Under the hoods of search engines

Less than a year ago, Wall Street was openly pondering the demise of the search engine market as company stock prices plummeted to single digits.

Now, search engine stocks are red hot--and the turn of events has left some scratching their heads.

Investors who take a closer look at this volatile sector may find some of these companies to be overvalued. Analysts and fund managers warn that today's stock prices reflect the potential value of these companies, rather than their present worth.

That potential has grown recently as the search engines have changed their business models to incorporate e-commerce deals with major online vendors. Under the strict navigation and advertising revenue model that reigned a year ago, the industry could only support one or two winners. But with the advent of the e-commerce partnerships, the "navigation" space seems roomier.

Search engines have been busy in the past few months signing deals with major online vendors. Last week Lycos (LCOS) announced a deal with Barnes and Noble that sent Lycos stock up 20 percent the day it was announced.

"A lot of announcements coming from these companies over the next quarter will be commerce related," predicted Andrea Williams of Volpe Brown Whelan.

Wall Street's confidence in e-commerce plans is even benefiting the stock of a search engine that doesn't have such a plan yet: Infoseek.

"I think the activity in its stock price is a function of the agreement between Lycos and Barnes and Noble," said Walter Price of RCM Capital. He credited the recent upswing in the sector to "the notion that other businesses want to establish commerce on the Web and will need to partner with someone, and the notion that the logical partners are search engines."

Despite the optimistic marriage of search engines and e-commerce, many analysts remain skeptical of the current search engine euphoria.

"It's hard to justify the purchase of any of these based on the current financials they're generating," said Frank Korth, of the Zurich Kemper Technology Fund.

Korth, who has divested his fund of shares in Yahoo (YHOO), and has not acquired shares in Lycos, Excite (XCIT), or Infoseek (SEEK), warned that with Internet stocks in general, the high growth rate has a high decay rate built into it.

"You can't keep growing at 70 percent, and if you haven't taken account of that, when the market takes a reality check you could lose half your money if you bought it near the top," he said.

Lycos serves as a case in point of a stock overvalued based on its lack of earnings, but one that is trading at a price that is justified based on its future plans, one fund manager said.

"Lycos is overvalued on earnings, but I'd say that they're a good deal closer to accomplishing that goal [of establishing themselves as a brand]," said Price. "If you establish yourself as brand on the Internet, that's worth billions of dollars. With the Barnes and Noble deal, they are closer to getting there."

He believes the rising stock price is justified.

"Whether it's worth 32 or 22 a share, I think that's a function of psychology right now," Price said. "Would I buy the stock at 32? Probably not. [The price] will pull back as enthusiasm gets tempered somewhat."

Lycos, which has recently run up to the low 30s, helped spur the search engine sector with better-than-expected fourth-quarter results. (See related story).

Excite is viewed by one analyst as trading at a discount. Carrying a higher traffic rate than Lycos, Excite was widely regarded to be in second place behind Yahoo.

"Compared to other stocks in the...sector, Excite is trading at a considerable discount, despite the fact that it holds a solid No. 2 traffic position in the industry," said analysts Shaun Andrikopolous in an Alex. Brown report.

Excite finished the day up nearly 30 percent at 22-17/32. (See related story)

Like the other engines, Excite stock is escalating mostly on potential energy. The stock has risen about 40 percent in two days, despite the fact that the company has not yet earned any money. But analysts defend that price.

"I don't think Excite is overvalued," said Williams. "Excite is the second strongest in terms of branding and in traffic, next to Yahoo, and that high level of traffic is indicative of the high level of revenues Excite should be able to generate."

However, some analysts question whether Excite has a business model good enough to match its traffic numbers.

"I've never been impressed by Excite management's ability to control costs and spending," said Hambrecht & Quist analysts Paul Noglows. "This presents a clear contrast to Lycos, which has shown an incredible ability to run the business in a cost-efficient manner."

Infoseek, whose stock has been on the decline for most of the year, has received a slight lift of late. But apart from riding the coat tails of its competitors' e-commerce deals, analysts find little to explain that rise.

"Infoseek is a marginal company," said Price. "I haven't seen Infoseek sign any major agreements with business-oriented companies...Any company that is not making money and not showing how it's going to make money in the next year or two is going to be more and more vulnerable. It seems like any company that does not have a plan to make money is fundamentally overvalued."

Yahoo is a buy on several analysts' list, but some are more coy when it comes to sizing up whether it may be overvalued.

"What sent Yahoo into the upper atmosphere was that they proved their business model," said Tim Albright of Cowen & Company. "It's the most leverageable and scalable business model we've come across in any company. Their incremental revenues hit the bottom line efficiently. They can scale up traffic from 10 million hits to 40 million hits with comparatively little [change] in costs."

Asked if Yahoo, currently trading at around 55 despite meager earnings,was an overvalued stock, Albright refused comment. He noted, however,that he rates the search engine with a "strong buy."

Yahoo's other advantage over its competitors is impossible to replicate:they got there first. "They have the first-mover advantage and so they didn't have to play catch up in branding," said Albright.

Williams predicted that search engine revenue would be driven primarily by advertising over the next twelve months, but that e-commerce would play an increasing role in revenues.

Some observers think that even if there is a surge in e-commerce deals there will be only one or two search engines left standing in the end: Yahoo and another, yet to be determined.

But Williams said that the market would accommodate all four companies for at least the next year.

"It's not clear when the music stops who's going to be left without a chair," said Williams. "They could all survive, but only a handful will really dominate."