SAN FRANCISCO (CNN/Money) -
Last week was rough for executives at Overture Services, a leading pay-for-performance Internet advertiser based in Pasadena, Calif. Unfortunately for them -- and for Overture's shareholders -- the future doesn't look much brighter.
On April 23, Overture (OVER: down $0.13 to $10.77, Research, Estimates) reported first-quarter results and dramatically reduced its forecast for the year ahead. Investors sent its stock off the cliff: In three days Overture shares dropped from $16.48 to just under $11.
For the quarter, Overture reported net income of $11.1 million, or 18 cents a share, compared with net income of $29.3 million, or 48 cents a share, a year earlier. First-quarter profits dropped 62 percent, despite a 57 percent rise in revenue.
Next quarter, Overture expects earnings of $2 million to $4 million, or 4 to 6 cents a share, on revenue of $240 million to $255 million. According to First Call, analysts had been expecting net income of 12 cents a share for the second quarter. After learning of the diminished forecast, many analysts lowered their recommendation on the stock.
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Most of Overture's woes can be traced to one source: Google. The privately held company based in Mountain View, Calif., "is eating Overture's lunch right now," says Derek Brown, an analyst at Pacific Growth Equities. A year ago, Google decided it wanted a piece of Overture's business and launched AdWords, its own pay-for-placement service. Since then, Overture's traffic acquisition costs have skyrocketed from about $40 million in the first quarter of 2002 to just over $120 million in its most recent quarter.
What's more, Overture's Ebitda profit margins have decreased from about 23 percent in the first quarter of 2002 to slightly north of 10 percent today. In short, Overture is now spending more to make less. That's why investors are running for the exits.
Of course, Overture's problems aren't unique, nor is the company's fate sealed. Overture literally created the market for pay-for-performance search ads in the late 1990s (back when it was called GoTo.com) and hung around until the idea caught on. Now that it's clear that there's real money to be made, other major players such as Google and Yahoo! (YHOO: down $0.18 to $24.78, Research, Estimates) have moved in on the business.
"The good news for Overture is that paid search's time has come," says Rob Rosenthal, an analyst with IDC. "The bad news for Overture is that paid search's time has come. While it's nice to have that validation, there's a lot more competition right now."
To slip out of the noose that Google has placed around its neck, Overture needs to take action -- and fast. First and foremost, it must diversify its revenue stream. Currently, its top two customers, Yahoo! and Microsoft (MSFT: up $0.53 to $25.74, Research, Estimates), account for 65 percent of total revenues. Its top 10 clients account for 83 percent. Overture needs to cut that 83/10 ratio to a more palatable number such as, say, 80/20.
The next 18 to 24 months will be crucial. Google is aggressively ramping up its advertising services, and Yahoo! recently made moves to improve its own search services. Yahoo! could even launch its own Overture-like program.
Overture stock is trading at 52-week lows, and the company is a leader in a still-growing market. At first glance, that may seem like a tempting situation for Wall Street bargain hunters. But look before you leap. With Google breathing down its neck and uncertainty surrounding the company's strategy, Overture is a stock that tech investors should regard with caution.
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