Ask Jeeves, and Ye Shall Receive

Shares of Ask Jeeves (ASKJ) soared 40% to a 3 1/2 year high of $29.01 on Thursday after the Internet company doubled its size by agreeing to buy a group of rival Web sites. The Emeryville, Calif., search-engine operator will shell out $150 million in cash plus 9.3 million shares to acquire privately held Interactive Search Holdings. The deal was initially valued at $343 million.

"It's not a technology acquisition, but a traffic acquisition," says Imran Khan, an analyst at Fulcrum Global Partners in New York.

Founded in 1999, Interactive Search Holdings owns Web properties such as Excite.com, MySearch.com and iWon.com. Collectively known as the Excite Network, the Irvington, N.Y.-based group of Web sites ranks No. 9 in the U.S in terms of traffic, according to research firm comScore Media Metrix. During the fourth quarter, Interactive Search Holdings performed approximately 700 million searches, compared with 680 million for Ask Jeeves.

In its battle with search-engine giants Google and Yahoo (YHOO), Ask Jeeves can use all the help it can get.

"We believe we are going from 3.5% of market share to a little over 7%," says Steve Sordello, chief financial officer of Ask Jeeves. The company currently ranks fifth behind Google, Yahoo, Microsoft's (MSFT) MSN Network and Time Warner's (TWX) America Online. Google controls 35% of the search market, while Yahoo has a 27% share.

"And we are closely approaching AOL's level," says Sordello. "We are very close to No. 4."

It's been quite a turnaround for Ask Jeeves, a company that Wall Street all but wrote off two years ago. Business has bounced back dramatically over the past few months as advertisers returned to the Internet in droves. In particular, search engines have captured more marketing dollars by pointing Web surfers toward paying advertisers' links, a strategy known as paid search. For example, an Internet user searching for information on toothpaste may be directed to a Web site operated by Colgate-Palmolive (CL). Colgate typically pays Ask Jeeves for the prominent placement in the search results, and may also pay additional fees if searchers click on the link. By the fourth quarter of 2002, the company had turned a profit. The stock is up 64% since we last wrote about Ask Jeeves last July.

CFO Sordello traces the resurgence back to September 2001, when Ask Jeeves acquired its own search capabilities, rather than licensing the technology from one of the bigger players. The company also made the strategic decision to concentrate on Web searches. The plan seems to be paying off. Ask Jeeves has increased its market share of searches in each of the last five quarters.

"We've been growing faster than the market in terms of queries," says Sordello. "We grew traffic at about 35%, and revenue grew by 65%. And through the acquisition we will now double traffic."

The search business is highly dependent on user traffic, since costs are fairly stable whether sites are conducting 200,000 searches or 200 million. As traffic grows, so does revenue, and much of that money falls right to the bottom line. Ask Jeeves' profit margins are in the high-20% range, and Sordello says the company wants to raise that figure to 30%.

"As people do more searches, they have higher monetization rates, and pricing is going to go up," says Khan of Fulcrum Global Partners. "This is all good for the search companies, as they have a fixed-cost business model. You will see a lot of revenue growth and earnings expansion, and earnings will grow at a faster rate than the revenues because the business is especially leveragable."

That's why Ask Jeeves is so gung-ho about its purchase of Interactive Search Holdings. Even before the deal, Ask Jeeves raised its first-quarter earnings guidance to 17 cents a share on revenues of $37 million, up from 15 cents on $35 million. That works out to 18 cents a share on a pro-forma basis. For the full year, earnings were expected to be 64 cents a share — 68 cents pro forma — on sales of $148 million. Throw in Interactive Search Holdings, and Ask Jeeves projects a combined 2004 pro-forma profit between 85 cents and 90 cents a share on revenues of $220 million to $230 million.

For 2003, Ask Jeeves earned $7.6 million, or 13 cents a share, on sales of $31.8 million.

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"The industry average for click rates on sponsored search or paid placement is about 50 cents a click," says Fulcrum Global Partners' Khan. "In 2004, the search-placement market alone will grow 40%. And Ask Jeeves will grow at a rate similar to the industry. I don't think the stock is overvalued. It has a lot of leverage in the model, and sponsored search is still in an early stage of the industry. If you look at the business model, search is a very fast-growth space, and there aren't a lot of spaces growing 40%. It's an effective way to market and target advertising. I think there is a lot of earnings upside from the company." (Khan doesn't own shares of Ask Jeeves; Fulcrum Global Partners doesn't have an investment-banking relationship with the company.)