Overture's Clicking

Overture Services offers Internet advertisers a model that really works. This profitable company should do even better when the online ad market rebounds and the economy recovers. Google, however, will provide formidable competition.

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By Rex Moore (TMF Orangeblood)
November 27, 2002

If you look back over the past few decades, you can't help but see a collection of trends. The most recent examples in the investing world are the incredible booms of dot-com, telecom, biotech, and Internet infrastructure stocks, followed by their incredible busts. Those who can identify such trends ahead of time will, quite obviously, be way ahead of most other investors.

I'm not saying it's easy to know precisely when such trends will occur; in fact, I believe it's next to impossible. However, if we're fortunate enough to know they're coming, we should still be able to benefit from them if we exercise some patience.

Online advertising
The stunning decline in online ad spending went hand in hand with the dot-com crash. As dozens and dozens of Internet companies went belly up, their marketing budgets died along with them. That money stopped flowing, CPM rates (the cost advertisers paid per thousand clicks) plummeted, and businesses like Yahoo! (Nasdaq: YHOO) that relied on such spending were hurt severely.

Ad rates have now stabilized, but there aren't many who expect a return to the days when dot-coms fell all over themselves to spend marketing dollars. The preferred method of operation back then was to advertise and grab as much market share as possible, and worry about how to make money afterward; indeed, most companies who followed that strategy are gone now. But that doesn't mean we won't see a rebound in online spending. The Internet's not going away. More people are using it for more things every day, and ad dollars will naturally follow.

So, I believe the online ad market will rebound in due time.

One company that will no doubt benefit from that is Overture Services (Nasdaq: OVER), the leader in pay-for-performance search advertising. The business model caters to companies that don't want to pay for useless advertising but will gladly shell out for real results. In other words, it caters to most every company out there.

It's a great concept: Advertisers bid for placement in search results, which the company provides to services such as Yahoo!, MSN, AltaVista, and Lycos. Thus, when a consumer types a word or phrase into, say, Yahoo!'s search engine, the first results he'll see are "sponsor matches" provided by Overture.

I tried this with the phrase "Christmas gifts." The first match was for a "Harry Potter Watch, Great Gift, Only $20" on Looking on Overture's website, I see that WatchCart pays $2.13 each time someone clicks on this listing.

The next is "Give the Perfect Gift for Christmas," for which Boston Market pays $2.12 per click. StarNamer bid $2.11 per click and landed third on the list. And so it goes, with literally hundreds of companies bidding on the phrase "Christmas gift."

There's a certain beauty to this system, as each advertiser decides exactly how much it's willing to pay to reach highly targeted consumers who are actively searching for the company's product or service. The more it pays, the more prominent its listing, and the more traffic it will get.

Buoyed by its success in the U.S., Overture is expanding operations overseas. The United Kingdom attained profitability in just 15 months, Germany is going well, and launches are planned for France and Japan in the coming months. This expansion will create a slight drag on earnings for the next year or so, so that's something to keep in mind when comparing year-over-year results.

Even in the current depressed advertising climate, the company earned $84 million over the past year, or $1.40 per share. It also brought in $57 million in free cash flow during that period and trades at 19 times trailing-12-month earnings.

Overture seems well-positioned to take advantage of both a rebound in the online ad market a recovery in the U.S. economy.

There are two factors potential investors must keep an eye on, and they are very much related. The first is Overture's reliance on a relatively few major search distributors, such as Yahoo! Indeed, 10 of its affiliates accounted for 83% of revenue in the most recent quarter.

The company lost a big contract with AOL Time Warner (NYSE: AOL) earlier this year, and its contract with the U.K. site Freeserve expires this week.

Overture is working toward hedging this risk by continuing to sign partnerships with smaller websites. Search boxes on dozens of less-traveled sites might very well add up to significant revenue. Still, there's no denying the large amount of traffic generated by companies such as CNET Networks (Nasdaq: CNET) and Alta Vista is valuable.

The second risk comes in the form of the biggest name in Internet search space: the mighty Google. This seems to be the search engine of choice for more and more surfers, and its technology is generally considered to be the best. The company's name has even become a synonym for searching: A coworker asked me the other day if I was "Googling." (At the time I was gurgling, not Googling.)

Overture lost its AOL contract to Google in May and is no doubt battling it this week for Freeserve. Google is privately held but may IPO in the next few months.

Overture is still the top dog in the pay-per-click industry, however, and has garnered respect among advertisers. Google must be respected, but at this time, there's no reason why both can't benefit from upcoming favorable trends -- whenever they may occur.

Rex Moore is ready for snow. At time of publication, he owned no stories mentioned in this article. The Motley Fool is investors writing for investors.