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.

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.

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.

Search Share: Google Gains, Everyone Else Loses (Again)

Bob Peck of Bear Stearns offers a detailed analysis of Comscore's domestic search share numbers for April.  Search is by far the largest category of online advertising, and number of queries is the primary revenue driver.  So query share is crucial. 

Bob's full note is available at Searchblog.  Here are the key points:

• Google's share of US queries jumped another 140 basis points to nearly 50%, up 27% year over year.  This is a continued deceleration of the y/y growth rate, but it's still impressive--especially relative to the rest of the industry.

• Yahoo lost 70 basis points to 27% and grew only 6% year over year.  Yahoo is doing better than the other major players, but this ain't saying much.  It is important to note that Panama, even if wildly successful, won't help increase query share.

• MSN dropped 60 basis points to 10%.  Given how much time, effort, and money Microsoft has invested in search over the years, this is, in a word, pathetic. (But not surprising).  Importantly, the $6 billion Microsoft is spending on aQuantive won't help this trend.

• Ask Network was flat at about 5% and Ask.com was flat at a dismal 2%.  Search is not TV, and Ask's massive advertising push has had no effect on the site's market share.  There is no reason to expect this will ever change.

 

Implication of Flattening Keyword Prices

Jason Jones:  Fathom Online reports that year-over-year growth in U.S. keyword prices remains in mid-single digits.  This means that Google, Yahoo, et al, are losing a growth-driver and must grow their paid search businesses through international expansion, breadth of keyword buys, and market share gains.  The flattening of keyword prices explains both the tepid growth of all search players except Google, and the recent pick up in M&A interest in the branded-advertising business.

Where will advertisers shift their focus as ROI's begin to stabilize in the paid search business?  Probably to contextual & behavioral advertising.

          Price    q/q    y/y
1Q07    1.46    -3%   5%
4Q06    1.51    2%     6%
3Q06    1.48    17%   3%
2Q06    1.27    -9%   
1Q06    1.39    -3%   
4Q05    1.43    -1%   
3Q05    1.44 

Peter Hershberg of Reprise Media responds (Text adapted from comment below and from this Jan 2006 piece on Reprise's site): 

[FROM COMMENT]: The fact that people continue to reference Fathom's KPI is mind-blowing to me...  While it is *possible* that keyword prices are stabilizing, there's no way anyone outside of the search engines themselves know with any degree of certainty.  Along those lines, it's worth noting that in January of 2006, Fathom's KPI suggested that keyword prices for 2005 had fallen by 16%. Google's stock more than doubled over that time period...

[FROM JAN 2006]: Fathom's sample size of 500 keywords is not representative of the entire universe of advertising opportunities available on Google. There are literally millions of unique keywords being purchased in the search marketplace today. Furthermore, the KPI doesn't include either proper or brand names -- keywords that typically deliver significant volume at higher average CPC's. (In fairness to Fathom, they acknowledge this shortcoming in each of their reports. Whether or not the press picks up on it is another story...)

Second, and more importantly, Google's stock continues to rise because it's CPC's simply ARE NOT falling. And even if they were, there would be no way for Fathom, or anyone else, to know that was the case.

How can I be so sure? Because of Google's "Quality Score," a topic I've written about on several occasions in the past.

For anyone not familiar with this concept, Google defines Quality Score as "the basis for measuring the quality of your keyword and determining your minimum bid. Quality Score is determined by your keyword's clickthrough rate (CTR), relevance of your ad text, historical keyword performance, the quality of your ad's landing page, and other relevancy factors."

This essentially means that two (or more) advertisers could be required to bid completely different CPC's to occupy the same position against the same keyword. In other words, the advertiser with the "better" Quality Score might have to pay just $.10/click for the top position against the keyword "wireless accessories," while an advertiser that's been penalized for poor ad copy, a landing page that's light on content, or some other "violation" would be required to pay $.50/click for the same position.

      

Click Fraud Getting Worse, Especially on Content Networks

Click Forensics, a Texas-based company that tracks click fraud using detailed campaign data from more than 3,500 marketers, reported that industry-wide click fraud increased modestly in Q1 to its highest level ever: about 15% of all clicks, versus 14% in Q4 2006.

More ominously, click fraud on "content networks"--the third-party advertising solutions that support an ecosystem of thousands of small content companies--increased a more significant 3 points, to 22%, from 19% in Q4.  This trend is dangerous for small content providers in addition to search engines.  A continuation of this trend will soon result in more than a quarter of all content-network clicks being considered fraudulent, a level that could begin to cut significantly into the revenue of smaller content providers.

Also significant: Fraud on high-priced keywords--those over $2 a click--rose to 22% from 21% in Q4, confirming the theory that higher priced keywords are more susceptible to fraud than average- and low-priced keywords.

From the release:

“It appears that click fraud perpetrators are becoming more sophisticated even as search providers step up their efforts to fight click fraud,” said Tom Cuthbert, president and CEO of Click Forensics, Inc. “Click fraud seems to be following a similar path as other online fraud schemes such as spam and phishing - the problem is growing as fraudsters fine tune their methods.”

Video Piracy 2.0: Get Ready for Viewer Lawsuits

The Journal's Kevin Delaney details the latest frontier in online video piracy: Sites like www.YouTVpc.com that assemble links to your favorite movies and TV shows--which are hosted on third-party servers in, say, Malaysia. 

YouTVpc's proprietors don't upload the video content--they just find it and link to it.  Unlike YouTube, they also organize it in a user-friendly fashion: lists of shows by year and episode, etc.  The proprietors spend their evenings searching for videos and answering concerned emails from users saying "is this legal?" (Answer: Maybe, for now.)  They cover their costs with advertising and live off Jolt cola and kettle chips.

Implications:

• Merely "linking" to pirated video may not be illegal yet, but, presumably, after fierce lobbying and lawsuits by the MPAA, et al, it might be. (Although this would be a heroic and disturbing precedent--making lists of links illegal). 
• If such efforts fail, the MPAA, et al, will presumably follow the path blazed by the RIAA, et al, and start suing thousands of American consumers who watch pirated video.  The consumers' defense, presumably, will be, "But I didn't download it."  To which the MPAA, et al, will reply, "See you in court."  And the threat of hundreds-of-thousands-of-dollars-of-legal-fees later, most consumers will, sensibly, cave.

What is not likely to happen, but should, is that the MPAA and traditional video production companies should note that 1) successfully suing users hasn't saved the music companies, and 2) the world has changed forever and there is no way stuff the cat back in the bag.  In light of this, BigMediaVideo should pursue a parallel course:

1. Post all their old shows online on their own sites immediately and allow other sites to link to them.
2. Make clear that videos hosted on their sites are LEGAL to watch, whereas video at all other unapproved locations are ILLEGAL (and viewers may be sued, etc.)
3. Build the best-available online directories of online video (an area in which YouTube, for some reason, is failing), so as to establish a presence in video search.
4. Get better at embedding sponsorships, product placements, and, if necessary, short ads in the videos to generate as much revenue as possible.
5. Create subscriber plans in which paying users can get new videos instantly (thus offsetting any lost revenue from folks who prefer to watch TV on their PCs).
6. Share a modest referral fee with sites whose users link to and view the videos (thus encouraging affiliates to promote them.)
7. In short, EMBRACE change, instead of fighting it every step of the way.

Time Warner to Keep AOL, Sell Cable, and Buy...MSN?

Matthew Karnitschnig of the WSJ kicks off the morning with a Twilight Zone piece about how Time Warner may not dump AOL after all, but instead sell off cable and "double down" on the Internet by buying another big net company. 

Without commenting on the plausibility of this theory (except to say that it would be quite a change of heart), here are some thoughts:

• Oh, the irony!  The theory behind the strategy, apparently, is that cable will become increasingly commoditized and less relevant in a world with the Internet and Internet TV, etc.  It was, of course, exactly this sort of thinking that led to the "transformative" AOL-Time Warner merger in the first place.  Without concurring that cable will become less relevant (somebody has to plumb the pipes), this would lend credence to the idea that the AOL-Time Warner merger wasn't a colossal, bubble-headed strategic error, but just early. 

• The most sensible big-net-company acquisition/merger candidate is MSN.  A combined AOL-MSN would dominate online communications, and, together, would have the scale and clout that each company alone currently lacks.  The integration, management, and long-term growth strategies, of course, would be a nightmare.

• Assuming Time Warner isn't up for that challenge (and who could blame them), companies like Facebook, Bebo, Music Nation, and others fit into the company's entertainment DNA and would help offset/refresh the demographics of AOL's geriatric user base.  They also wouldn't require another bet-the-company roll of the dice.

AOL's having a 'meet the new AOL' event today, so maybe we'll get further details.

UPDATE

A reader suggests another sensible Time Warner acqusition candidate: Joost.  Any others?   (I personally think Joost would make sense but also be extremely risky, because 1) the site hasn't even launched yet, and 2) if/when Joost is owned by one of the big media companies, it will lose its status as a neutral "Switzerland" BigMedia solution.)

Google Swallows DoubleClick for a Mere $3B

What's $3.1 billion between friends?  Or, put differently, what's it worth to fix your display-advertising problem, corner the market for the "advertising operating system," and deliver a hammer-blow to an already prostrate Seattle-based competitor?  $3.1 billion?  Sure.  Only a few quarters of free cash flow.

So now Google controls a vast share of the market for graphical online advertising, too.  And has yet another display on its world-domination dashboard about who's doing what where.  For those with an eye on the really-long term, it's hard to see how this isn't good news.

For those with an eye on the near-term stock price, meanwhile, it's probably bad news: Lower margins, a big management challenge, a significant price tag, an admission on the largest scale to date that it sometimes makes sense to buy instead of build (no shame in that--just lower returns on capital), and so on.  But as Google made abundantly clear in its IPO prospectus, management (sensibly) isn't focused on the short term.

CBS Video Deals: Quincy Smith Being Smart Again

CBS's portfolio of video distribution deals shows that CBS Interactive's president, Quincy Smith, is still using his head. 

Quincy, you may remember, then at Allen & Co, was one of the investment bankers who sold YouTube to Google.  Before that, he was the IR man at Netscape and a Valley venture capitalist--so he knows smart Internet ideas when he sees them.  And CBS, you may remember, was one of the first major TV production firms to embrace (or at least experiment with) online video distribution through non-CBS properties.

CBS didn't participate in the DOA bigmediavideo YouTube killer occasionally known as NBCFoxTube (although it will reportedly distribute video through it).  It didn't alienate the entire digital industry by suing YouTube for $1 billion (instead, it did a small partnership).  And, now, intelligently, by doing distribution deals with anyone and everyone BUT YouTube, it is establishing precedent and leverage for the inevitable major YouTube negotiation.

According to Brooks Barnes in the WSJ, in its video deals, CBS is also retaining full control over the sale of advertising that will be shown in conjunction with its videos--a big sticking point for traditional media companies, who value their relationships with advertisers.  It is also demanding 90% of the advertising revenue, with only 10% going to the distribution partner.  For the distribution partners' sake, one hopes this is "net revenue", as the streaming costs alone will probably eat at least 10% of the top line.

Most importantly, CBS is doing everything it can to diversify its distribution channels, attract a loyal base of online users, and make its content ubiquitous--all of which will allow it to credibly maintain to the folks at YouTube that it--CBS--can take or leave a full-blown YouTube deal.  Whether this is in fact true is a different question, but CBS is doing everything it can to make it seem so. 

The quarterback behind these intelligent CBS machinations, I suspect, is Quincy Smith.  So give that man (and CBS) a hand!