Yahoo Inc's third-quarter forecasts fell short of Wall Street expectations, sending shares 3.2 percent lower, as the Internet company announced plans to step up spending despite persistent weakness in the advertising market.

Chief Executive Carol Bartz said Yahoo was hiring more engineers and sales and marketing staff as it invests in new products and branding -- a reversal from the cost cuts the company embarked upon in past months.

Chief Financial Officer Tim Morse, on a conference call, said the company was committed to bolstering its profit margins in the long run. But in the near term, he said, there are things we've got to get done and a lot we don't control in this economic climate.

Bartz did not address reports that discussions about a search and advertising partnership with Microsoft Corp were gaining steam. But she described Microsoft's new search engine, Bing, as a good product that improves experimentation around search and she said she believed there were clear benefits in the search business to being large.

The noises were all encouraging, Sanford Bernstein analyst Jeff Lindsay said regarding a potential deal with Microsoft. If there wasn't some basis to these discussions, she would have been far more negative about Bing.

Yahoo is the second-largest Internet search engine in the United States with a 19.6 percent market share in June, according to comScore, while Microsoft occupies the No. 3 spot with 8.4 percent share.

Some analysts and investors believe the two companies need to team up to better compete with Google Inc , which has a 65 percent share of the U.S. search market.

SPEND, SPEND, SPEND

Yahoo forecast revenue for the current quarter of $1.45 billion to $1.55 billion, while pegging traffic acquisition costs -- the portion of revenue that Yahoo pays its partners -- at 26 percent of revenue.

That suggests net revenue of $1.07 billion to $1.15 billion, by Reuters calculations, below the $1.17 billion expected by analysts, according to Reuters Estimates.

Bartz said Yahoo expects to lose about $75 million in revenue from its quarterly base-line as a result of an initiative to eliminate disruptive ads the company feels irks its users.

Then, Yahoo plans to spend an additional $75 million in the third quarter on a new marketing campaign and product improvements.

Cowen & Co analyst Jim Friedland said investors had expected Yahoo to invest in the business following the cost cuts, but he said the amount of the increase was greater than anticipated.

He said the value of high-profile marketing campaigns is unproven for Web companies. There's frankly not a lot of history of success in spending on branded campaigns in the Internet space, he said.

Yahoo reported its financial results on the same day it introduced a major redesign of its homepage. The company hopes the move will make it more relevant to users increasingly turning to social networking sites like Facebook and Twitter.

It also announced a deal with AT&T Interactive on Tuesday in which AT&T's sales force will sell display ad space on Yahoo to local businesses.

Bartz said the company was seeing less fear in the marketplace.

But the slump in ad spending continues to weigh on its results.

Yahoo said display advertising revenue fell 14 percent year-over-year in the second quarter, while search advertising revenue declined 15 percent.

Total revenue dropped 13 percent to $1.57 billion from a year ago as advertisers remained tight-fisted.

Excluding traffic acquisition costs, Yahoo booked net revenue of $1.14 billion, in line with the average of analysts' expectations, according to Reuters Estimates.

Revenue from search advertising fell 15 percent from the year-ago quarter, while display ad revenue fell 14 percent.

We're in challenging times in all of the sectors within advertising, including online, said Ross Sandler, an analyst at RBC Capital markets. These guys are being disproportionately hit by overexposure to premium display, which has been an area that has been especially weak.

Yahoo posted net income of $141 million, or 10 cents a share, versus $131.2 million, or 9 cents a share, a year ago. Analysts, on average, were looking for 8 cents a share.

For the current quarter, Yahoo forecast income from operations of $55 million to $65 million, down from $76 million in the second quarter.

The company forecast operating cash flow of $330 million to $370 million, compared with the average analyst forecast of $413.5 million, according to Reuters Estimates.

Shares of Yahoo fell 54 cents from their $16.75 Nasdaq close after the company posted its results.

(Reporting by Alexei Oreskovic and Anupreeta Das; Additional reporting by Laura Isensee in Los Angeles; Editing by Gary Hill)

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