Yahoo! Inc. (YHOO) reported third quarter earnings that beat the Zacks Consensus Estimate by 6 cents. Revenue beat the consensus by 40.7%.

Google’s (GOOG) results also thrashed estimates last week, signaling a broad-based recovery as reflected in higher advertisement spending.

Revenue

Gross revenue of $1.57 billion was flat sequentially (up 0.2%) and down 11.8% year over year. The better-than-expected results were driven by a smaller negative impact of the ad quality initiatives announced in the second quarter and a stronger affiliate business than was originally anticipated.

The decline from the year-ago quarter indicates that although business seems to be improving, it is still at a significantly lower level than the pre-recession period.

Net Revenue

Excluding traffic acquisition cost (the portion of revenue shared with Yahoo’s partners), net revenue for the quarter was flattish sequentially (down 0.4%) and down 14.6% year over year. The U.S. accounted for 75% of net revenue.

Traffic acquisition cost (TAC) was up 1.7% sequentially, but down 3.7% from the year-ago period. The improvement from the year-ago period was due to a 14.6% decline in TAC for the international business. TAC in the U.S. increased 1.4% sequentially and 2.9% from the year-ago period.

However, TAC as a percentage of total advertising revenue was down 7 basis points (bps) for the U.S. business and up 7 bps for the international business. The percentage of TAC to gross revenue for the international business is roughly half that of the U.S. business.

Revenue by Product Line

Over 87% of quarterly revenue was derived from Marketing Services, while the balance was fees-based. Marketing Services revenue was flat sequentially, as the sequential improvements in the Display and Affiliate businesses were offset by declines in Search and Other businesses. The 11.9% decline from the year-ago quarter was broad-based.

Search generated 23% of total revenue (down 1.2% sequentially and 19.0% year over year), Display 25% (up 1.8% sequentially and down 8% year over year), Affiliate 33% (up 1.4% sequentially and down 6% year over year) and Other 6% (down 10.4% sequentially and 26.9% year over year).

Fees-based revenue was up 1.4% sequentially and down 11.6% from the year-ago quarter.

Operating Results

The pro forma gross margin for the quarter was 55.2%, up 30 bps from the previous quarter’s 54.9%. The gross margin on net revenue was up 87 bps sequentially and down 2 bps from the year-ago quarter. The improvement in gross margin is attributable to management’s refocus of the company’s business, which will be discussed at the Analyst Day next week.

Operating expenses of $636.7 million were higher than the previous quarter’s $608.2 million. The operating margin was 14.8%, down 145 bps from the 16.2% recorded in the previous quarter.

The increase was almost equally attributable to the higher sales & marketing, product development and general & administrative expenses (as a percentage of sales) that more than offset the higher gross margin. Operating profit as a percentage of net revenue was down 189 bps sequentially, but up 66 bps from the year-ago quarter.

Excluding the impact of restructuring charges, stock compensation expenses, amortization of intangible assets, a $98 million gain on the sale of interest in Alibaba.com and the associated tax impact, the pro forma net income was $237.6 million or 15.0% net income margin, compared to $229.7 million or 14.6% in the previous quarter and $254.1 million or 14.2% in the year-ago quarter.

Including the special items, the GAAP EPS was 13 cents compared to 10 cents in the June 2009 quarter and 4 cents in the September quarter of last year.

Balance Sheet

The company has a solid balance sheet, with cash and short-term investments of $3.9 billion, up $432.7 million in the last quarter. The company generated $355.1 million from operations in the last quarter and spent $99 million on capex, netting a free cash flow of around $256 million. It also spent $91 million on share repurchases at an average cost of $15 per share.

Guidance

Management expects fourth quarter revenue of $1.6-1.7 billion, operating cash flow of $400-450 million and GAAP operating income of $135-155 million. The tax rate is expected to be 26-27%. The company expects to spend $200 million on capex in the fourth quarter.
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