Diller Should Be Selling

Here's a question to type into the Ask Jeeves ( ASKJ) search engine: Just when will Barry Diller admit that IAC/InterActiveCorp ( IACI) has been knocked out of the battle to be an Internet titan?

On Monday, Diller's IAC said it plans to spend around $1.8 billionpurchasing the Web search engine Ask Jeeves, which started life as asite on which people could ask questions and then be forwarded to Webpages that might contain the answers.

While the deal has some Wall Street analysts enthused, it looks like an expensive and defensive maneuver by Diller, whose travel-focused Internetacquisition strategy has left investors so confused and disappointedthat IAC's stock trades nearly 40% below its 52-week high.

Fierce competition in the online travel market has hurt IAC businesses such as Hotels.com and Expedia so much that analysts expect IAC to post only 6% growth in pro forma earnings in 2005. Diller's reputation has taken a battering. Once seen as a savvy dealmaker, he is now regarded more as someone who has overpaid for Internet assets and then failed to achieve the goals he targeted with his purchases.

But instead of admitting to mistakes and doing a properrestructuring, IAC's approach has been to come up with moves that seem more aimed at diverting attention from real problems. Take the corporate split announced in December.

So what's wrong with the Ask Jeeves purchase? While Diller haspatently failed to build an Internet powerhouse to rival Yahoo! ( YHOO) or Google ( GOOG), it doesn't mean that every deal he does is a dog. After all, Internet advertising is a high-growth business, and Diller has snapped up Ask Jeeves for around 20 times earnings, based on Wall Street's profit forecast for 2005. That's hardly expensive, going by valuations on Google and Yahoo!.

IAC's defenders also note that IAC gets to extend its reach into the Internet search field with the purchase. While Ask Jeeves' share of the market is small, it will strengthen IAC's existing local Internet search services, like Citysearch.

However, there are far more reasons not to like this deal. First, any big acquisition makes it harder for investors to do proper year-over-year comparisons of financial results. IAC issued a bruising profits warning in August. Managers may see weakness in the business, and another profits disappointment may therefore be on the way. It might be useful to have Ask Jeeves -- with its exposure to the supposedly buoyant Internet advertising market -- to point to as a future source of growth if the travel outfits are tanking.

And the deal isn't cheap. A look at Ask Jeeves' annual report shows that last year it made only $45 million in free cash flow -- cash flow from operations minus capital expenditures. That means that IAC's deal, at $1.8 billion, is being done at a multiple of 40 times free cash flow. That's steep.

Moreover, the acquisition is going to force IAC to issue a huge amount of shares at a time when investors are complaining that Diller has issued way too much stock in recent deals. True, the company says it plans to buy back at least 60% of shares issued to buy Ask Jeeves, but doing so will eat up a lot of cash. Purchasing 60% of the shares issued in the deal could easily cost $1 billion. Stock purchases could be even higher if IAC decides to offset the heavily dilutive impact of its stock compensation program by buying back stock. IAC had $4.9 billion of cash at the end of last year.

If the Ask Jeeves deal is overpriced, why do it now? One could just about argue that with IAC, Ask Jeeves may begin to really compete against Google, Yahoo! and Microsoft ( MSFT) in the search space. But there is absolutely no indication that Diller would know how to beat back the Googles of this world.

In fact, recent developments suggest that one of the main reasons that Hotels.com and Expedia are underperforming isthat the search engines are taking business from them. People aregoing onto Google to look for sites that sell flights or hotels andbypassing IAC's sites in the process, or at least finding a world ofother options.

In essence, then, Diller is buying an also-ran search engine to fight off the encroachments of much larger search engines -- and paying through the nose to do so. It is one more move that shows that IAC isn't ready to admit that it's getting pushed out of the game.

A far smarter deal for Diller would be to sell all of his Internet assets now. He'd get a much higher price now than he will two years down the road, when the Internet craze will have died down and the flaws in his Web properties are apparent to all.

In keeping with TSC's editorial policy, Peter Eavis doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He welcomes your feedback and invites you to send any to peter.eavis@thestreet.com.

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