There's an old adage that a rising tide lifts all boats. But in the search industry, where the tides have been rising like crazy, the biggest boats are rising a lot faster than the smaller ones.

Ad spending on the Internet has been booming for the past year, and the fastest growth has been coming from search-related ads of the kind found among engines such as Google ( GOOG) and Yahoo! ( YHOO).

Google's revenue, which is nearly entirely generated from search-related advertising, grew 93% in its latest quarter, while Yahoo!'s revenue, a mix of search and branded ads, grew 55%.

After the two big search engines reported first-quarter earnings, their stocks rallied. Over the past few weeks, Google has risen 27% and Yahoo! 12%. But smaller companies competing in the search space aren't doing as well.

LookSmart ( LOOK) is down 69%, FindWhat ( FWHT) is down 73%, ValueClick ( VCLK) is down 29% and Mamma.com ( MAMA) is down 55%. Moreover, none of these stocks benefited from spillover rallies on Google's and Yahoo!'s stellar results.

What's odd about the lackluster performance of smaller search companies is that their revenues are growing fast. Until recently, none of them has been perceived to be the victims of Google and Yahoo!. Although many news stories have noted radio and newspaper stocks coming under selling pressure amid signs that the Internet is sapping away some of their ad business, small search companies have performed even worse.

"The market's big enough that a number of players can benefit from it now," says Aaron Kessler, an analyst at Piper Jaffray, which does banking with Google but not Yahoo!. "The interesting thing is it appears it's already turning into a two-horse race. It looks like Google and Yahoo! will continue to outperform and the second- and third-tier players will continue to underperform."

Analysts caution that it's too early to say for sure that the search market is splitting into two camps, although that's where the evidence points. "There was clearly a bifurcation in the first quarter in the performance of search companies," says Derek Brown, an analyst at Pacific Growth Equities.

"It's still a little early in the cycle to pinpoint exactly what seems to be changing. But perception is that bigger players are growing disproportionately," says Brown, whose firm has no banking relationship with either company.

Google and Yahoo! have clear advantages: Their brands are the strongest. In the minds of Internet users and large advertisers, they are synonymous with search. Their networks of affiliates are extensive and growing. And each new feature that Yahoo! and Google add to search puts them another pace ahead of smaller companies that may need to ramp up costs to catch up.

While Google and Yahoo! have increasingly dominated the search-advertising market, the sector is still in an early growth phase. Normally, a market isn't winnowed down to two or three giants until it reaches a more mature phase in which growth has slowed considerably.

On Thursday alone, FindWhat fell 22%, and ValueClick dropped 11% after issuing first-quarter reports that disappointed Wall Street. FindWhat saw its profit drop 16% despite a doubling of revenue, prompting Jeffries & Co. to lower its rating on the stock to hold from buy.

ValueClick, meanwhile, saw revenue grow 40%, and it beat analyst estimates by 2 cents a share, yet investors remained concerned about its future prospects.

"ValueClick's Media division could face growth and/or margin challenges in coming quarters due to changes we see in the competitive landscape," says Brown. Google's recently launched initiative to give blue-chip advertisers say over where and how they advertise on its affiliated sites will pose a more direct challenge to ValueClick's core market than it faces now, he says.

Taken together, the two company reports suggest that impressive revenue growth isn't enough in an environment in which competition is making profit growth increasingly tougher. In other words, the young market for search has become every bit as competitive as a more mature sector such as PCs.

Why? Because the death match between Google and Yahoo! is sucking all of the air out. In their burning desire to outdo each other, they are pushing into areas that had been the quiet domain of a niche player like ValueClick.

Of course, Google and Yahoo! will still have competition from larger search engines:
  • Ask Jeeves (ASKJ), which is soon to be bought by InterActiveCorp (IACI);
  • Amazon.com's (AMZN) A9;
  • Time Warner's (TWX) AOL;
  • and
  • Microsoft's (MSFT) MSN.
  • But with AOL focusing on broadband, and Amazon and IAC both focusing on e-commerce, none of those companies will give search the obsessive priority needed to keep their engines on top. On Wednesday, IAC boss Barry Diller said he likes what he has in Ask Jeeves and doesn't plan any more search deals.

    As for Microsoft, much depends on how successful it is in incorporating a sleek, compelling search product into its upcoming Longhorn operating system. Until then, MSN will probably remain a player by virtue of the default redirect to its site that happens whenever someone mistypes a word in an Internet Explorer browser.

    There's always a danger in extrapolating trends from events that span only a quarter or two, but a picture is emerging of the future of Internet search that's hard for many to shake off: Google and Yahoo! become the two big ad companies on the Internet, as search ads and branded ads continue to blur. Companies such as IAC and Amazon will find search a strong lever with which they'll boost their core business.

    As for the smaller, pure-play search companies, 2005 might become the year of put up or give up.