Closing Market Report

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Saturday, August 21, 2004

Internet search engines
are hot, but for how long?

NEW YORK » Even with the splashy arrival of Google Inc., there aren't many publicly traded search engine stocks to choose from, and their valuations are not cheap. The growth potential for this sliver of the tech sector is huge, however, making it an attractive bet for more aggressive investors.

But buyer beware: The risks are outsized as well.

Part of the reason Wall Street is so excited about search engine stocks is it seems they are only beginning to realize their money-making potential. Slowly but surely, the Web is supplanting traditional sources of information -- phone books, help wanted ads, movie listings -- and becoming the place where we go to find stuff.

"This is a brave, new world, and you need to be part of it if you're an advertiser of anything," said Barry Randall, portfolio manager with U.S. Bancorp's First American Technology Fund in Minneapolis. "This is how people are going to learn about you."

Now, with paid search services like those offered by Google and Yahoo! Inc., advertisers and marketers can easily target their messages to each one of us, specifically, according to the key words we use. With paid searching, advertisers only pay for their ads on the Google and Yahoo sites if users follow their links. It's highly economical, and by tracking users who click, advertisers can directly calculate their returns.

To a marketer, this looks like a much better deal than placing ads in passive mediums, such as television, magazines, newspapers and Yellow Pages, where there's no real way to measure impact. With the Internet's unique, interactive nature, you know precisely how effective your advertising strategy has been.

Online advertising only makes up about 3 percent of total ad spending, but it is gaining market share, Randall said. Most of that gain is in paid search, which is seen as more effective and a better value than other types of online advertising, such as banner ads or pop-ups.

To get a clearer picture of what the most bullish investors on Wall Street are thinking as they snap up search engine stocks, consider this: Spending on ads in Yellow Pages totaled about $14 billion last year, while online paid search ad spending came to just $2.5 billion. That means there's an awful lot of business that could migrate to companies like Yahoo and Google in the years ahead. Smaller companies, like Mamma.com Inc., Ask Jeeves Inc. and LookSmart Ltd. also stand to benefit.

What's less clear is which of today's search engine darlings will capitalize most on this opportunity. Do a Google search for "search engines," and you don't have to dig very deep to find the dusty Web pages of yore, detailing the heady performance of stocks like Excite, Infoseek and Lycos. If the search industry was in its infancy in the late '90s, it is merely in its toddler stage now, analysts say.

"Like any early-stage, high-growth industry, be it biotech or technology in general or the Internet specifically, we're still in the early stages of this industry's evolution," said Mark May, senior internet analyst at Kaufman Bros. "The industry has been around not even 10 years. Trying to forecast where businesses will be in three to five years is still difficult. Results may be volatile, and because of that these are investments for risk-tolerant investors."

There's little doubt that the industry's underlying fundamentals look more appealing than they did a few years back. In the late 1990s, the companies advertising online were often short-lived startups -- not a stable source of ad revenue. Now that online advertising has been embraced by old economy names, there's less fear those dollars will go away.

Google has also proved itself a popular service among consumers, and May noted that it's still in the first inning of its product evolution. The company's Google Labs division is working on and introducing new products all the time -- such as the Froogle comparison shopper, the G-mail e-mail service and wireless services for mobile handsets -- which may help spur growth.

Google, launched in 1997 by a pair of researchers at Stanford University, holds a 55 percent share of the search market, just ahead of Yahoo. But the industry's short history shows that consumer loyalty to search services is perilously erratic. Google didn't exist a few years ago, and there's no guarantee it will exist a few years hence.

Search, said Randall, may prove to be an area that works best if there is just one winner. In this, it's like the auction business, where eBay Inc. has been elevated above all other online players. Buyers and sellers like having one place to go. People looking to find things like it if they only have to look in one place.

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by Financials.com


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