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Paid search feels growing pains

As euphoria fades, the industry may be starting to experience a slowdown. Get ready for the summer doldrums.

Paid search, the engine that's driving many Internet companies into profitability, is getting a dose of reality.

After surging at dizzying rates for the past two years, the paid search market this quarter showed signs of slowing down. Analysts and industry executives dismiss the idea that the paid search business is contracting. Instead, they say, paid search may be growing up.

"Could the search market--after explosive growth in 2002 and 2003--have reached the beginning stages of maturity, with pronounced seasonality in terms of price and volume? Probably," Mark Mahaney, an equity analyst at American Technology Research, wrote in an investor note Thursday.

The first and most pronounced sign of this trend taking hold occurred Wednesday, when Web giant Yahoo reported quarterly earnings that only met Wall Street expectations. Because Yahoo's Overture Services subsidiary runs one of the largest paid search businesses--and counts CNN and Microsoft's MSN as clients--its results are closely watched as a litmus test for the industry.

The other heavyweight is Google, which feeds cash to big-name partners such as America Online and Ask Jeeves. Google is preparing to go public this year and bases more than 90 percent of its revenue on paid search.

During a conference call Wednesday with analysts, Yahoo executives admitted that its paid search query volume and pricing were flat last quarter, causing a scare on Wall Street. Shares of Yahoo stock plummeted 12 percent in after-hours trading, but recovered a bit the following day.

Paid search is still growing, but not as quickly as the previous quarter. Overture revenue grew 39 percent from last year, but that's less than the 45 percent growth it saw during the first quarter, according to Mahaney's note.

"Yahoo grows in step functions," said Safa Rashtchy, an equity analyst at Piper Jaffray. "You always have a flattish period. You can't have two jumps in a row at (the) level of the first quarter."

Commercial search is a business that relies on volume. Companies such as Yahoo's Overture subsidiary and Google allow advertisers to bid on keyword placement, and then they pay the companies a fee every time a Web surfer clicks on the link. Overture and Google have sparked a financial revival for many Web companies and brought battered giants such as Yahoo, America Online and MSN back to life. The business has helped Yahoo so much that it acquired Overture last year for $1.63 billion.

While the business has been booming, there are some concerns that per-click pricing has reached its peak. Once Google goes public later this year and reports earnings every quarter, there will be a better understanding of how to measure paid search.

"Seasonality was only a minor concern last year, and it is a major concern now," said Jordan Rohan, an equity analyst at Schwab Soundview Capital Markets.

Still, Wall Street analysts are bullish and putting a positive spin on these results. The euphoria and the breakneck growth for paid search may benefit from a bit of a slowdown, they say. Just look at traditional advertising, which shines when the weather is lousy and then sags during beach-going months.

To its credit, Yahoo continues to show strong signs of growth outside of paid search. Subscription revenue jumped to $104 million from $88 million last quarter, while the company's long-stagnant HotJobs subsidiary showed some signs of much-needed life.

In the meantime, Yahoo executives are crossing their fingers and hoping the mood swings will change like the seasons.

"To us, we're very happy," Yahoo CEO Terry Semel said in an interview Wednesday. "We weren't at all surprised. Pricing is stable. Everything is good."