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Tickers in this Article: YHOO, GOOG, MSFT, TWX, MER
If you are a shareholder of Yahoo Inc. (YHOO) or an avid follower of the Internet Software & Services space you probably saw the recent downgrade made by Merrill Lynch (MER) analyst Lauren Fine. Lauren downgraded the company from a buy to neutral in a recent note to clients. The major factors contributing to the downgrade included the company's current valuation and its shrinking share of the internet search market as competition starts to heat up.

The downgrade sent shares lower by nearly 3% Wednesday and added to the frustrations of shareholders. In 2005, the company only managed to add 4% to their share price while its major rival Google (GOOG) added an astounding 115% over the same period. We will look at the reasons for the downgrade to gain a better understand if this relative lack of performance will continue for 2006.

Surprisingly, the reason for the downgrade had little to do with expected performance of the company for the next year. The overall consensus of the market is that the online ad revenue space will continue to boom as companies spend more of their marketing budget online.

Yahoo derives a large portion (88% of revenue in 2004) from advertisements on its sites. So this should be great news for Yahoo, right? Well, not exactly. The case being made in the downgrade is that this growth has already been priced into the shares of the company, so their is little upside potential for investors.

If we look at some basic valuation numbers we can get an idea if it is an argument to consider. The expected full-year earnings (released Jan. 17) is $0.60 per share (excluding one time capital gain in Q2 '05), placing the company's P/E at 70. The general expectations for full-year 2006 earnings are $0.73 per share, placing the company's forward P/E at 56. If the market holds the current P/E of 70 at the end of 2006, shares in the company would be priced at $52.50, which is about 25% higher than where it is today. This sounds great for investors, however the big assumption we made was that the market would still price the company at 70 times earning, which assumes that the market still feels as good about Yahoo's future as it does now.

This is where the second point of Lauren Fine's thesis comes in. She argues Yahoo is fully valued. While the industry prospects still remain bright, increased competition and maturation weigh on the future outlook for Yahoo. Again, this does not mean that Yahoo is a bad company, it just means that due to the industry landscape it will have tougher times ahead. Companies such as Microsoft (MSFT) and AOL (TWX) are all focused on gaining a bigger share of this lucrative market, in which more marketing money is being directed online.

Increased competition provides more options for companies looking to advertise online, leading to pricing pressure in the space and ultimately lowering margins. There are also more companies sharing the online ad revenue pie, Yahoo shareholders can only hope that the pie grows enough to compensate. All of this makes the earning growth prospects for Yahoo less compelling as they once were...unless the company brings on new streams of revenue.

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