Deceptive Search Results Are No Good For This Quartet
Reuben is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
The Federal Trade Commission (FTC) recently sent a letter to search engines effectively warning them that their advertising has become more deceptive. While this won't likely have a big impact on industry giant Google (NASDAQ: GOOG), it could make life harder for companies like Yahoo! (NASDAQ: YHOO) and IAC Interactive (NASDAQ: IACI).
Search Results or Advertising?
The FTC highlights that “failing to clearly and prominently distinguish advertising from natural search results could be a deceptive practice.” And that “in recent years, paid search results have become less distinguishable as advertising...” While the FTC didn't come out and say the search engines were duping users, it did clearly ask that search companies “make sure the distinction is clear.”
One example of the search/ad confusion is placing paid search results (advertising) at the top of a search result page. The paid ads are differentiated by a colored background, but are intended to look like part of the “natural” search results. Its a fine line keeping both advertisers and search users happy.
Not a Big Problem
Google is the undisputed king of Internet search. The company doesn't have to work too hard to get people to use its search tool and the volume of searches it processes gives it a huge lead in the industry. Having to switch things up a little bit probably won't hurt the company much, but reduced click rates on more obvious ad content could cause margins in online search to shrink a little.
That would exacerbate the company's already notable margin pressure. Margins in its mobile advertising business are smaller than its web-based ad business and it recently purchased low-margined device maker Motorola. Shrinking margins is a long-term problem to watch because the shares are trading near all-time highs.
While a trailing price to earnings ratio in the 26 range isn't outlandish, it suggests that the company needs to keep both the top and bottom lines growing or the shares could pull back sharply. Shrinking margins make that harder to achieve.
Smaller Search, Bigger Problem
IAC Interactive's Ask.com could feel a bigger hit because it isn't as widely used as Google. Moreover, the Search and Applications division makes up more than half of the top line and produces twice as much profit as the company's dating services. Those are the only two divisions making money.
If search revenues pull back, every penny lost translates into a penny that doesn't drop to the bottom line. Since IAC doesn't have as broadly based a business, making advertising more obvious, and likely less productive, could be a big problem. Of course, falling afoul of FTC rules would be worse.
This is an issue to watch closely, since revenues have been heading higher over the last few years and the shares sport a PE of about 22. A falloff in search could lead to a swift share decline.
Microsoft's (NASDAQ: MSFT) Bing is the second most used search tool. It is reported in the company's Internet Services division, which posted revenues of $832 million in the March quarter. Overall, Microsoft's revenues were $20.4 billion, which makes search just a little more than a rounding error. Since search isn't a core business, the FTC's concerns aren't a notable issue for the company.
Bing is really a way to challenge Google on its home turf as Google pushes Microsoft in other areas, like web browsers. So Microsoft is probably the best positioned to deal with any hit the FTC shot across the bow might cause. Growth and income investors should find its growth prospects, around 2.7% dividend yield, and reasonable valuation (the trailing PE is about 18) of interest.
A Search by Any Other Name
Bing is also the brains behind Yahoo's search tool. Search is a troublesome business for Yahoo!, however, since revenues fell 10% in the first quarter. The $425 million in search revenues were more than a third of the company's $1.14 billion top line.
That said, Yahoo! is working hard to broaden its product portfolio, including the recent agreement to buy Tumblr. It is also looking to use its cash hoard from selling half its stake in China's Alibaba to buy into a video service. The company is still a work in progress under new CEO Marissa Mayer, with the top line seemingly stabilizing around the $4.9 billion mark.
With a still strong brand name, plenty of cash, the other half of Alibaba to sell, and a changing business, Yahoo! is a decent turnaround play. While there hasn't been a transformational event, there are enough little positives to suggest that things are moving slowly in the right direction.
No search engine is going to shut its doors because of the FTC's concerns, but the entire industry could see profitability pinched. For smaller players more reliant on search, like IAC and Yahoo!, that could be problematic. For Google, which is already dealing with tightening margins, it just makes life more complicated and its high-priced shares more risky for investors. Microsoft, meanwhile, doesn't make enough from search for the issue to matter much at all. But that just makes its growth prospects that much more compelling.
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Reuben Brewer has no position in any stocks mentioned. The Motley Fool recommends Google. The Motley Fool owns shares of Google and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!