A Question for Answers Corp.

Question: Does it make sense for a company with 2006 revenues of $7 million to spend $100 million in cash to buy another company with $7 million in 2006 revenues? According to Answers Corp. (ANSW) – and a couple analysts whose banks make a market in the company – the answer is yes, at least if you look ahead a year.

Answers Corp., which runs the information site Answers.com, announced on July 16 that it would pay that amount for Lexico Publishing Group, which owns Dictionary.com, Thesaurus.com and Reference.com (see ANSW conference call discussing the acquisition).

Answers.com, launched in 1999, is trying to become the leading reference site on the Internet, while not competing directly with search engines. It started out as a site providing information about such topics as health, finance, business and entertainment, directing people to licensed information from sources such as Barron’s and Encyclopedia Britannica, as well as its own editorial team. Last November it paid $2 million for FaqFarm, now called WikiAnswers.com, a site that allows users to answer questions posted by others. Since then, WikiAnswers has become the second largest Q&A site on the Web, with 8.5% of the market as measured by visits, albeit far behind the leader, Yahoo! Inc.'s (Nasdaq: YHOO) Yahoo! Answers.

Investors understandably see this as a big and risky deal for a small company. Since the announcement on July 16, the stock has lost about $3, trading now at about $10.50. Its 52-week high was nearly $18 per share in early June, based mostly on rumors that it would be acquired, possibly by Google or another search engine. Its current market cap is $84 million.

The investors’ reaction is not a surprising one. Answers currently has just $9 million in cash and equivalents. In order to make the $100 million purchase, it has filed a shelf registration to sell up to $140 million in debt securities, common and preferred stock, warrants and units. Answers.com reported a $303,000 net loss on $3.4 million revenues for the first quarter ended March 31. For all of 2006, it had a net loss of $8.6 million on $7.0 million revenues. Privately-held Lexico had net income of $2.8 million on $7 million revenues for 2006, according to the press release on the acquisition.

But the two investment banks that follow Answers, both of which expect to provide investment banking services for the company in the next six months, believe the acquisition makes sense for 2008 profitability (the company expects the deal to close this fall.) That’s primarily because Lexico is not as good at creating revenues from its site visitors as is Answers.

Dictionary.com, Lexico’s primary money maker, generates revenues of $1.75 per million page views [RPM], from a mix of display ads and Google ads. But its Google ads are the weak point, generating just $.030 RPM. Answers has spent the last couple years optimizing its site to generate more profitable Google ads, resulting in $3.70 RPM from AdSense, according to Canaccord Adams. “Dictionary.com is not monetizing its assets very well,” says Canaccord Adams analyst Colin Gillis.

Gillis says that every $1 increase in RPM that Answers can squeeze out of Dictionary.com will result in an additional $5 million in revenue, dropping directly to the bottom line. For 2008, Gillis is projecting a total RPM (both display and Google ads) of $8.93 for Answers.com and $4 for Dictionary.com. With an estimated 3 billion page views on Answers.com and 5 billion on Dictionary.com in 2008, the combined company should have a net profit of $15.1 million (almost all of it from Dictionary.com) on revenues of $47.8 million.

Gillis figures that Answers is paying six to seven times 2008 EBITDA for the company, much more palatable than the 34 times 2006 EBITDA that has spooked investors.

Matthew Weiss at Maxim Group projects slightly lower numbers. His “conservative” estimate is that Dictionary.com could generate $9 million in EBITDA next year, pricing the acquisition at about 11 times 2008 EBITDA. “This stock is not for the faint of heart,” says Weiss. “But it’s simply a math problem. The long-term potential is better.”

The math, of course, depends on a lot of assumptions, including maintaining their 30% rate of annual traffic growth and ad pricing remaining stable. Weiss has set a target price of $18 per share for Answers, while Gillis has targeted $20 per share, a 26X multiple on his 2008 earnings estimate. The closest comparable companies are the search engines. Yahoo is currently trading at P/E of 49, IAC/Interactive (which owns Ask.com) has a P/E of 50, and Google’s is at 44. Not for the faint of heart indeed, but for investors who like to gamble, Answers could prove to be the answer to their dreams.