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Margins May Tell Overture Story

Overture Services (OVER) investors are worried about business that the Internet company might lose. But maybe they should worry instead about the business the company might win.

Shares in Overture, formerly known as GoTo.com, plummeted earlier this month after news broke that the remarkably successful online advertising firm lost a distribution deal with EarthLink (ELNK - Get Report) to search engine Google. The stock has since regained most of that ground and closed Friday at $30.93.

But maybe people are focusing on the wrong risk, says one investor who is betting that the price of Overture's shares will fall. Instead of fearing that Overture's pay-per-click search engine will lose its presence on sites such as Yahoo! (YHOO - Get Report) and AOL Time Warner's (AOL) America Online, investors should instead worry about the money Overture might have to spend to keep its place.

That's because compared with traditional media practices, Overture retains an exceptionally large portion of the money it collects from advertisers, instead of passing it on to the Web sites that use its revenue-generating search engine. As was the case with previous outlying Internet-based businesses, the economics of Overture's operations will over time come to resemble those of television, newspapers and other media, argues the short-seller, speaking on condition of anonymity.

That return to the mean would substantially hurt Overture's bottom line. Overture, which in its latest quarter kept nearly 49 cents out of every dollar it collected from advertisers, risks resembling advertising sales organizations in other media -- companies that, after they sell a dollar's worth of advertising, hold onto 15 cents of that dollar at best, and often closer to a nickel.

Pay as You Go

Overture's business, which enables advertisers to pinpoint customers and name their own price, has indisputably been successful in satisfying advertisers and making money. Here's how it works: Advertisers pick words and phrases that people might search for, and choose the price they'd like to pay for each search term. When consumers search for that term -- anything from "data recovery" to "chocolate" -- advertisers' listings appear, in order of bid size, highest bid first. Advertisers pay Overture only when end users click on their listing to visit their site. Overture itself pays portals and other affiliates for "traffic acquisition" -- the privilege of running the listings on their properties.

Those affiliate deals -- a combination of revenue-sharing arrangements, flat payments and flat per-click fees -- ate up 56% of Overture's revenue in 2001. But they hardly hampered the financial performance of Overture, which blew past analysts' estimates for the fourth quarter ended Dec. 31 and enjoyed a 20% operating margin.

But rather than looking at Overture as an innovative Internet company, says the short-seller, people should look at it simply as a new media advertising representative: a middleman that sells advertising on behalf of the media companies that are its affiliates. As the Internet media business consolidates -- top-10 media companies collected 75% of Internet ad revenue in the third quarter, according to the Interactive Advertising Bureau -- publishers become ever more powerful.

That trend raises the question of whether Overture's unusually large slice of the ad revenue pie is defensible, or whether Overture's rich margins are simply another short-lived Internet novelty.

Old media precedents aren't encouraging. Historically, national advertising representatives for newspapers retain only 15% of ad sales money as a commission, says newspaper industry consultant John Morton. Average rep commissions of 15% are a distant memory in broadcast advertising, says Gordon Hastings, former president of ad rep powerhouses Katz Television and Katz Radio; TV averages fell to 10% in the 1970s, and radio fell to 11% in the 1990s. TV commissions have since fallen farther -- according to anecdotal evidence, they are now close to 5%.

Meanwhile, Overture is telling analysts to expect that for 2002, that traffic acquisition costs will average 55% of revenue for 2002 -- effectively giving the company a 45% commission, or plenty of room to fall in a worst-case scenario.

Different This Time

To be sure, Overture is different in several ways from traditional advertising reps. With its flat-rate agreements with affiliates, it's making upfront commitments that reps traditionally don't. Overture doesn't simply sell advertising space, either; rather, it has invested in staff and systems designed to ensure that its advertiser-paid listings are useful editorial information.

Finally, as the company has made clear to Wall Street, Overture has persuaded affiliates that their share of Overture's revenue -- whatever the exact percentage -- is a more rewarding option than trying to duplicate Overture's business with all the attendant costs, risks and delays. In a recent note, Salomon Smith Barney analyst Lanny Baker concludes that for portals desiring to build their own Overture knockoff, the upside payoff isn't so wildly good that it's worth the downside risk.

But, argues the short-seller, as fewer publishers win greater shares of Internet traffic and ad revenue, the do-it-yourself option becomes more attractive for them, and their bargaining power with Overture increases. The threat is by no means hypothetical: Yahoo!, for example, has said it is contemplating the launch of its own Overture substitute.

Overture CEO Ted Meisel wasn't available for comment over the weekend. But on the company's earnings conference call with analysts last week, Meisel acknowledged that the balance of power between Overture and its affiliates could shift.

"While I'd like to tell you that I think we've found an equilibrium for the next 10 years, I think it's just too early to say," said Meisel. "I think the key -- and certainly the thing we're focused on here -- is to make sure we're delivering more value to our partners than they could possibly find through alternatives, including homegrown alternatives. And that will ultimately be determinative of what we share, and our margins."

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