Pressure on Yahoo! to complete a deal with a rival such as Microsoft increased last night after the internet search engine unveiled a sharp fall in profits for the second quarter of the year.

Fears that the world’s second-largest search company is losing ground, distracted by a six-month onslaught by Microsoft and weakened by a slowing American economy, raised concerns that Jerry Yang, co-founder of Yahoo!, may not be able to deliver a promise to boost the company’s share price.

In May, the management of Yahoo! rejected a $33 a share offer from Microsoft. Last night Yahoo! shares were changing hands at $21.40 each.

Yesterday, after the New York stock market had closed, Yahoo! admitted that net profits during the second quarter of the year had fallen by almost 19 per cent to $131 million, while total revenue increased 6 per cent to $1.79 billion.

Net revenue increased 8 per cent to $1.35 billion, just shy of Wall Street expectations of $1.37 billion.

Mr Yang blamed the fall in earnings on a “difficult economic environment” and increased costs. The company did not disclose how much it had spent on defending itself from unsolicited approaches from Microsoft. Yahoo!’s main advisers included Goldman Sachs and Dresdner Kleinwort, the investment banks and Blackstone, the private equity group.

While Mr Yang took over as chief executive at the end of last year to spearhead the company’s recovery, cutting jobs and introducing a new business strategy, investors are nervous because Yahoo! is losing out to the world’s biggest internet company — Google — in the fight to secure online advertising contracts. Estimates of the internet advertising market reckon it will be worth $80 billion by 2010.

Blake Jorgensen, chief financial officer, last night stuck by the company’s full year outlook for 2008 despite the dual distractions of Microsoft and the slowing US economy.

As the Yahoo! share price inched up 1 per cent in after hours trading, Jeffrey Lindsay, an analyst at Sanford Bernstein, the broker, said: “Clearly, it [the share price] is telling us that these results are poor, but relative to what people were expecting, they’re not so bad. Investors braced for the worst.”

Mr Yang said: “Yahoo! is executing against its strategy, and we believe is well positioned for long-term growth and maximising stockholder value. Yahoo! saw benefits in the second quarter from a number of the strategic initiatives that we have been delivering against, including the roll out of innovations in search and the announcement of a number of important partnerships.

“We are seeing validation that we have the right strategy as we continue to make transformational investments that position us to take advantage of pivotal trends driving growth on the internet.”

Yahoo’s earnings figures come a day after the internet group agreed to appoint Carl Icahn, the billionaire shareholder activist, and two of his nominees to the board, ending a proxy battle and reducing the chances of immediately revisiting a Microsoft deal.

The agreement between Mr Icahn, 72, and the Yahoo! board removes the threat of a bloody battle that would have seen Mr Icahn seek to remove all the members of the internet company’s board at its California annual general meeting on August 1.

Mr Icahn is seeking to force Yahoo! to secure a deal with a company such as Microsoft or AOL, the internet arm of Time Warner, to help the company to compete more effectively against Google.

On a conference call with investors last night, Yahoo! reminded shareholders that its deal with Google was still to be approved by regulators.

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