February 28, 2006, 12:00 AM

Are these guys making too much money?

The high cost of keyword search bids is turning some retailers off.

The blows were unexpected for two premier online brands. Jeweler Blue Nile Inc. and florist FTD Group Inc.-both of which should benefit greatly from holiday gift giving and both among the 50 largest web merchants-found themselves coming up short in 2005’s fourth quarter online sales and wondering why.

Fourth-quarter orders at FTD.com were 4% below Q4 2004, while Blue Nile’s sales fell short of management’s expectations and were up 13.5% in a market that grew 25%. Both ultimately fingered the same culprit: High bid prices had spoiled their expectations for how many sales search marketing would drive.

“In December, we had three weeks of sales that were below expectations,” Blue Nile CEO Mark Vadon said in a conference call with stock analysts for the fiscal first quarter, which ended Jan. 1. As it had in the past several years, ever since search marketing had replaced portal advertising as its preferred advertising channel, Blue Nile placed most of its ad dollars into search for the 2005 holiday season.

While the season started out strong in November, by December, “irrational competition,” in Vadon’s words, in search keyword bidding had pushed up Blue Nile’s cost per click on Google to more than 50% over the prior December. The price of its top five keywords rose by over 80%. As prices surged, a more crowded search market converted fewer searchers into buyers, he added.

Paid-search marketing had suddenly lost its shine as the jewelry retailer’s most effective means of bringing in new customers. “We were surprised at how aggressive search marketing got,” Vadon said.

Aggravating the situation for many retailers is the habit they’ve built up over the last several years of over-relying on search to maintain traffic and sales, experts say. “Three years ago, Internet search was a good value for any retail category, but now it’s not always the value it was,” says Aaron Kessler, senior research analyst who follows e-retailers for investment research firm Piper Jaffray & Co. “It’s a great marketing channel when it works, but many retailers have become too reliant on it.”

In December, Blue Nile learned the limits of search engine marketing, Vadon admitted. “Our marketing skewed toward search engine marketing, and given our experience, it had seemed like the prudent thing to do,” he said. “But we were unable to drive traffic as we had expected.”

As Christmas approached, Vadon figures, more jewelry retailers jumped on the paid-search wagon, hoping to hit the peak of the shopping season at or near the top of search rankings. “A tremendous number of small players play in the market for a week or two,” he said.

That not only sent keyword prices sky-high for popular terms like “diamonds,” “pearls” and “jewelry,” but it also crowded the paid-search listings with additional advertisers. And when consumers click through more paid-search listings to check out offers, it leads to lower conversion rates, Vadon said. “As bidding goes up, it causes downward pressure on conversions,” he said.

The beat goes on

Strong competition among search marketers continued into the first quarter of this year-even among companies that provide search platforms, Vadon went on. “We saw MSN Shopping appear on Google, bidding to take customers from Google to MSN,” he said. “Those economics just don’t add up.”

An indication of the popularity of search can be found in Google’s financial reports. Google’s revenue and profits have surged steadily over the past several years. Revenue grew 14-fold from 2002 to 2005, with last year’s $6.14 billion up 98% over 2004. Net income grew nearly 15-fold over the same period, to $1.47 billion from $99.67 million, as it grew to 24% of revenue last year, Google reports.

Whether Google may be in for a market resistance that could temper its growth depends on how many more retailers like FTD and Blue Nile pull back on search engine marketing, analysts say. “As long as retailers can get ROI out of search, they don’t care how much money Google makes,” says Piper Jaffray’s Kessler. “But it remains to be seen how many retailers will be able to get the ROI they need.”

As Google’s numbers show, Internet search continues to be a major force in advertising, often accounting for 50% or more of traffic and sales acquired through online advertising, experts say. A study by web marketing and analytics firm WebSideStory Inc. found that the average fourth-quarter 2005 conversion rate for customers who arrived at a site via a search engine was 2.3%, more than double the average 0.96% from other online advertising sources such as affiliate sites and banner ads. And web search is appearing more among mainstream advertising, as shown by recent Pontiac TV commercials that show a Google search page, with a voice-over advising consumers, “Don’t take our word for it. Google Pontiac and discover for yourself.”

Retailers continue to be attracted to search because that’s where Internet users are. In December, the number of searches conducted across some 60 Internet search engines grew 55% year-over-year to nearly 5.1 billion, according to researchers Nielsen/NetRatings. Meanwhile, the number of people connecting to the web grew only 3% over the same period.

If current trends continue, U.S. spending on search engine marketing will outpace other forms of online advertising, growing from $4.2 billion last year to $7.5 billion in 2010, as the current online leader, display ads, grows from $5.1 billion to $7.2 billion, Jupiter Research reports.

But as important as search marketing has become to marketers, it has also become more complex and more challenging to squeeze out the ROI. Even major retailers whose powerful national brands bolster their marketing efforts say they’re putting more resources into search marketing, while keeping a more watchful eye on the payback. “We grew our SEM budget aggressively last year and we’ll continue to grow it aggressively this year,” says Sam Taylor, vice president of online stores and marketing for Best Buy Co. Inc. “But the bottom line is it has to be profitable on an ROI basis.”

FTD’s woes

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