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research note.confusion 10-q creates buying opport

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    Confusion Over Language in 10-Q Creates Buying Opportunity
    AUGUST 19 2003
    EQUITY RESEARCH: Internet Services
    Jon R. Hickman
    [email protected]
    Phone (510) 918-4045
    Research Note
    This note is used to provide information to you
    on a timely basis. It is informational only.
    Please speak to our analyst for a more
    thorough discussion of the subject matter…..Jon R. Hickman (510) 918-4045 Halpern Capital, Inc.

    www.HalpernCapital.com
    August 19, 2003
    Price/ Revenue EV/ EBITDA EV/
    Year EPS* EPS (MM) REV (MM) EBITDA
    2004E $0.36 7.6 x $207.50 1.2 40.0 6.1
    2003E $0.18 15.6 x $156.81 1.6 19.4 12.6
    * based on Cash Earnings

    In its recent 10-Q LookSmart included additional disclosures
    concerning MSN’s ongoing testing of search results in the UK. We
    believe there is very little that is actually new in these disclosures and we do not believe these disclosures represent significant new risks for the continuation of LookSmart’s relationship with MSN. We remain convinced that the two companies will renew the licensing relationship
    with terms that are beneficial to both firms. We are not changing our earnings estimates and feel that the recent price decline in LookSmart’s shares represents a very attractive buying opportunity.

    OUR THOUGHTS
    In its 10-Q released last week, LookSmart added additional comments in the discussion of its relationship with MSN (these comments had not been included in past 10-Qs). These additional disclosures contained information about some of MSN’s recent search testing in the UK. Investors have interpreted these
    comments to signify that the licensing relationship with MSN and MSN’s use of the LookSmart directory is in jeopardy. As a result, LookSmart’s shares have declined over 30% from the Thursday August 14th close. Below we will discuss
    the comments in the 10-Q and our impressions of the real meaning behind the company’s comments.

    We believe there were three comments that served to spook LookSmart investors:

    1. Microsoft conducted a test on a small percentage of searches on its web site in the UK that eliminated the directory layer of the search results.

    2. Microsoft indicated that it will expand this test across all searches on it web site in the UK
    NASDAQ: LOOK- $2.75

    3. Microsoft has also indicated that it intends to conduct a similar test on a small percentage of searches on its
    web site in the United States.

    In analyzing these statements we would point out that Microsoft initiated an effort to restructure its search product early in
    2003 with a complete new team of people. While building a new product Microsoft is concerned with maximizing both
    relevance and revenue within the current solution. To gain understanding and expertise in the search market the team at
    Microsoft has been in a “test and learn” mode for much of the summer and will continue to test combinations and
    variations of search solutions for relevance and revenue. This new team at Microsoft is renegotiating the licensing and
    distribution agreement with LookSmart and it is interested in as much information as possible to help them in these
    negotiations. One additional fact is that in 2002 Microsoft generated roughly $42 million from the LookSmart
    relationship, an amount that should rise substantially in 2003
    With this background our view of Microsoft’s actions and

    LookSmart’s comments are as follows:
    1. Microsoft is simply testing the LookSmart product against other solutions for both revenue and relevance as many other distribution portals and distribution partners have done in the past. We are confident that LookSmart provides the market leading solution for relevance and revenue in paid inclusion. The addition of LookSmart’s ORS product improves further search relevance and has increased the company’s technological
    advantage. When the results from Microsoft’s testing are available, we believe they will again demonstrate that the LookSmart solution is advantageous to Microsoft and its advertising sites.

    2. Though the testing will include a larger sample of searches over the next few months, these actions by Microsoft are not expected to affect LookSmart’s results for the remainder of 2003.

    3. There has been no indication that Microsoft is working on building its own directory service and we believe it
    is unlikely that Microsoft has or will be able to find a replacement for LookSmart’s directory and the results it
    provides to the market.

    4. We believe that Microsoft’s decision to test in the U.S. is actually advantageous to LookSmart. The U.S. directory has a greater paid density and will produce better revenue results than the UK directory.

    5. Microsoft has indicated interest in testing LookSmart’s new ORS product. We believe that LookSmart continues to benefit from growth in e-commerce and is also a direct beneficiary of the
    growing use of targeted marking on the web. Data from Comscore Networks through the end of July indicates that overall
    online retail spending in the 3rd quarter is up approximately 34% year over year and online retailers are anticipating a
    strong holiday season. Additionally, we believe that advertisers are becoming more aware of the value of paid search
    (including paid inclusion) and are switching from banner ads and expensive TV advertising.

    We would also point out that LookSmart has the very real opportunity to add additional distribution partners in the
    coming months. The company has indicated in the past that there have been meaningful discussions with enterprises such
    as AOL and Yahoo. LookSmart’s paid inclusion solution improves relevance in search results and provides excellent
    targeted marketing for advertisers and these facts are not lost on the large internet portals. We would not be surprised to
    have LookSmart announce another large distribution partnership in the coming months. With addition of another
    distribution partner and the agreement with Terra Lycos, LookSmart’s reliance on MSN traffic would be substantially
    reduced.

    VALUATION AND CONCLUSIONS
    LookSmart’s second quarter was excellent and points to the growing success of its product offerings. We remain
    confident that LookSmart’s long-term potential is intact and is actually improving. We are not changing our revenue or
    earnings estimates. We continue to believe that cash earnings will be $0.18 in 2003 and at current prices the shares once
    again represent a compelling value and recommend purchase of the stock.
 
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