Shares in Overture Services (OVER) fell more than 17% Friday after a Salomon Smith Barney analyst cut his earnings estimates, price target and rating for the stock.
Overture's drop Friday is the latest twist in a volatile Wall Street debate over the long-term prospects for Overture, which operates an advertising-supported, pay-per-click search engine that appears on
MSN and other Internet properties.
While Overture bulls point to the company's remarkable ability to increase revenue and profits in an otherwise anemic Internet advertising market, Overture short-sellers insist that competition from rival search engine operator Google, along with the bargaining power of big players like Yahoo!, will erode Overture's gross margins by forcing the company to pay an ever-higher percentage of advertising revenue to the companies on whose properties Overture's search engine appears.
Overture's shares fell $4.83 Friday, or 17.5%, to trade at $22.70.
Friday's report by Salomon Smith Barney analyst Lanny Baker, however, opens up a new front in the ongoing debate. Rather than saying Overture's margins are at risk from big players like Yahoo! and Microsoft -- companies with vast online distribution networks that presumably can drive a hard bargain with Overture -- Baker says that the privately held Google's entry into the paid-search market threatens Overture's pre-eminence among smaller distribution partners that account for a majority of the company's earnings.
To and Fro
Baker cut his price target on Overture Friday from $31 to $21 and his rating on the stock from outperform to in line. While keeping his fourth-quarter 2002 earnings estimate steady for the company, Baker cut his full-year 2003 earnings estimate from $1.10 per share to 95 cents -- from 5 cents over the high end of Overture's guidance down to 5 cents over the low end.
Salomon Smith Barney or an affiliate has done investment banking for Overture in the past 12 months.
In his report, Baker says his research indicates that Overture's smaller distribution partners account for 70% to 75% of Overture's profits, though they only generate about 35% of Overture's revenue. That disparity, says Baker, likely arises because the smaller sites on Overture's network are offered lower payments than big players like Yahoo! in return for employing Overture's paid-search listings on their sites.
Though Baker acknowledges that smaller Web publishers have less bargaining power than larger ones, he says that Google's entry into the paid-search market gives all publishers "an alternative to play off against Overture." In addition, because Google generates much of its revenue on its own site -- revenue it does not have to share with any distribution partner -- Google can pay more than Overture can for traffic generated from third-party Web sites.
In his calculations, Baker estimates that Google could "easily" pay its search engine partners 80% to even 100% of the revenue they generate from running Google's paid listings on their site. That revenue split would put pressure on Overture, which doesn't push traffic to its own site, to pay a higher percentage of revenue to third parties, says Baker. Overture says it expects to pay 61% to 63% of revenue on traffic acquisition costs next year; Baker estimates that industrywide, traffic acquisition costs will rise from 55% in 2002 to 65% by 2004.
To be sure, the market isn't as simple as Baker's calculations. Overture has repeatedly been able to beat analysts' estimates, and it has done a good job of operating and improving the quality of its service to advertisers. In addition, though Google's books are nonpublic, it appears that Overture has been able to generate much higher absolute dollars in revenue than Google.
Thus the Overture debate plays on.