FOOL ON THE HILL

The Next Dot-Com Miracle?

Overture is being hailed as the next dot-com miracle. Rick Munarriz thinks that while the praise for the pay-for-performance pioneer is long overdue, he also thinks it's just that -- overdue. He sees falling margins and growing competition holding the stock back in the future. If pessimism were a keyword, this Fool would be bidding plenty.

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By Rick Aristotle Munarriz (TMF Edible)
October 9, 2002

Don't confuse the last laugh with the latest one. The market's pretty stoked with Overture (Nasdaq: OVER) right now. It sees dot-com profitability and growing revenue. And, let's be honest here, that's a pretty nifty costume to be sporting these days.

On the surface, it appears like we have the ultimate feel-good stock story. Deep within the wreckage of the Internet bubble, in which eBay (Nasdaq: EBAY) was thought to have been the sole substantial survivor, beats the heart of a portal.

If you're not familiar with Overture, it started out five years ago as GoTo.com. While most search engine portals would mine the Internet for relevance, GoTo's search results would spit back its own list of advertisers first, in order of how much each sponsor would be willing to pay for the potential click-through.

The company's pay-for-performance model may sound insulting in theory, I won't argue against that. It's like running a dating service where folks get hooked up with the highest bidder for certain traits rather than the ideal match. It's like walking into a grocery store with a shopping list and leaving only with the products that had the largest in-store displays. It blurs ethics. It kicks technology in the shins. But, by gum, it works.

The portals laughed at GoTo and its users the way one has to chuckle at folks who watch shows about commercials. Yahoo! (Nasdaq: YHOO) and Lycos had tech savants dreaming up ways to provide more efficient searches, while GoTo was simply bowling for click-throughs. But then the Internet's helium tank emptied out. Money was tight. Advertisers were falling off like flies. Search engines scrapped for sponsors, while GoTo was sitting pretty in its brick house made of performance-based ad streams.

GoTo ditched its name, its green traffic light logo and its reputation as a lightweight. It went corporate. By inking deals with many of those who once laughed at the company's peculiar business model and search strategy, it proved to be the perfect win-win situation. Overture grew its reach while the popular search sites partnered to broadcast Overture's results for a piece of the action.

So far, so good. The company reported its first quarterly profit during last year's September quarter and it hasn't looked back. Its list of active advertisers has grown to 67,000 members, paying an average of $0.30 for each generated lead. The fact that the number of sponsors is growing while so many other media companies dependent on the ad market are struggling might seem like a blessing, but there are cracks in that rainbow.

While the pay-for-performance list of sponsors has been chock full of A-list advertisers such as Dell (Nasdaq: DELL) and Bank of America (NYSE: BAC), it should come as no surprise that many of the latest click-through bidders are fringe players. So far this year, days sales outstanding (DSO) has grown from 11 days to a full two weeks. Not only is it taking Overture longer to collect, but with paid introductions down sequentially the average advertiser spent less in the June quarter than it did back in March.

Yet Overture's real problem lies in its ankle-high barrier to entry. Sure, it was able to buy exclusive space on the Web's most popular search destinations when it was the only game in town, but now that everyone knows that you can jot the Overture business model on the back of a cocktail napkin, the competition has arrived.

Google poses the biggest threat to Overture right now with this spring's launch of AdWords Select. It's a very similar pay-per-click sponsorship program, only packaged in the wrapper of a much better search engine. Google has already stolen AOL Time Warner's (NYSE: AOL) America Online and Earthlink (Nasdaq: ELNK) from the clutches of Overture. Last month, Ask Jeeves (Nasdaq: ASKJ) showed Overture the door. It is doing its premium listings in-house with the help of its Teoma subsidiary.

While the company has been able to extend partnership deals with Yahoo! and Microsoft's (Nasdaq: MSFT) MSN.com, do you really think these heavyweights won't have their own system in place when the time comes to renew in a couple of years? AltaVista will need some serious handholding before its contract is up for renewal in May.

I don't want to strip Overture of its pioneer status. It came in as the butt of a joke and wound up kicking butt. Well done! But maybe it was too good. Maybe it proved that it was just too easy. While the company has ambitious plans to expand overseas, it's also coming at a time when it is losing virtual real estate stateside.

Like one of its own advertisers, Overture is now in a bidding war to rent visibility in cyberspace and that means you can kiss the meaty margins of the past goodbye. While its traffic acquisition costs during the second quarter ran at just 53% of total revenue, the company sees that climbing to as high as 62% next year.

So it should come as no surprise that while the company is expecting the top line to grow nicely next year, it is looking for net profits to fall. Pegging its 2003 earnings outlook between $0.90 and $1.05 a share, that will be well off the $1.19 a share that Overture is set to earn this year. To be fair, this year's result is bloated by a tax-advantaged first quarter. On an earnings before interest, taxes, depreciation, and amortization (EBITDA) basis, it is expected to improve from a $106 million showing this year to at least $125 million in EBITDA come 2003.

Don't bid on it. The company has been able to blast through Wall Street estimates over the past year as it has been able to tiptoe through the Eden it created. With the rest of the industry now catching on, payola-influenced search listings are no longer the exclusive handiwork of Overture. With the leaner margins, the diluted sponsor base, and the crowded marketplace, won't this all end badly?

In a symphonic concert, an overture is the introduction to a musical piece. The market sees just that -- a beginning. I see a fadeout. So, let Overture laugh now. It earned the right to do so. Just don't be so sure it will be the one that laughs last -- or next.

Rick Aristotle Munarriz can't imagine anyone ever bidding for his name as a keyword. His mother might disagree. She might even be the only one to bid. Rick's stock holdings can be viewed online, as can the Fool's disclosure policy.