Internet Outsider

How Mortgage Collapse Could Wallop GOOG, YHOO, RATE, et al

From Silicon Alley Insider: We believe most analysts are severely underestimating the impact the mortgage collapse could have on online advertising spending.  The same trends that are hurting mortgage companies will likely weaken spending by other financial services and housing-market-related companies--and the financial-services sector alone accounts for one-third of U.S. online advertising.  This bodes poorly for the revenue performance and stocks of Google (GOOG), Yahoo (YHOO), AOL (TW), Bankrate (RATE), and other ad-driven companies.

Yesterday, Peter Kafka laid out the bullish case for the mortgage-impact-on-online-ads and then explained why we take a more bearish view.  In this follow-up analysis, we run the actual numbers.  Here are the key points we think the bulls are missing:

1. The factors hurting mortgage companies will affect more than just the mortgage sector, especially other financial services companies.
2. Financial services alone accounts for about one-third of U.S. online ad spending.

We have run five scenarios  (conservative to aggressive), which we explain in detail after the jump.  Using the "base" scenario (middle case) and actual Q2 revenue for the "Big Four" (Google, Yahoo, AOL, and Microsoft), here is the summary conclusion: 

Assuming full impact of the mortgage crisis but no other economic spillover, we estimate that Q2 "Big Four" revenue would have been 5% lower (19% growth vs. 26%).  Assuming reasonable economic spillover, we estimate that revenue would have been 13% lower (9% growth).  This impact would be enough to cause the leading companies to miss numbers in Q4.

U.S. Internet Advertising Revenue    Q206A    Q207A    Y/Y                                                   
Total Actual "Big Four"                        $3,349    $4,212    26%                                     

With Est. Mortgage Impact Alone (Base)             $3,997    19%
With Est. Total Economic Impact (Base)              $3,654    9%      

This page lays out the actual year-over-year growth for the Big Four and our five scenarios for the potential mortgage impact on online advertising. We first estimate the impact of the mortgage collapse alone.  Then we estimate possible additional impact from an economic chain reaction. We run five scenarios, from conservative to aggressive.

MORTGAGE IMPACT

For our "mortgage impact" analysis, we make the following assumptions:

1. Financial services percentage of U.S. online ads (34%, per July Nielsen estimate of impressions)
2. Mortgage sector percent of financial services spending (20% to 40% range, 30% base)
3. Mortgage sector spending reduction after collapse (-30% to -70%, -50% base)

We conclude that a fall-off in mortgage sector spending alone could shrink Q2 run-rate online advertising spending by -2% to -10% (-5% base).

OTHER ECONOMIC IMPACT

As Peter Kafka explained yesterday, the mortgage sector is not a hermetically sealed corner of the financial services industry.  The crisis has already hit the performance and stocks of investment banks, private-equity firms, and other financial services companies.  A declining housing market, moreover, is putting pressure on REITs, real-estate agents, appraisal firms, contractors, home-supply companies, movers, and other industries, some of which will likely reduce online ad spending accordingly.

Our "economic spillover" analysis makes the following additional assumptions:

1. Percent reduction in "non-mortgage" financial services spending (-5% to -25%, -15% base)
2. Percent reduction in non-financial online ad spending (-2% to -20%, -6% base)

We conclude that the mortgage collapse plus a reasonable economic spillover could reduce run-rate U.S. online advertising spending by -5% to -23% (-13% base). 

IMPORTANT NOTE

This analysis makes assumptions about only U.S. online advertising revenue.  Google's U.S. revenue now accounts for only one-half of its business.  Please feel free to weigh in with thoughts: hblodget@alleyinsider.com.

Mary Meeker's YouTube Math

From Silicon Alley Insider: Morgan Stanley's Internet analyst Mary Meeker was a good deal more optimistic than we and most others about the revenue impact of YouTube's new overlay ads.  Specifically, Mary concluded that the overlays could immediately add $4.8 billion of gross revenue and $720 million of net revenue to Google's annual results.  This compared to the tiny $12 million to $360 million of gross revenue that we projected.

Well, we were baffled at how Mary could be so amazingly bullish, so, on a tip from a reader, we checked her numbers.  And, Mary, it may be time to scream at yet another research assistant.  Why?  Because, in advertising lingo, "CPM" means "Cost Per Thousand" not "Cost Per One."  When Mary updates her model to divide by 1,000, therefore, we expect she will wish to revise her conclusions.

What happens to Mary's estimates when you do the math right?  Well, that $4.8 billion of gross revenue becomes $4.8 million, and the $720 million of net revenue becomes $720 thousand.  So if, as Mary suggests, Google can float ads on top of 20 million streams a month, secure a $20 CPM, and keep 15% of the gross revenue, the overall impact will actually be, as we suggested yesterday, immaterial.

Here's Mary's note (PDF) Meeker's YouTube Math.  Here's a page laying out Mary's math and the correct math.  And here's our own YouTube math.

(Update: And let he who is without sin cast the first stone... As Charlie Wood points out, the original version of this post had its own numerical typo. Mary, I'm feeling your pain!)

"We estimate that Google will generate $100 trillion of revenue in 2010. Or maybe $10 billion.  Whatever."

Analyzing YouTube's Revenue Potential

From Silicon Alley Insider: So, Google's YouTube will finally sell video ads.  How much revenue will they generate?  Most likely, not enough to materially affect Google's overall revenue for at least a year or two.  Over the long haul, the contribution could be very material, at least on the top line.

Let's run the numbers. 

Emily Steel's WSJ and Miguel Helft's Times articles included several key data points:

• YouTube is testing overlay ads that run along the bottom of videos.  If viewers click on these ads, the videos they are watching will pause, and the ad will launch.
• YouTube will only run ads on videos from signed content partners (for now).
• In tests, approximately 75% of viewers presented with an ad chose to watch the whole ad.
• Google plans to begin by charging a $20 CPM.

Combining this information with Comscore's finding that YouTube streamed 1.7 billion videos in May, we can construct a basic range of revenue estimates.  What is important here, moreover, is not how much revenue YouTube can generate today, but how much it can generate in, say, five to ten years, when video is many times more popular, other ad formats are in use, and the company has many more content partners. So, we'll also run a range of estimates based on possible traffic in five years.

ASSUMPTIONS

For our initial scenarios, we make the following assumptions:

• Google streams 2 billion videos a month (up modestly from the May numbers)
• A sub-set of this group are from content partners and will eventually have ads (we'll run a range of 10%-50%)
• A sub-set of this group will have ads that are actually watched (we'll run a range of 33%-75%.  In tests, 75% of videos were watched, but this was likely heavily influenced by the curiosity factor.  In the early banner ad days, banner click-through percentages were high, too).
• The ads will be highly targeted, full-motion video, and should therefore command a high CPM (we'll run a range of $10-$50).

RESULTS

We ran five scenarios, from Conservative to Aggressive (please see this page for details). In the Conservative scenario, YouTube generates about $8 million in revenue, less than 1/10th of one percent of Google's overall revenue ($16 billion).  In the Aggressive scenario, the company generates about $450 million of revenue--enough to make a meaningful contribution, but barely.

FIVE YEARS FROM NOW

We also ran scenarios using a far higher number of monthly streams (range: 10 billion to 50 billion), a greater percentage of ad penetration within videos (range: 50% to 70%), and a similar percentage of ads watched as in the above scenarios (range: 33% to 60%).  Here, the revenue is far more meaningful.  In the Conservative scenario, YouTube generates $200 million of revenue: nice, but nothing to write home about.  In the Aggressive scenario, however, the company generates $13 billion of revenue--closing in on Google's current revenue today.

BOTTOM LINE

In short, YouTube's revenue won't likely be material to Google for at least a year or two and possibly more.  The impact on the bottom line, moreover, will probably be even less pronounced: Serving a video ad, even for Google, is far more expensive than serving a text link.  At a $20 CPM, the gross margin on such ads will likely be well below Google's current margins.

After the jump: More details from the WSJ story
In this spreadsheet: Detailed assumptions and results.

About That Crashing Stock Market

A reader was kind enough to ask me to comment about the market, so here goes:

I don't know whether this is a "correction in a bull market" or the "start of a bear market," but I am far more persuaded by the latter case.  After ten years on Wall Street, however, I can promise you this: No one else knows either.  Go ahead and listen to the parade of smart guests on Bubblevision--their reasoning ranges from impeccable to hilarious--but just don't let yourself get seduced into betting big one way or the other.  Because no one knows.  (We have 50/50 odds, though, so half of us will be "right").

One thing we do know: Based on correctly calculated long-term valuation trends (cyclically adjusted P/E), the stock market is still extremely expensive (close to the peak levels of 1929, 1966, and 1987, and only below the all-time peak of 2000).  I expect that this will eventually revert to the mean, and that one of these days we will see the "start of a bear market" that could take us below the 7700 trough on the DOW in 2002. This could be it (and if it is, this is just what it will look like). And given the housing market, credit crunch, oil prices, etc., it's not hard to see how we would get there.  But anything is possible, and long-term valuation trends are nearly useless for near-term timing calls. 

Why is this relevant for Internet companies?  Because the direction of the stock market is important for those who run both public and private firms, whether it seems so or not.  Crashing markets often herald crashing economies, which lead to reduced consumer spending and advertising revenue.  And crashing markets also throw buckets of cold water in the face of those who were just gleefully distributing angel and VC cash. 

I've spelled this out in more detail in the second post below, which includes a handy guide laying out the assumptions you should make about how bad it could get.  And don't forget to blame Sergey and Larry--their Q2 started it.  :)

Google Blows Up the Stock Market
The Market's Crashing: Are You Recession-Proof?

The Great Advertising Share Shift: Google Sucks Life Out Of Old Media

[From Silicon Alley Insider] Everyone talks about advertising dollars shifting online, but when you're fighting all day in the trenches it's tough to get a handle on what this really means.  Here's what it means:

US advertising revenue at 4 big online media companies--Google (GOOG), Yahoo (YHOO), AOL (TWX), and MSN (MSFT)--grew by $1.3 billion in Q2, or 42%. 

US advertising revenue at 15 big television, newspaper, magazine, radio, and outdoor companies (Time Warner, Viacom, CBS, etc.) shrank by $280 million in Q2, or 3%.

Put differently, U.S. advertising revenue at all 19 companies increased 8% year over year in Q2, to $13.8 billion ($55 billion annualized).  The online portion of this pie grew from $3 billion to $4.2 billion (23% share to 30% share).  The offline portion, meanwhile, shrank from $9.9 billion to $9.6 billion (77% share to 70% share).  The online companies, in other words, picked up 7 percentage points of market share in a single year.

Other fun facts:

Within our company set, the only traditional media business that grew U.S. advertising year-over-year in Q2 was Outdoor (up 13%). Meanwhile:

• Television (cable and broadcast) shrank 1%, or $50 million
• Print (magazines and newspapers) shrank 5%, or $170 million
• Radio (terrestrial) shrank 7%, or $105 million

Obvious Conclusions

Traditional media executives--especially in the newspaper business--often blame their current woes on "the real estate market" or "cyclical weakness."   Economic weakness may be exaggerating the downturn, but it's not the real problem.  Whatever weakness is hitting the newspapers is also hitting Google.

Media power is not only shifting by medium (the handful of Internet companies are collectively valued more highly than most of their traditional media brethren combined), but by geography. Most "big media" companies are still headquartered in New York. Most media power, however, is now headquartered in California.

These trends are secular, not cyclical: TV networks, radio networks, and newspaper companies won't suddenly wake up one morning and find themselves back in charge.  Individual Internet companies may screw up (see Yahoo/AOL), but if they do, others will rise to take their place (Google).

Traditional media executives are doing a superb job of milking cash flow out of shrinking businesses, but you can't save your way to prosperity.  The smartest companies acknowledge this and are 1) returning cash flow to shareholders, 2) diversifying via M&A (as the Washington Post has done), and/or investing in or buying promising interactive businesses.

Details

We looked at US advertising revenue for 19 companies: Google, Yahoo, AOL, Microsoft, Time Warner, Viacom, CBS, News Corp., CBS Radio, Citadel, Disney, Entercom, Clear Channel, Clear Channel Outdoor, Time Inc., New York Times Company, McClatchy, Dow Jones, and Gannett.  We divided the companies into the following sectors: Online, Television, Print, Radio, and Outdoor.  Please see detailed data, analyses, and notes here.

Running the Numbers: Why Newspapers Are Screwed

[From Silicon Alley Insider]: It's easy to say that the New York Times and other newspaper companies are screwed, but sometimes it helps to actually run the numbers.  Do you know why they're screwed?  It's actually not the cost of paper, ink, trucks, printing plants, and other physical distribution expenses.  Rather, it's the cost of content creation.

Senior New York Times reporters believe they are underpaid, and, relative to other highly educated folks at the peak of their professions, they sure are.  But relative to the online revenue they generate, those talented reporters, columnists, editors, and fact-checkers actually cost a fortune.

Newspaper content generates way more revenue in the physical world than it does online, because offline it can be packaged with classifieds and display ads and actually sold.  In the online world, meanwhile, it has to be given away, and because classified ads are now run by classified sites and newspaper sites are only one of dozens of places where people get news, the advertising opportunity is comparatively tiny. 

How tiny?  Compete.com says the monthly reader base of NYTimes.com is about 7.5 million people. Offline circulation, meanwhile, is about 1.1 million.  If we assume that the ratio of offline/online revenue at the Times Company is similar to that for the publication itself, the 7.5 million online readers generate 10% of the publication's revenue, and the 1.1 million offline subs generate 90%. Offline circ and ad revenue are both declining.  So let's think about what might happen as these trends continue.

Specifically, let's pretend that, tomorrow morning, every print reader stops buying the paper, and, instead, reads it online.  To be safe, let's further assume that each offline "subscription" actually encompasses two or three readers.  In other words, let's pretend that, tomorrow, print circulation goes to zero, and online readership jumps by 2.5 million.  What would happen to the business?

1. The company would eliminate paper, distribution, printing, and all other physical production costs.
2. Online inventory (and, therefore, revenue) would increase by about 33% (7.5mm to 10mm users)
   
3. Content creation costs would stay the same.  (The site would have to pay the freight for all the  content it now gets for free).
4. All print revenue--ads and circulation--would vaporize.

No, no, you say, the latter assumption is absurd.  By the time print papers disappear, that $55 billion-plus of annual newspaper advertising will all have moved online, so the companies will be fine.  Yes, the advertising will have moved online.  But, no, newspapers won't be fine.  Why not?  Because only a small fraction of that $55 billion will flow to newspaper sites as opposed to eBay, Monster, Yahoo, Google, et al.  We can quibble about the exact percentage, but just for kicks, lets pretend that, if the paper were suddenly eliminated, 25% of NYT's offline revenue would flow to NYTimes.com. 

With these assumptions, we can make the following adjustments to the NYT's Q2 numbers.  (The calculations and assumptions are laid out in more detail on this page).

REVENUE:

1. Cut offline revenue to zero
2. Boost online revenue by 33% to account for increase in online readership
3. Boost online revenue by 25% of offline revenue under assumption that some will follow online.

COSTS:

1. Cut "raw materials" costs to zero.
2. Cut "other" production costs to zero, under assumption that they are ALL print-production and distribution related (which they probably aren't)
3. Reduce "wages and salaries" by 25%, under assumption that some are print-production and distribution related (which is probably too big a reduction)
4. Reduce sales, general, and administrative costs by 33% to account for lower revenue base.

RESULTS:

Revenue drops by more than half, 40%-50% of employees get fired, and the company still loses money.  Using the NYT's Q2 numbers and these assumptions, for example, revenue would have dropped from $789 million to $285 million.  More importantly, EBITDA (earnings before interest, taxes, depreciation, and amortization) would have dropped from $118 million to -$64 million.  Which means that management would just be getting ready to fire a few hundred more people.

This, in short, is why newspapers are screwed.

AOL: A Mistake to Go Free? (NYT and DJ Take Note)

With everyone speculating about what will happen when TimesSelect (NYT) and Wall Street Journal Online (DJ) go free, it makes sense to check in on the last major wall-removal story: Time Warner's (TWX) AOL.  Was AOL's move a good one?  Or should it have hung on and watched its subscriber base slowly dribble away?

Answer: It was a good move.  AOL certainly sacrificed some near-term cash flow, but, critically, it has retained (or replaced) the lost subscribers in the form of unique users.  If AOL hadn't made it's email available for free, meanwhile, it likely would have lost most of these subs forever. Also, even as AOL's subscription revenue plummeted, the company has preserved its cash flow, which is far more important. 

What hasn't happened, which would have been nice, is that unique users and pageviews haven't swelled as the rest of the world learned that AOL is now free.  This said, they also haven't collapsed, which was a distinct possibility.  (Why? Because each AOL "subscriber" represents more than one unique user, as there are usually multiple users in the same household. Also, in the old days, AOL subscribers generated far more pageviews-per-user than average uniques, because of the frequency with which they checked email.  So the loss of each subscriber could theoretically have meant the loss of more than one unique and several multiples of average pageviews.)

Let's put some numbers on this...  (If you want to see the quarterly progression, percentage changes, and calculations, please check out this spreadsheet.  It's online, so just a quick click and no downloads or worries about nasty Excel viruses.)

Subs. Over the past year, AOL has shed 7 million subscribers, approximately 3 million more than it would have lost if it had maintained the status quo.   Importantly, the attrition rate has now returned to almost the pre-free rate (1 million a quarter), and the sub base is still a considerable 11 million.

Cash Flow. Thanks to big cost savings in marketing, sub retention, and network expenses, AOL managed to nearly preserve its pre-free subscriber cash flow.  (We estimate pre-free cash flow of about $400 million a quarter versus about $300 million now).  The company will continue to shed subscribers, and most of the big cost savings have already been booked, but subscription revenue should continue to throw off at least $200 million a quarter for several quarters.  (We estimate the subscription profitability by assuming an operating profit percentage of 35% for the company's ad revenue, calculating the operating profit from ads, and then backing into the operating profit from subs.  Please see the bottom of the spreadsheet).

Users.  Unique users have been relatively stable at about 110-115 million for the past year, despite the loss of 7 million subs.  This suggests the subs who quit the paid service are sticking around.

Pageviews.  Similarly, pageviews have stabilized and are now beginning to increase again (although most of the sharp gain in the last quarter was the result of a measurement-method change).  This, too, suggests that subs are sticking around.

Of all the companies considering going free--i.e., NYT and WSJ--AOL certainly had the most to lose.  And, for AOL, at least, pulling the wall down has turned out to be a good decision.