UPDATE 3-Yahoo outlook misses, shares drop

* Q3 revenue, cash flow outlooks lag Street expectations

* Q2 EPS 10 cents vs Street's 8 cents

* Q2 net revenue $1.14 billion in line with Street

* Shares fall 2.8 pct (Adds conference call details, updates stock price)

SAN FRANCISCO, July 21 (Reuters) - Yahoo Inc's (YHOO.O) forecast for third-quarter fell short of Wall Street's expectations, as the Internet company announced plans to step up spending and cited continued weakness in the advertising market.

Shares of Yahoo fell 2.8 percent in after hours trade, following a 1.5 percent drop on the Nasdaq.

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.

Yahoo Chief Executive Carol Bartz said on a conference call that the company was hiring more engineers and sales and marketing staff as it invests in new products and branding initiatives.

"We're really going to move to reposition the Yahoo brand and the Yahoo company," Bartz said.

Yahoo forecast income from operations for the current quarter 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.

"Looks like guidance is a little light for the third quarter," said Colin Gillis, an analyst at Brigantine Advisors. "But she (Bartz) is probably moving it to the game of 'guide light and beat.'"

Second-quarter 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 advertising revenue fell 14 percent.