Today's Most Hated Internet Stock -- and Why You Should Consider Owning it

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Capitulation . That's an often-used word on Wall Street to describe when investors completely give up and throw in the towel. It's not always a bad thing: Some investors love to find situations where a stock has been so crushed that shares are taking a final beating as the last remaining bulls exit a stock.

And that's what happening with Yahoo! (Nasdaq: YHOO) on Wednesday. Shares are off nearly -10% after another dismal earnings report, briefly touching lows not seen since 2003 (with the exception of the early 2009 market swoon).

Yahoo is surely having a tough go of it. Sales hardly budged in 2008, fell -10% in 2009, and are only barely growing in the first half of 2010, even as rivals are starting to benefit from an improving economy.  That's why Google (Nasdaq: GOOG) is worth more than eight times Yahoo.

And even though Yahoo's top-line results disappointed, it's worth noting that +2% year-over-year sales growth marks the fifth straight quarter of improvements. (Yahoo's sales had been falling at a double-digit clip last summer).

Despite those woes, investors should also take note of the positives. For example, the company has figured out ways to lower its costs to provide content to users, pushing operating margins up more than 200 basis points in the most recent quarter to around 11%. And that allowed operating income to more than double and net earnings to grow +53% from a year ago.

Management sees further gains ahead. Operating margins could approach 15% by 2012, and 20% by 2013, according to management targets. Yahoo may not be a great sales growth story, but it's shaping up to be an excellent profit growth story. Profits should rise at least +20% this year, and if some progress is made on that operating margin target, profits should rise another +20% in 2011 and 2012 -- even if sales growth is flat.

And Yahoo's cash pile remains hefty at a recent $3.8 billion ($2.71 a share), which is, as you might guess, going toward stock buybacks. The company bought $385 million in stock in the first quarter, $496 million in the second quarter. And the company's board authorized a fresh $3 billion stock buyback plan at the end of June. If completed, that would reduce the share count by -15%, boosting earnings per share by a commensurate amount. Any margin expansion would only extend profit gains.

Most important, Yahoo's search engine remains relevant. The number of searches conducted rose +7% from a year ago. And as long as Yahoo remains as a key player in the search field, it always has a shot at regaining luster against Google if it can tweak its site for improved results or enhanced features. In effect, don't count Yahoo out, even though its share price tells you that you should.   

Action to Take --> As Yahoo's profits rise and its stock sinks, the company's price-to-earnings ratio (P/E) gets smaller and smaller. If you exclude the company's cash balance, then shares trade for around 11 times potential 2012 profits of $1 a share. Again, that forecast assumes zero revenue growth. But economists still think that the economy will eventually be back on the mend. Which is always a good thing for advertising-related businesses like Yahoo.

Realistically, Yahoo would be of greatest value to another technology giant. We won't re-hash the value of a potential link up with the likes of Microsoft (Nasdaq: MSFT) , as that ship has sailed (and sailed and sailed). At some point, Yahoo's board will realize that its growth opportunities can be better exploited in the hands of another player.

For now, the company must simply keep expanding profit margins, keep buying back stock, and keep tinkering with its content strategy. That approach isn't finding favor with investors right now, but this company is far healthier than the dismal stock price action indicates.


-- David Sterman

David Sterman has worked as an investment analyst for nearly two decades. He started his career in equity research at Smith Barney, culminating in a position as Senior Analyst covering European banks. David has also served as Director of Research at Individual Investor and has made numerous media appearances over the years, primarily on CNBC and Bloomberg TV. David has a master's degree in management from Georgia Tech. Read More...

Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.

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This article appears in: Investing , Investing Ideas

Referenced Stocks: GOOG , MSFT , YHOO

David Sterman

David Sterman

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