LookSmart's Microsoft deal looks rocky

LookSmart stated in its second-quarter financial report, filed last week, that Microsoft began testing its own search technology on several of its U.K. sites in July. Those tests eliminated the directory layer of search results in which LookSmart's listings currently appear, according to the company. LookSmart estimated that it derived 64 percent of its overall listings revenue from Microsoft-related business over the last six months.

According to LookSmart, Microsoft indicated that it may combine directory and index layers of search results on its Web sites into a single set. Directory listings are selected by editors who evaluate sites by categories. Index listings are generated by crawler-based search technology. LookSmart said consolidating the listings would "likely result in significantly lower paid clicks and listings revenues" and admitted that it could lose its distribution deal with the software giant altogether.

On Friday, LookSmart shares tumbled, dropping more than 20 percent to just more than $3. The company's stock continued to fall Monday.

Industry analysts agreed that the loss of Microsoft's business could prove damaging for LookSmart. Charlene Li, principal analyst for Forrester Research, pointed out that, unlike rivals such as Inktomi and Overture, LookSmart doesn't have a captive audience to help drive revenues. Search giant Yahoo owns Inktomi and is in the process of acquiring Overture.

"Microsoft holds its own future in its hands regarding search, and it very well may be able to do without LookSmart," Li said. "I think LookSmart has got to be saying to Microsoft, 'Why not buy us instead of building similar tools in-house?'"

"The key for MSN, Yahoo and AOL is that they know the context of the searches--whether users are more likely to be looking for dishes or a country when they search for 'China,'" Li said. "It's probably only a matter of time before Microsoft can create an effective search tool from an algorithmic standpoint."

Earlier this year, Microsoft quietly launched its new search program, dubbed MSNBot, which scours the Web to build an index of HTML links and documents. The proprietary system handles robot functions previously left to partners such as LookSmart and Inktomi. As the software giant continues to make the search technology a more significant piece of its overall strategy, analysts think the tool could also threaten Web search providers such as Google.

According to Li, Microsoft's heavy flow of MSN-based Internet traffic and its ability to use its search tools in its array of Web sites will likely equate to success for MSNBot.

Microsoft indicated to LookSmart that it would expand its MSNBot tests across all searches on its U.K. sites starting as early as September, and that it plans to conduct a similar test on some of its U.S. sites in October. LookSmart said it would remain dependent upon Microsoft for licensing revenues in the remainder of 2003 and reported that it believes the licensing portion of its current agreement could still be renewed into 2004. However, the company admitted that such a renewal would likely deliver a smaller amount of licensing revenue than does its current deal.

One ray of hope for LookSmart is Microsoft's indication that it would also test a range of different search configurations over the next several months, some of which would still drive clicks through LookSmart listings. The company reported that some of the implementations could even "preserve a majority of paid clicks and listings revenues." But LookSmart said if its Microsoft contract is not renewed, the company's overall financial results would be "materially and adversely affected."