahoo! on a relative basis.

This is not to say that a slowing economy would not hurt Google as well. When the day comes where we see dramatic ad budget cutbacks, it will be time to exit both stocks. I just don’t think we are seeing that yet. Last quarter we saw a bad quarter from Yahoo!, followed by a strong report from Google. That supported my thesis. This week we found out that Yahoo! again is having trouble. I think Google will post a solid third quarter, and as a result, I am keeping the paired trade on for now. When the online advertising market starts to suffer due to the business cycle beginning to turn over, then I’ll take the profit from the trade and move on to something else.

Full Disclosure: I have a position in the paired trade mentioned above, long shares of Google (GOOG) and short shares of Yahoo! (YHOO).