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Analyzing Search Engines as Invesments

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Search has become increasingly popular, but do the common stocks of search engines make a good investment? High-tech investment analysts share a glimpse of the techniques they see to value publicly traded search firms, and which companies appear to be succeeding.

A special report from the Search Engine Strategies 2003 Conference, August 18-21, San Jose, CA.

The Job of a Financial Analyst

Many people know that financial analysts research investment opportunities for their company and clients. Fewer are aware, though, of how a financial analyst conducts research, or how they relate it to search advertising. Eric Martinuzzi, a Senior Research Analyst/Internet Analyst for Craig-Hallum Capital Group LLC, provided an overview of this process.

"We're an institutional equity and investment banking firm specializing in the needs of institutional investors and growing companies," said Martinuzzi. "We study these companies and bring researched investment opportunities to money managers. We also offer fundamental investment analysis of publicly traded securities."

So what does a financial analyst look for when researching publicly traded securities? Two key things: freshness and fundamentals. An analyst must always make sure data is fresh and valuable to money managers. "We have to uncover companies in either turnaround status, or emerging - before anyone else does," said Martinuzzi.

Martinuzzi's explained that the fundamentals of a financial analyst's research are made up of several key components:

  • Markets. Always start off with the current statistics available, but an analyst's job is to investigate and come up with a unique viewpoint. "You don't really need to be an expert in the field," he explained. "All you need to do is add up the top lines of these pure plays in search to see how the market is growing very quickly."
  • Growth drivers. What are the catalysts for a company's growth? Usually an analyst can tell by what products are being attacked from all sides, especially by the bigger companies who put out their own versions of similar products to compete.
  • Customers. Talking to advertisers is also part of research. Before coming up with an initiation report on a company, Martinuzzi will talk to at least five different customers or distribution partners. "Conferences such as Search Engine Strategies are a good opportunity for analysts to talk to those people," he said.
  • Stock opportunities and multiples. "Multiples" are the measurements an analyst uses to come up with a price target for a stock. Multiples include projecting out earnings, seeing what things should be valued at, doing multiple of sales, and discounting cash flows. If a financial analyst can see a value where a current stock should be raised from the level it is currently trading at, he will encourage investment in it. "At our own firm, we're not going to make a living just coming out with neutral ratings in stocks," said Martinuzzi. "Our clients want to know what they should buy."
  • People. People in a company are ultimately going to be the ones who drive an industry, especially in a rapidly changing market such as search. "It's an intangible, but you have to make an assessment of the people who work for a company," he stated. "Are they sharp or do they just think they're sharp?" And as for Martinuzzi's own company? "We want growth, profitability, and a strong balance sheet," he said.

The Financial Analysis of Search

Financial analysts have watched and measured consumer behavior with search engines over the past several years. In aggregate, the analysts on the panel were overwhelmingly positive about the prospects for search. It has exceeded expectations -- and importantly, search advertising is here for the long-term.

"Search is a very real and a very fast growing business," said Safa Rashtchy, Principal and Senior Internet Analyst for U.S. Bancorp Piper Jaffray. "From almost nothing 2 years ago, search is now a $1.5 billion industry and is on track to exceed $2.1 billion for 2003, and up to $7 billion by 2007" - a 50% annual rate of growth. Search is clearly big revenue maker for the portals are they are becoming increasingly reliant on this revenue."

"To me, when I first looked at what paid search was, now here's an industry with a tail end," added Martinuzzi. "And by that I mean that I don't even need to be an expert. I can just go out and buy the basket of these [search” securities and still do well, as opposed to doing a dartboard with an application company that may or may not be there in the foreseeable future."

While Rashtchy's statistics demonstrated that actual search volume grew at less than 5% and 7.5% for 2002 and 2003, paid advertising has doubled its own revenue figures every year.

Even though paid listings are clearly the dominant leader in search advertising revenues, paid inclusion was shown to have the highest growth rate. "Our figures show that paid inclusion has already doubled its revenues for 2003 over the previous year," said Rashtchy. "This doubling trend is projected to continue at least until 2007."

Rashtchy noted that his totals did not include revenue figures from contextual ads or local search advertising, which are still in its infancy stages for measurement. While he sees problems for even large portals with harnessing the power of local search, he has no doubt that it will eventually happen.

"You need massive distribution resources to target local companies on a geographically specific basis, but I have no doubt that will happen," said Rashtchy. "The real issue is how do you sell it? If the portals find a way it could be bigger, about 70-80 percent of advertising is local advertising."

Why Search is Rising

Search advertisers have known for years about the proven success of their own industry. So what's new about search to finally get the attention Wall Street and the general advertising public?

"Search advertising has now gone mainstream," said Rashtchy. "Advertisers are increasingly relying on search advertising to fuel their online marketing and e-commerce. It's a sustainable industry that's benefiting everyone: users, merchants, portals, and the search technologies. Even most ad agencies now have some type of search advertising program."

A good deal of that growth, according to Rashtchy, can be attributed to small businesses. "What fueled paid search advertising's growth in U.S. is that it has an efficient small business market," he said. "Overture was fueled originally by the small business infrastructure."

Martinuzzi added that the advantage of investing in a search company is that there's not a lot of competition, by comparison, to other industries. "There is fierce competition when it comes to competing for the distribution ad," he said, "but on the advertiser side, it is such a new industry and market that we have yet seen a true price appreciation to advertisers, which is great to advertisers who are getting a good bargain right now. That's just another sign of the legs of this industry."

Money going into search advertising can also mean money being removed elsewhere. So where are the revenues for online search being diverted from?

"In the beginning, it will probably come from other forms of online advertising," said Rashtchy. "Gradually, it will come from TV and some other types of broadcast advertising."

Questions and Concerns

Some audience members expressed concerns that with more attention and more money being diverted to search, won't the big media agencies try to take search advertising over? Neither panelist, however, believed this to be likely. "Search is a lot more analytical than the other agencies are capable of doing," stated Rashtchy, adding that professional search marketers are in their own field, possessing a significant advantage over agencies with just a background in traditional advertising and other areas of online advertising.

"An agency usually just works as a middleman," said Martinuzzi. "And many times clients do not want a middleman." Panel moderator Danny Sullivan added "A lot of the agencies are still trying to figure out the whole search thing. Many still just outsource. Some agencies are just not set up to do search marketing. It just doesn't fit into what they do."

Another audience member asked that with all of this increased advertising if there would be a backlash. "When it comes to search ads, most people still have no idea of what's an ad and what's a listing," Sullivan stated. "But the truth lies in between what the FTC says and what the search engine advertisers say. Ads are useful in the context that you use them."

Sullivan also cautioned that if search engines get caught up in the monetization and their relevancy fails, the engines will see a backlash, and consumer agencies will come in and establish guidelines.

Rashtchy added that commercialization of search can also improve relevancy. "30 percent of searches are already commercial in nature," he said, "and about 10 percent of the queries are B2B related."

The inevitable question for the financial analysts: When is Google going to do an initial public offering of shares, or will they ever? Why not stay private as long as they can? And what impact will it have when they do come out?

Rashtchy believes that any public offering from Google will rank as one of the biggest IPOs ever. "It will be owned by some of the biggest institutions, and, to some extent, rejuvenate the entire IPO market and extend interest into the search market," he said. "I don't know when it will go out or not, but the market seems to be very ripe."

"Companies go public for several reasons: greed, exit strategy, and having some compensation for employees," Rashtchy continued. "Also, being able to access capital markets and raise capital. But this is less of an issue for Google because they don't have this need, but being able to do this would still increase their strategic advantage."

"If and when it happens, it's going to raise the profile," said Martinuzzi. Google is such a common thing people do. It is one of the great brands out there. Search advertising issues are going to be much higher profile when this thing happens."

Grant Crowell is the CEO and Creative Director at Grantastic Designs, Inc., founded in 1993 in Honolulu. He has 15 combined years of experience in the fields of print and online design, newspaper journalism, public relations, and publications.


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