Looksmart Limited (LKST)

[Bryce]

Lookinsmart, try this its not as nice as Trade Wise's report
But its readable

Jon R. Hickman [phone] Halpern Capital, Inc.
PLEASE READ IMPORTANT DISCLOSURE INFORMATION PROVIDED IN THE BACK OF THIS REPORT
EQUITY RESEARCH: Internet Services
Halpern
Capital
LookSmart Ltd.
The Clear Leader in Paid Inclusion
Compelling Value in Dynamic Market May 15, 2003
Year Price/ Revenue EV/ EBITDA EV/
Dec EPS* EPS (MM) REV (MM) EBITDA
2004E $0.34 6.9 x $ 206.50 1.0 38.0 5.4
2003E $0.16 14.3 x $ 153.40 1.3 18.0 11.4
2002 $0.14 16.3 x $ 96.03 2.1 14.4 14.2
* based on EBITDA Earnings
LookSmart’s stock represents a truly compelling opportunity. The
company dominates paid inclusion, a market that we expect to be a $2
billion opportunity by 2007. With its markets growing rapidly, we expect
revenue growth of 60% and 35%, and EBITDA EPS of $0.16 and $0.34
in 2003 and 2004, respectively. The stock is currently trading at an
enterprise value of 1.3 times 2003 revenue, and 14 times 2003, and 7
times estimated 2004, EBITDA EPS.
INVESTMENT SUMMARY
ƒ LookSmart reached profitability in 2002 and is now generating free cash
flow. Revenue growth is expected to be as much as 50% in 2003 and the
company is investing aggressively to insure continued growth in the
future.
ƒ
LookSmart should continue to benefit from the growth in online retail
spending and rising online ad spending. Online e-tailing increased 27%
in 2002 and is expected to grow at least 20% in 2003 reaching $95
billion.
ƒ
LookSmart is the clear leader in its segment of the market. Revenues for
its paid inclusion business in 2002 were more than 5 times the nearest
competitor. Advertising on the web is currently a $6 to $7 billion dollar
industry and the paid inclusion is expected to become at least a $2
billion market by 2007.
Initiation Report
NASDAQ: LOOK - $2.35
(closing price 5/14/03)
Current Price: $2.35
52 Wk. Range: $0.76 - 3.82
Shares Out (million) 109
Market Cap (million) $256
Enterprise Value (million) $204
Avg. Daily Volume: (thousand) 1,900
Book Value Per Share $0.66
Jon R. Hickman
[e-mail]
Phone [phone]
ƒ LookSmart dissolved its joint venture with British Telecom in
December 2002, eliminating a $40.2 million note (essentially, all
outstanding debt). At the same time, LookSmart was able to gain
complete control of its UK and Japanese operations allowing broad
exposure to the rapid growth of the international paid search markets.
Trading
Phone [phone]
ƒ LookSmart has the real possibility of adding other large distribution
relationships in 2003 with entities such as Yahoo and AOL..LookSmart Ltd.
May 13, 2003 www.HalpernCapital.com Page 2
INVESTMENT THESIS
We are initiating coverage of LookSmart, the dominant player in the paid inclusion market, as they rapidly become a significant resource for advertisers on the web. The company is benefiting from the rapid growth of e-tailing on the web and the attractiveness of paid inclusion as a means for advertisers to target specific potential customers. In 2002, paid clicks grew 109% to a level of 437 million. In Q1 of 2003, the growth rate was even better as the number of paid clicks grew to 176 million, 150% above Q1 of 2002.
We estimate that LookSmart’s current share of the paid inclusion market is above 70%. In 2002, LookSmart’s listing revenues were $74 million. Last year, Inktomi recorded revenues for paid inclusion of $15 million while other competitors
were even smaller. LookSmart clearly dominates this market and will likely keep a majority market share as the market expands. Furthermore, the company is currently accelerating product development spending in order to take advantage of
new product opportunities and protect its market position. Current projects include spending to: 1) improve the search
algorithm at WiseNut - its proprietary search engine, 2) enhance the benefits of combining the WiseNut search engine
with LookSmart editorial expertise, and 3) improve the backend experience for its advertisers/customers. This stepped up
spending is being driven in part by early indications from customers that these products represent meaningful
advancements/improvements to relevance and customer ROI.
In early 2000, LookSmart and British Telecom (BT) entered into a joint venture to provide local directory services in
Europe and Asia. Under the terms of the venture, each company had an equal equity interest and each company was
required to provide equal funding to the enterprise. To provide its share of the capital LookSmart borrowed $50 million
from BT. The agreement was renegotiated in December 2001, leaving LookSmart with $35 million debt at a 15% annual
interest rate.
In December 2002, BT and LookSmart agreed to terminate the venture. In return for $3.5 million in cash and 1 million
shares of LookSmart stock BT forgave the debt owed (now $40.2 million) and the joint venture transferred the operating
assets and the directories of the UK and Japanese subsidiaries to LookSmart. LookSmart recorded a one time gain of
$32.6 million in Q4 of 2002, but, more importantly, the company now owns two very good international search properties
and is well positioned to apply its US technology and expertise to its international units. The international search market is
expected to grow rapidly. By 2005 the market is projected to reach $500 million. LookSmart already has relationships
with some of the larger international portals and with their directory expertise they should be able to develop this market
more fully during the next 12 to 24 months.
LookSmart and its market, paid inclusion, are presently not well understood by Wall Street and the current stock price is
not reflective of the potential revenue and earnings growth the company is likely to generate in the coming years.
Specifically, LookSmart has unique competitive advantages and an overwhelming leadership position. The company’s
business model is durable, cogent and profitable. As a result, the stock is undervalued and represents a very attractive long
term opportunity.
COMPANY DESCRIPTION AND BACKGROUND
LookSmart, currently headquartered in San Francisco, was incorporated in 1996 and grew rapidly in the early days of the
internet by delivering targeted banner ads around Internet search results and leveraging the value of the LookSmart
directory of Internet URLs. As the attractiveness of banner ads waned, the company successfully transitioned its business
into what the company now calls “search targeted marketing.” LookSmart now employs close to 400 people spread over
the US, UK, and Japan. They have been able to grow their “search targeted marketing” into revenues of $96 million in
Jon R. Hickman [phone] Trading [phone] Halpern Capital, Inc..LookSmart Ltd.
May 13, 2003 www.HalpernCapital.com Page 3
2002 with an expected increase of roughly 60% in 2003. Simply put, the revised business model now generates
significant revenues by providing very relevant search results to potential customers of online businesses.
The service is called “paid inclusion” and is part of the growing paid search market place. The company’s LookListings
product provides businesses the opportunity to list their sites (for products and services) in a broadly distributed directory.
The company distributes its search results (primarily from the directory) across a large network by partnering with leading
Internet portals, Internet service providers, and search engines and media companies. The service’s two main benefits are:
1) Users get highly relevant search results, and
2) Advertisers (the online sites who paid to be included in LookSmart’s directory) receive highly targeted leads
to online shoppers/potential customers.
For this service LookSmart receives an average of $0.17 per click each time a user clicks through to an advertiser’s listed
site. In 2002, LookSmart delivered a total of 437 million paid clicks for its listings and advertising customers. Paid search
has quickly become a proven and very cost effective method for online sites to acquire customers. Paid inclusion is the
segment of the e-tailing market with the best growth prospects and is currently gaining real traction in the market place.
MARKET
As usage of the Internet and World Wide Web became pervasive in the mid to late 1990s, the idea of generating revenues
from Internet search and from advertisers became quite popular. Early attempts to profit from Internet search centered on
the delivery of banner ads. Though the effectiveness of banner ads proved disappointing, the market opportunity remained
attractive and advertisers adapted. The recent perception has been that advertising on the web died with banner ads.
However, as noted in a recent article in Business Week, the reality is that advertising is “… just changing. The popularity
of banner ads is giving way to ads tied to search results. That will help boost online advertising to $6.6 billion this year.”1
By mid 2002, US Internet users were initiating roughly 250 million searches per day with an estimated half of these
searches for specific commercial goods or services. Forrester Research estimates that about 80% of consumers find a
desired web site for products and information through the use of a search engine. A recent study from Shop.org (released
in mid May) estimates that online retail sales will climb to $100 billion in 2003, a 32% increase from 2002. At the same
time, consumers are demanding that search results be increasingly relevant. These two elements - the shear number of
internet searches and the demand for relevant search results, combined with the opportunity for advertisers to reach highly
targeted potential customers, has given rise to a new direct marketing approach: “paid search.”
The “paid search” market has two main segments: “pay for placement” and “paid inclusion”. The estimated size of the
paid search market today is roughly $2 to $3 billion with a much larger potential. As testament of the growing importance
of search in the world of the Internet, Yahoo, Ask Jeeves, Overture, and Microsoft have all recently announced “new and
improved” search capabilities or plans to improve their respective search offerings.
Pay for placement is the more mature of the two markets and is also the more widely-understood segment of paid search.
Pay for placement is the practice of an Internet portal, such as MSN, selling the first 3 or 4 listed positions from a search
result to the highest bidder of specific key words. The portals are selling the key words. Below is a screen capture for a
search on MSN for the key words “rock music.” MSN calls the first three listings in this search “Featured Sites” and has
sold placement for these key words to the three highest bidders. The idea is that consumers initiating a search will click
through to these “featured sites” because they are early in the list. About 26% of the click throughs in an average search
occur in these “featured sites”. Advertisers pay on average about $0.28 per click. Today, this market represents the
majority of the $2 to $3 billion “paid search” market. The main competitors in this part of the paid search market include
Google and Overture (LookSmart does not compete here).
Jon R. Hickman [phone] Trading [phone] Halpern Capital, Inc..LookSmart Ltd.
May 13, 2003 www.HalpernCapital.com Page 4
FEATURED SITES - ABOUT
1. RollingStone.com Top Pick
Pioneering music magazine proffers reviews and features from the print version, plus
exclusive photos and audio-video clips.
www.rollingstone.com
2. Barnes & Noble.com
Choose from a large selection of rock music available on CD.
www.barnesandnoble.com
3. Amazon.com
Shop the large selection of rock music.
www.amazon.com
The second, and, in our view, the more interesting part of the paid search market is “paid inclusion.” In 2002, paid
inclusion was roughly a $130 million market. Paid inclusion is the practice of selling the inclusion of a web site listing in
a directory. The directory is based on the editorial content of the individual sites and is searched for key words.
Placement of an individual web site listing in the search result is based on relevance, as opposed to the bidding process
that powers the pay for placement arena.
The search results using the directory and paid inclusion (see example below) include the majority of the listings in a
search (numbers 4 and up) and comprise about 74% of the clicks in an average search. MSN calls these listings “Web
Directory Sites.”
1. WEB DIRECTORY SITES - ABOUT
2. Rock on the Net
Music directory providing regular music news and charts, plus selected links to artist’s sites and info,
online stores and record labels.
www.rockonthenet.com
3. Rock 'n' Roll Hall of Fame
Take a multimedia tour of the hall honoring hundreds of artists who shaped rock'n'roll. With pictures,
sound files, and bios for each inductee.
www.rockhall.com
4. Rockmine Archives
UK-based rock music archive. Includes a rock "Cyclopedia" listing groups and their members, a
rock diary, and quiz pages.
www.rockmine.music.co.uk
5. History of Rock 'n' Roll, The
Highlights the golden decade of 1954-63, which included the musical talents of Marvin Gaye. With
historical info, biographies, and audio samples.
www.history-of-rock.com
Jon R. Hickman [phone] Trading [phone] Halpern Capital, Inc..LookSmart Ltd.
May 13, 2003 www.HalpernCapital.com Page 5
The paid inclusion model works as follows:
1) An advertiser signs up its web site to be included in the LookSmart directory.
2) A user initiates a search.
3) Relevance determines whether or not an advertiser’s site listing appears in the search results.
4) The user clicks through to the advertiser’s web site.
5) The advertiser receives a very targeted and timely sales lead.
6) The directory provider (i.e. LookSmart) receives a click through fee (average is $0.17) from the advertiser.
7) The directory provider (LookSmart) pays about 50% of the fee back to the portal (or other site) that generated
the user traffic.
The model is so robust because it provides a user of the search with extremely relevant results while the advertiser
receives a highly targeted lead just at the moment when a potential customer is shopping.
COMPETITION
LookSmart faces competition from a number of fronts as the growth of the paid search market place is causing
competitors to step up their interest and commitment. In addition, the rapid rise of the popularity of Google has focused
industry attention on the benefits of relevance in search. The primary competitors in the paid inclusion market today
include:
1) Inktomi/Yahoo
2) Ask Jeeves
3) Overture – (through the recent acquisitions of Alta Vista and Fast)
On a revenue basis in 2002, LookSmart was about five times that of the next largest competitor, Inktomi (now part of
Yahoo). However, considering the names listed above, it is clear that the industry is attracting more and better
competition. Yahoo is certainly going to put more resources at work to improve the paid inclusion product at Inktomi.
Overture, with its two recent acquisitions, is also targeting this market area as a source of future revenues. Overture
expects to roll out its new paid inclusion service this fall. At the same time, we would note that it is difficult to do paid
inclusion well. LookSmart has a substantial lead and many years of experience refining its product offering. Additionally,
in spite of the fact that Yahoo/Inktomi and LookSmart are competitors, LookSmart announced during its quarterly
conference call, a renewal of its distribution relationship with Inktomi. The market is already large and is expected to
grow more than 50% through 2005, offering plenty of opportunity for 4 or 5 solid competitors.
THE LOOKSMART ADVANTAGE
Though the industry will attract more competition in the coming years, LookSmart brings four distinct competitive
advantages to the paid inclusion market place:
• The relevance and size of the listings in the directory. The directory currently includes over 2 million sites
and the editorial group at LookSmart is continually refreshing and adding to the directory on a daily basis.
The company is intensely focused on significantly improving relevance - the more relevant the listings, the
higher the rate at which clicks convert into sales for the advertisers. No one in the industry has a directory as
large or as deep as LookSmart and this asset is truly a differentiating advantage.
Jon R. Hickman [phone] Trading [phone] Halpern Capital, Inc..LookSmart Ltd.
May 13, 2003 www.HalpernCapital.com Page 6
• The breadth and quality of its distribution network. A larger distribution network allows LookSmart to
provide higher volume and a higher quality of clicks to its customers/advertisers. We expect the company to
sign agreements with one or more key distribution partners this year.
• The fees charged to advertisers. These include cost per-click fees, set-up fees, and maintenance fees. All are
competitive and very reasonable for the advertisers/customers.
• The convenience of the services and information available to the advertiser/customer. Using
LookSmart’s web tools, an advertiser is able to constantly monitor and make changes to search marketing
campaigns. A unique and powerful part of the LookSmart offering is the ability of advertisers to easily track
the clicks coming from the directory, providing information on the relevance of key words and the ultimate
ROI of the campaign. LookSmart uses this same tracking technology to measure which sites receive the most
clicks for specific key words and then this information is fed back into the search algorithm to continually
improve relevance.
As noted on the Q1 2003 conference call, the company is aggressively investing in enhancements to its current product
offerings to maintain its market dominance. Though company management has said little about the specifics of these
efforts, revenues from new products should hit in the third and fourth quarters of this year. The products the company
seems the most excited about are centered on enhancing the benefits of combining the WiseNut search engine with the
LookSmart editorial expertise.
1 ST QUARTER RESULTS
After the company’s recent quarterly report, its miss on the bottom line and the lower EBITDA guidance going forward,
we feel there is a significant misperception of LookSmart’s current value and longer term prospects. The best illustration
of the company’s real worth and potential is a look
at its listings revenues.
The company missed the quarterly guidance by
$500,000 on the bottom line due to added legal and
tax expenses primarily related to the UK and
Japanese operations. This was a relatively small
miss and has little bearing on the company’s longer
term fundamentals.
The real key to the LookSmart story is the revenue
growth. Revenues for the quarter were actually
above expectations. The chart to the left (taken
from LookSmart’s latest quarterly information)
shows the dramatic and continuing growth in
listing revenues. Note the sequential growth from
Q4 02 into Q1 03. Given the expected growth of
paid search in general and paid inclusion
specifically, we feel it is highly unlikely that this
trend will change anytime soon. The company’s
problems for the quarter had nothing to do with
the demand for its services or the costs of
distribution. The only issue going forward is the level of expenses and over time expenses are controllable.
Jon R. Hickman [phone] Trading [phone] Halpern Capital, Inc..LookSmart Ltd.
May 13, 2003 www.HalpernCapital.com Page 7
As the industry grows, we believe LookSmart will maintain a considerable share (at least 50%) of the market and when
the market reaches the estimated $2 billion mark, LookSmart will be a much larger company and the recent quarter’s
issues will be forgotten.
Given LookSmart’s years of development, strength of the embedded technology and the large partnership network, we
feel it is highly unlikely that the company’s overall offering could be duplicated by a competitor any time in the
foreseeable future. The future potential is huge and we feel the company is on track to take full advantage of coming
opportunity.
RISKS/THE MSN RELATIONSHIP
Apart form the normal execution risks that any enterprise faces there are two specific risks to LookSmart’s growth
potential over the next 6 to 12 months. By far the issue of most import in investor’s minds is the MSN relationship.
Currently, the company generates well over half of its annual revenues from MSN-generated traffic. The current contract
defining this relationship and the revenue split ends in December of this year.
There is no question that LookSmart is willing and eager to re-sign with MSN. The issue is…does MSN need the
LookSmart offering to continue to be an effective competitor in the search market? We believe the answer is yes for the
following reasons:
1) We believe that the focus of MSN’s efforts surrounding search is “relevance.” We believe that MSN
(along with everyone else) is aggressively trying to combat the threat from Google. To this end, teaming
with LookSmart offers MSN access to a tool, the LookSmart directory, which dramatically enhances
relevance due to the editorial review received by all the listings in the directory.
2) To duplicate this directory would take MSN several years and millions of dollars in resources to either
build the technology themselves or purchase a directory from a LookSmart competitor. The fact that the
LookSmart BT joint venture was slow getting off the ground is a testament to how difficult it is to build a
quality directory service.
3) At present there is not a ready made acquisition candidate as the competitors that are still independent
(Ask Jeeves and FindWhat) are primarily involved in the pay for placement market and have not built
robust directories.
4) A recent report out of IDC states that MSN is in the midst of a major refocusing effort. IDC believes that
MSN will move out of the Internet access business and will become strictly a portal. If this is the case, we
feel it is unlikely that MSN would want to disrupt the revenue stream from LookSmart while changing its
whole consumer focus.
5) Building a competing directory is an undertaking requiring contracts with millions of advertisers and is
not something we believe MSN could do in secret. No word has, as yet, leaked out that MSN is working
with Web sites to editorialize content for a MSN directory.
6) On top of the relevance issue, MSN would also have to develop the back-end service, reporting and
tracking tools. Some of this technology, especially the click tracking tools acquired with the LookSmart’s
purchase of Primary Knowledge, is highly proprietary.
We are confident (as is LookSmart) that the association the two companies have is attractive and rewarding for both
parties (in 2002 MSN received about $40 million from its share of the revenues advertisers paid for the LookSmart
Jon R. Hickman [phone] Trading [phone] Halpern Capital, Inc..LookSmart Ltd.
May 13, 2003 www.HalpernCapital.com Page 8
service). For all of the above reasons we are optimistic that MSN and LookSmart will negotiate a long term contact that
will renew their current relationship with terms that are again beneficial to both companies. However, the risk will remain
and investors will worry until a new agreement is announced. However, if MSN were to choose some other solution, other
than working with LookSmart, our projections for 2004 revenues and earnings would have to be significantly reduced.
The second specific risk pertains to the company’s distribution network. Though the current network is quite broad and
offers adequate opportunity for growth though the end of 2003, LookSmart will need to sign other large distribution
partners to continue to grow at the expected pace into 2004. If LookSmart is unable to expand the network, growth
expectations in 2004 and 2005 would have to come down.
CONCLUSION
We feel that LookSmart represents not only a solid and promising fundamental outlook, but also a very attractive value at
current prices. The stock has suffered during the last two years with the collapse of technology, Internet issues and
associated difficulties as the company transitioned into the paid inclusion market. More recently, as noted above, the
company missed quarterly earnings expectations and lowered its earnings guidance for 2003. As a result, with the drop of
the stock, the valuation is compelling on both an absolute and relative (to its peers) basis.
Assuming there are no further missteps in the coming quarters and there is favorable news concerning the MSN
relationship, share price will likely move higher to reflect the positive dynamics of the market and the business model.
In conclusion, we believe LookSmart offers attractive return potential based on its unique position in the “Paid
Inclusion” market. We believe that LookSmart is years ahead of the competition with its proprietary directory and
additional web tools. With a dominant hold on its market, which is growing over 50% a year, we believe that LookSmart
will be able to continue its trend of unabated growth in the coming quarters. Once certain concerns, such as MSN and new
competitors, are resolved, the stock should be able to reflect its full valuation potential.
1 “The E-Business Surprise”, Business Week, May 12, 2003, pp 60-66
Jon R. Hickman [phone] Trading [phone] Halpern Capital, Inc..LookSmart Ltd.
May 13, 2003 www.HalpernCapital.com Page 9
Jon R. Hickman [phone] Trading [phone] Halpern Capital, Inc.
MANAGEMENT TEAM
Evan Thornley – Chairman
Before founding LookSmart in October 1995, Evan was a consultant at McKinsey & Company, the global consulting
firm, in its New York, Kuala Lumpur, and Melbourne offices.
Jason Kellerman - Chief Executive Officer
Jason joined LookSmart's San Francisco team as director of eCommerce in March 1999. He was appointed chief operating
officer for LookSmart in July 2001, and was promoted to chief executive officer on October 1, 2002.
Dianne Dubois - Chief Financial Officer
Before joining LookSmart in August of 2001, Dianne most recently served as the vice president of finance, North
America for E*TRADE. While at E*TRADE, she was responsible for the development of E*TRADE Advisor, including
its strategy, operations and management.
Peter Adams - Chief Technology Officer & Senior Vice President
As chief technology and product development executive, Peter leads all aspects of LookSmart's product development,
engineering and technical operations. Prior to its acquisition by LookSmart in October 2001, Peter was CEO of Primary
Knowledge.
Brian Cowley - Senior Vice President, Business Development
Brian rejoined LookSmart after serving as vice president, general manager of sponsorship & services at eBay. At eBay he
was responsible for $140M in revenue and managed a team of 25..Jon R. Hickman [phone] TRADING: 866-454-3004
2001 2002 2003E 2004E
Revenue
Listings 59,466 74,659 138,934 196,500
Licensing 14,533 14,699 14,469 10,000
Other 9,774 6,670 - -
Total 83,773 96,028 153,403 206,500
Cost of Revenues 27,721 37,385 76,917 105,000
Gross Profit 56,052 58,643 76,486 101,500
Operating Expenses
Sales & Marketing 22,118 20,786 24,587 26,500
Product Development 23,129 23,139 28,182 28,000
General & Admin. 9,652 10,261 12,554 15,000
Total 54,899 54,186 65,323 69,500
Operating Profit/(Loss) $1,153 $4,457 $11,163 $32,000
Non Operating income/(exp) (10,551) 23,425 154 100
Income Tax Benefit / (exp) (102) 80 (116) (100)
Net Profit/(Loss) (9,500) 27,962 11,201 32,000
Shares - fully diluted 109,000 109,000 109,000 110,000
EPS - fully diluted (0.10) 0.25 0.10 0.29
EBITDA Earnings/( loss) 12,722 14,393 17,964 38,000
EBITDA Earnings/( loss) Per Share 0.13 0.14 0.16 0.34
Revenue
Listings 71.0% 77.7% 90.6% 95.2%
Licensing 17.3% 15.3% 9.4% 4.8%
Total revenues 100% 100% 100% 100%
Gross Margin 66.9% 61.1% 49.9% 49.2%
Operating Expenses (not all items include)
Sales & Marketing 26.4% 21.6% 16.0% 12.8%
R&D 27.6% 24.1% 18.4% 13.6%
General & Admin. 11.5% 10.7% 8.2% 7.3%
Total 65.5% 56.4% 42.6% 33.7%
Operating Profit/(Loss) 1.4% 4.6% 7.3% 15.5%
Net Profit/(Loss) -11.3% 29.1% 7.3% 15.5%
Revenue
Listings NA 26% 86% 41%
Licensing NA 1% -2% -31%
Total revenues NA 15% 60% 35%
Gross Margin NA 5% 30% 33%
Total Operating Expenses NA -1% 21% 6%
Operating Profit/(Loss) NA 287% 150% 187%
Net Profit/(Loss) NA -394% -60% 186%
EBITDA Earnings/( loss) Per Share NA 7% 14% 106%