Yahoo!'s recent quarterly profit fell 18%, as the besieged Internet giant posted revenue growth at the low end of its expectations. But Wall Street has given the stock a pass so far in trading.

As usual, Wall Street doesn't do its homework. Yahoo! has a massive profit pothole in its results.

Yahoo!'s profit would have dropped more than 40% without gigantic non-cash, paper gains it gets to include in its quarterly numbers, boosting its bottom line, from an investment it owns in a Chinese e-commerce company.

I've warned you about this problem already ("Why Microsoft Should NOT Up its Bid for Yahoo!," see also "Why Yahoo! Can't Go it Alone," and "Why Carl Icahn May Fail at Yahoo!")

I've been trolling through the footnotes for Yahoo! (YHOO) and found other problem areas as well, other issues that Wall Street analysts have also overlooked.

Yahoo!'s paper gains matter because it has been in a fight for its life, a fight never before seen in the history of the company.

Microsoft wants Yahoo!'s search engine, as Google, the dominant force in search with three-quarters of the market share, has crushed the competition. Yahoo! only has about a third of Google's share, and Microsoft's own inhouse search engine is on life support. When Yahoo! punted on Microsoft's offer to buy it for a very rich $37 a share, billionaire activist investor Carl Icahn bought a stake in Yahoo! and threatened a proxy fight to dump Yahoo! chief executive Jerry Yang and the company's board.

Yahoo! called a truce with Icahn, giving him a seat on Yahoo!'s board as well as seats for two members of his slate (including a former AOL exec, a potential successor to Yang). Now Yang has to make the case at the upcoming August 1 shareholder meeting that Yahoo! should remain independent, and that it can enter into deals that will hike its stock price, now moribund at around $21, back up to the $37 a share level Microsoft initially offered. An Olympian task to be sure.

Yang told an analyst conference call on Tuesday that Yahoo! had been "looking at every alternative possible" including financial transactions to drive shareholder value.

Why he didn't do what Henny Youngman advised--nem di gelt, Yiddish for take the money when Microsoft offered $37 a share--is beyond me, given the flat tires in Yahoo!'s earnings.

Despite Yahoo!'s paper gains, the general consensus on its profit results, delivered after the close of regular trading, were that they were not as bad as some analysts feared.

The results were pretty bad on closer look. Yahoo! missed by 2 cents a share its recent quarterly consensus estimates of 11 cents, explaining that whiff on the fact that it had to pay 17% of its profit, or $22.3 mn, toward legal expenses to ward off a hostile takeover offer from Microsoft (MSFT). Revenue rose 5.9% to $1.8 bn. 

Yahoo!'s profit miss would have been worse without the paper gains. In the first half, it recorded $673 mn in profits vs $303 mn in the year ago period. More than doubling profits looks great, right?

Wrong. A whopping 75% of Yahoo!'s first half earnings, and a big 42% of its recent quarterly profit results, came from non-cash, paper gains from its investments, including $401 mn from its 39% equity stake in Alibaba.com, the Internet commerce company.

Without those colossal paper gains, Yahoo!'s profit results would have been in a ditch and its operating profits would have been deep into the red. It's a quality of earnings problem I've warned you about in prior blogs. US companies are allowed to book in their profits any paper investment gains they earn from investing in other businesses, according to US accounting rules.

You can see why Yahoo! desperately needed those non-cash paper gains. For the first half, Yahoo!'s operating expenses rose to $1.9 bn from $1.6 bn vs the year ago period. That's why operating income dropped to $221 mn from $354 mn in the same period a year ago.

Yahoo! bought its 39% stake in Alibaba.com in 2005. The deal gave Alibaba.com the right to buy back Yahoo!'s stake if the Internet giant were to be taken over, in order to preserve its management independence, according to a filing with the Securities and Exchange Commission.

The Chinese company had planned to exercise its right to buy back Yahoo!'s investment in its company if Microsoft bought Yahoo, reports indicate.

If  Microsoft successfully bought Yahoo!, and Alibaba.com then yanked back Yahoo!'s stake in it, Yahoo!'s profits would have seen a gigantic hole blown wide open in its profits.

So what. Anyone really think Alibaba would have bought back Yahoo!'s stake if Microsoft bought Yahoo!?  Anyone look at the perilous condition of Alibaba's own shaky profit results?

And here's what you also should be worried about. Yahoo has $11.7 bn in net worth, generally assets minus liabilities. That's up from $9.7 bn at the end of last year. Again, sounds ok right?

Wrong. More than a third of that sum, $4.7 bn, comes in the form of good will and intangible assets, the mushy stuff actuaries, auditors and accountants help Yahoo! to price tag on its own. These sums usually represent the future value of research projects, or things like the brains in an R&D operation and such.

What the heck is in those line items? The earnings release don't tell us, you'll have to wait for the full quarterly report it files in a month or so with the Securities and Exchange Commission.

I also want to remind you of this issue, whether Yahoo!'s board of directors had an incentive to kick Microsoft's subsequent $33 a share offer to the curb (a $33 a share offer made subsequent to its intial bid, see blog "The Real Reason Why Yahoo!'s Board Rejected Microsoft?").

Remember, Yahoo! bailed when Microsoft wouldn't meet its demand to increase its bid to $37 a share from $33, saying the offer undervalued Yahoo!

A shareholder class action lawsuit filed by the pension funds for Detroit policemen and firemen as well as its city workers against Yahoo! spells out not just what it calls a web of cushy interlocking relationships and rich pay for the board members, but what it says is the real reason why Yahoo!'s board rejected Microsoft's $33 a share offer to buy the Internet giant.

The suit alleges that 80% of the value of the director's compensation in fiscal 2006 and over 70% in fiscal 2007 came in the form of stock options that had strike prices either at or below the $33 a share bid, so the offer would hardly make them any money.

So, it remains to be seen whether Microsoft simply buys more than 33% of Yahoo! on the open market to seize control of the company's coveted search engine, leaving Yahoo! as a portal.

Yahoo! knows that operating alone as a portal without the search engine would really endanger the company. Yahoo! markets itself as you want to start your day with Yahoo!, given the various information offerings on its home page.

But I can just as easily start my day with a newspaper.

So where does that leave Yahoo!? Searching for alternatives that still leave it looking weak. For instance, any deal to hook up Yahoo! with Time Warner's AOL (TWX), as has been discussed, would be the equivalent of marrying a sewing machine with a typewriter.

Frazer Rice, one of the smarter Wall Street private bankers, has some shrewd insights on what Yahoo! investors can expect.

"Yang has yet to articulate where he wants to take the company, and his comments indicate a bit of a throwing things at the wall and hoping something sticks," says Rice, who has his own site, frazerrice.blogspot.com, check it out.

Rice notes that you can expect Icahn to "do what he does best, make short-term restructuring moves to cut bloat and increase efficiency," and then "move on to the next project. That is not the same as having a vision to drive the company into the next 25 years." Rice adds that neither Yang or Icahn "have a compelling long-term vision for the company at the moment." Unlike Apple, which makes risky "big bets" and succeeds "repeatedly," he says.

Yahoo!'s got $2.1 bn in cash and equivalents on the balance sheet, up from $1.5 bn in the December 2007 quarter. It'll need that increasing pile of dough to fight off Microsoft, Icahn's plans and shareholder lawsuits over purportedly bad decision making.