Internet Outsider

Microsoft Hallucinating? Or Planning to Buy Yahoo?

I'm going to go out on a limb here and assume that Microsoft division president Kevin Johnson is not a moron. So I'm also going to assume that, when Johnson said yesterday that Microsoft plans to grow its search share from 10% to 30% and its online ad share from 6%, he could not possibly be imagining that Microsoft could do this on its own.

So how could Microsoft actually achieve those goals?

Answer? (And there's only one). Buy Yahoo.

Buying Yahoo would give Microsoft 30% search share instantly. It would also boost Microsoft's ad share close to that 40% goal.

I continue to think that a Microsoft acquisition of Yahoo would be disastrous for Yahoo (not to mention creating an annoying one-time tax hit for us long-term Yahoo shareholders). But what such an acquisition would do to Yahoo is irrelevant. If Microsoft comes in with a Murdoch-like offer, Yahoo won't be able to refuse.
 
See Also:
Microsoft's MSN: Still Sucking Wind After All These Years
SAI's Microsoft Online Key Data Spreadsheet

Yahoo (YHOO) Traffic Grinds to Halt: Fat Lady Singing?

JMP Securities analyst William Morrison takes a detailed look at Comscore's global traffic trends for the year through July.  He writes an excellent macro piece, with several important findings, including the latest horrendous news at Yahoo.

The only trend that train-wreck Yahoo had going for it--global user growth--is no longer going for it.  If the company can't reverse this trend in short order, its only hope will be to sell itself (our thesis, not Bill's). According to Comscore, Yahoo!'s global traffic and usage actually declined year over year.  Yahoo's few remaining shareholders have been clinging to the hope that no matter how pathetic its recent business execution, its global audience and usage would eventually bail it out.  Well, now it seems as though this hope, too, may have long been in vain.

Importantly, the traffic decline is not just for the site as a whole, and it's not just pageview-related.  (Yahoo explains away some of its slow pageview growth by pointing out that it now uses a lot of video and AJAX.)  Rather, it includes some of Yahoo's most important and most profitable properties...

Morrison:

Yahoo attracted total worldwide users of 476 million in July, down 1% annually.  Pageviews declined 7% in the period, and minutes spent were down 1%.  Annual usage at Yahoo Mail declined by 9%, at Yahoo Games by 47%, at Yahoo News by 6%, and Yahoo Sports by 11%. On the positive side, Yahoo Messenger grew by 36%...Yahoo Answers by an astounding 332%, and Flickr by 198%.   While [this is] promising...these areas are typically monetized at a fraction of the rate of Yahoo!'s premium content areas.

Short of saying "Comscore is wrong," it's impossible to put a positive spin on this.  In fact, it's an absolute disaster.  Perhaps the reason Jerry Yang doesn't plan to announce a significant restructuring when he finishes his 100-day review is because he's realized there's no reason to bother.

Economics of Online Video 2: Unit Cost Analysis

From Silicon Alley Insider: After performing a detailed analysis of the economics of streaming video, we continue to believe it is a very tough business--with high capital costs and low profit margins.  In the first installment of this series, we explored the ramifications of this.  In the second, we take a closer look at unit costs.

Streaming video has a similar cost structure to many text- and graphics-based Internet businesses, with three significant additional costs: bandwidth, storage, and transcoding.  Each of these items increases the costs of video streaming relative to that of static content--without a reliable offset in terms of additional revenue.  In contrast to most text-based Internet content, moreover, these video-related costs are variable, meaning that they rise in direct proportion to video usage (not revenue--usage).  This means that the industry will not suddenly become wildly profitable as revenue increases.  On the contrary: It will likely continue to struggle to eke out a profit for many years.

In addition to the three major video-serving costs, which we detail below, there are two other critical inputs into most streaming video business models:

1. The percentage of videos that are monetizable. Low for video dumps like YouTube; high for network sites and professional "show" hosters like blip.tv.  Because video streamers incur the same costs for monetizable videos as non-monetizable ones, this assumption is critical.
2. Content production/licensing costs. Relatively low for TV networks, which can repurpose content, and high for the more plush online show production* (costs of shooting, editing, studio, etc.) and YouTube (royalties).

Most companies that store and serve video lie somewhere along a continuum of, say, 20%-100% on these two expense items, with the specific inputs having a huge impact on the potential profitability of each model.  To illustrate the importance of these costs, we have modeled:

1. A base "streaming video" model that lays out the basic cost structure
2. A "TV Network" version, which adjusts for low royalties and a high percentage of monetizability.
3. A "YouTube" version, with huge scale, high royalties, and a low % of monetizable content.
4. A "niche network" version (e.g., blip.tv), with medium royalties, high targeting, and a high percentage of monetizable content.

Here are the key considerations for the potential profitability (and value) of streaming video:

Revenue. Online video monetization should continue to improve, and, ultimately, online video should be as accepted and important an ad medium as, say, paid search.  Recent data suggests that "run of site" video CPMs range from about $5-$20, with targeted sponsorships ranging from $15 to, on occasion, $300-$500.  The high end sponsorships appear to be a bizarre outlier, and as with most other forms of online advertising, we expect that CPMs will drop as the thrill and novelty wears off.  So we are not expecting soaring CPMs to bail out the industry's high cost structure.  In our modeling, we've used a CPM range of $5-$25, with a "base case" of $15.

Percentage of Content That is Monetizable.  We have no doubt that, contrary to popular perception, dancing cat videos will eventually generate some revenue.  Blow-job videos and pirated TV content, however, probably won't--at least not on sites like YouTube.  Regardless, the percentage of videos that are monetizable at, say, YouTube, is far below that at, say, blip.tv (a niche network featuring professional "shows") and TV networks.  This assumption is critical, because if the streamer only monetizes, say, half of its videos, the "effective CPM" will be cut in half.  Our base assumptions are as follows:

YouTube:       30% monetizable.
blip.tv:            80% monetizable.
TV network:   100% monetizable.

Content production / royalty costs.  Assuming you're playing by the rules, you either have to pay to develop video content yourself or pay someone else for theirs.   In the text-based world, Google pays about 80% of revenue out in royalties ("rev share").  If the video royalties are anywhere near this level, YouTube's profitability is going to be minimal (if that).  We expect Google will adapt to the high-cost-structure reality by vastly reducing the revenue share it pays to video producers (which won't sit well with them).  In the meantime, however, we've modeled a high cost here:

YouTube:        70% payout
blip.tv:             50% payout
TV network:    20% payout

Bandwidth.  Video streaming eats bandwidth.  Bandwidth costs are declining rapidly, of course--which is the great business-model hope of many video streamers--but, importantly, these cost declines are often offset by increases in average video file size, as resolution increases.  For the purposes of this analysis, we have optimistically assumed that the costs of bandwidth, storage, and transcoding (see below) will continue to decline rapidly and that increases in average video resolution will not eat all these benefits.  Specifically, we use a range of $0.05 to $0.15 per gigabyte and a 20mg average file size, which produces a $1.00-$3.00 current per stream CPM.  We have assumed that in the "future," bandwidth, storage, and transcoding costs will decline by 75% versus today.   If file sizes increase rapidly, this could easily prove too optimistic.  A low-cost P2P solution, meanwhile, is likely years away.

Storage and Transcoding.   To estimate storage and transcoding costs, we have estimated capital equipment costs and then converted them into per-stream costs.  These costs should decline rapidly, too, but not if video file sizes continue to increase.

(*We're not suggesting that online video production costs a lot relative to TV, movies, etc.  Relative to those, they're dirt cheap.  The expensive ones still cost a lot relative to the revenue they can produce, however.) We are grateful to Mike Hudack of blip.tv, Dwight Merriman of ShopWiki (an SAI investor), and others for help with this preliminary cost analysis.  Please weigh in in the comments or via email (hblodget@alleyinsider.com), and we'll refine as we get more info.   

Economics of Online Video 1: One Tough Business

From Silicon Alley Insider: Streaming video is all the rage, with start-ups popping up like mushrooms, incumbents like Yahoo (YHOO) cramming video into every corner of their sites, and analysts locked in fierce debate about how much revenue the industry behemoths like YouTube (GOOG) might eventually generate.  Revenue is an improvement on the industry's experience to date, but it's time for a detailed look at streaming economics.  Specifically, what's the bottom line?  Can streaming video make money?  Can YouTube? 

(Note: we are analyzing video streaming here, not video downloads.  See Peter Kafka's analysis of the NBC/iTunes economics for a primer on the cost structure of the latter.)

After performing a detailed analysis of streaming video's cost structure, we remain convinced that it is one tough business.  Individual business models differ radically, of course, but in general:

• Costs are high
• Costs are variable (meaning that they rise in proportion to usage)
• Profit margins at scale will at best be fair-to-middling (10%-20%, not the 30%-40% text-based Internet media enjoys).

In general, therefore, we believe that observers are vastly overestimating the amount of money that will be made in streaming video, at least over the next several years.  What are the specific ramifications of these conclusions?

• Most dedicated streaming video start-ups will never make money and will disappear (either via bankruptcy or fire-sale).  Thus, streaming video entrepreneurs should raise as much cash as possible, now, while investors are still throwing it at them.  (Investors, meanwhile, should stop throwing it--immediately).  Also, all companies competing with YouTube in the "generalist" broadcast-yourself market should re-focus or sell themselves immediately (which is what we hear many are trying to do).
• The widespread adoption of streaming video may permanently reduce profit margins in the Internet media sector.  If YouTube gets as big as some flag-waving Google bulls hope, Google's profit margins will never be the same.  Is that the end of the world?  No.  But it could be the end of a steady upward march in Google's stock price, at least until margins stabilize at a new "adjusted for video" level.

The companies in the best position to benefit from the boom in online video are those with 1) enormous scale, 2) minimal production costs, and 3) business models built around something other than storing and streaming video. Such companies include firms that already produce countless hours of the stuff--TV networks, movie studios, etc., as well as video ad sales networks, video search firms (including YouTube), and new era production firms with absolutely rock-bottom production costs (Rosie in her bedroom with no make-up, a handheld video cam, and an incandescent light bulb).

As for the companies that actually store and serve video (YouTube, Heavy.com, blip.tv, Rocketboom, etc.), if they wish to survive the shakeout, they will need: 1) massive, industry-leading scale, 2) low content acquisition/production/revenue-sharing costs, and/or 3) a highly valuable, targetable, and defensible niche. 

Next up:  A detailed look at video-unit-economics.  Please share thoughts/insights in comments or email (hblodget@alleyinsider.com).  We will refine as we get additional input.

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.

The (Big) Problem For Hakia, Powerset, Mahalo, and Other Google-Killers

The "highlighter" feature that search-engine Hakia announced yesterday wasn't worth a press release, but it did get me to try the company's "semantic search" service, which is actually pretty cool.  As instructed, I asked Hakia three English-language questions:

Why did the stock market crash?
Where do I get good bagels in Brooklyn?
Who invented the Internet?

As promised, I got intelligent results for all (even the last one, which was a trick question).  For example, Hakia understood that, when I asked "why," I would be interested in results with the words "reason for"--and produced some relevant ones.  If I'm ever in the mood to ask an English language question--and I remember that Hakia exists while reaching for the keys--I might use the engine again.

But therein lies the problem--indeed, the problem for Hakia, Mahalo, Powerset, and the dozens of other companies that are pursuing next-generation search.  Contrary to the premise upon which most of these companies are based, I don't agree that current search sucks.  On the contrary, I almost always find satisfactory results immediately, conveniently, and with minimal frustration.  I also don't find myself wanting to ask the Internet English language questions all that often: It's usually easier to just type keywords.  The results (and display) could always be improved, of course, and maybe I'm always missing out on fantastic sites that have just the info I'm looking for, but ignorance is bliss.

On the questions I asked, Hakia certainly delivered nice results. But I'm used to using Google and Yahoo, and Google and Yahoo usually get the job done, and I almost never wonder whether I'm getting "the best possible results."  So unless Hakia, et al, focus on tight, defensible verticals--or sell their technology to Google/Yahoo/Microsoft--I don't think their future is promising. 

Don't believe me?  Check out Hakia's modest traffic over the past year. Or just ask the guys at IAC's Ask, who, despite being widely viewed as having the "best search on the web", despite massive advertising, and despite the brilliant Barry Diller, haven't budged off of 2% market share.

Facebook Puts Self Up For Sale: $10 Billion

[From Silicon Alley Insider]. Few seem to have noticed, but Facebook has now officially put itself in play.  Peter Thiel, a Facebook investor and director, granted a detailed interview to The Deal last week in which he rejected several lowball offers that have reportedly come over the transom--$3 billion range--and essentially offered to sell the company for $7-$10 billion.  The announcement would not have been any more direct if Facebook had written an open letter to Google saying: "Dear Eric: $10 billion and we're yours."

Yes, of course, Thiel also threw in all the required noises about how Facebook has no interest in selling, no interest in going public, etc., to make sure that when Google does walk in the door, it will be the Google folks who are selling.  He also explained why Facebook wasn't ready to sell (not developed enough) and why those who gripe about Facebook's low revenue are missing the point (we don't care about revenue yet).  But make no mistake: Any time a company is this specific about what it would take to get it to the table, it's for sale.  What's more, it's probably for sale at the low end of Thiel's $7-$10 billion range.

As a last gesture of helpfulness, Thiel was also kind enough to tell everyone how much revenue Facebook will generate this year--$150 million (so assume at least $200 million--have to set the bar low)--of which half comes from the Microsoft deal.  So, there, Google and Microsoft investment bankers, you now have everything you need.

Let's see, at today's Google stock price of $515, a $10 billion Facebook buy would amount to about 6% -7% dilution.  A veritable tuck-in!  And none of the copyright headaches that came along with the $1.7 billion YouTube acquisition.  Microsoft?  Why, you'll generate $10 billion in cash in the next few months.  So, step right up!  Yahoo? Um, sorry, missed your chance last year when you could have had it for $2 billion. David Shabelman, The Deal.  DealBook, NYT

Click Fraud Increases Again, Especially on Affiliate Networks. Bad News for Content Providers

Click auditing firm Click Forensics reports that the percentage of fraudulent clicks industry-wide jumped another point in Q2, to 16%, after remaining largely stable in 2006.  More alarmingly, Click Forensics says that fraud on affiliate networks like Google AdSense and Yahoo Publisher Network jumped 4 points in a single quarter, from 22% in Q1 to 26% in Q2. This trend has big implications for the thousands of new companies and bloggers who generate revenue through such networks.

Much of the fraud increase, Click Forensics says, comes from "botnets," which click ads automatically and are designed to appear to be humans.  Unlike the search engines, which continue to downplay click-fraud, Click Forensics can analyze end-to-end traffic logs (what a "user" does after clicking through to a site), and the firms consistently conclude that fraud is a bigger problem than Google and Yahoo say.  Google estimates that fraudulent clicks account for less than 10% of the total. Yahoo pegs the figure at somewhere between 12% and 15%.  Although these figures aren't too far off Click Forensics' numbers, Google and Yahoo do not release breakdowns on their affiliate networks.

The affiliate networks are not major profit drivers for these companies (they contribute a big percentage of revenue, at Google, especially, but not profit).  But they are critical revenue drivers for the gigantic ecosystem of small content providers that has sprung up around them.

Most advertisers currently regard click fraud as a cost of doing business.  (And they don't currently have much choice: Yahoo and Google do not provide enough click-level detail about which to complain).  As estimates of click fraud on the affiliate networks increase, however, advertisers will (or should) put increasing pressure on Google and Yahoo to control the problem, provide more detail, and/or provide larger refunds for bad clicks.   Any of these measures could reduce the revenue passed through to affiliate content providers.

Andy Greenberg of Forbes.com originally reported the Click Forensics data.

Yahoo Q2: Not All Bad

Everyone has focused on the negatives, so I'll hit some positives. Yahoo is clearly in trouble, however, so don't mistake these comments for rosy-eyed optimism.  The next year will determine whether the company restores what was once the dominant global Internet franchise to glory--or becomes one of the industry's biggest disappointments.  And, this time, if it stumbles down the latter route, it won't have a global advertising downturn to blame.

Positives:

• We did not have to hear Terry tell us that Yahoo had a great quarter, is outgrowing the market, and is in fantastic shape--and wonder whether he had ever set foot in the place.
• Jerry and Sue appear to understand the magnitude of the problem (competition, morale, talent, buzz, bureaucracy).
• Despite lagging the market, the company is still highly profitable: $1.5 billion free cash flow run-rate.
• Panama is working.  Revenue per search is up 15%-20% year-over-year.  This is crucial, as search is still the industry's largest and most profitable revenue stream.  Alas, the counter problem is that Yahoo appears to be continuing to lose search query share to Google (and in the latest month, god forbid, Microsoft).  With fewer search queries, improving RPS won't make a lick of difference.
• The user base is huge and still growing.  Yahoo now has 463 million users, up 13% year over year (and 17 million paying subscribers, up 18%).  Even if all else falls to pieces, this one metric represents enormous potential value.  The moment Yahoo's user base stops growing, the company is done.
• Revenue is, indeed, accelerating.  The most profitable revenue stream, search and display on Yahoo's proprietary properties, is growing faster than the rest of the business and is accelerating.  And given the rate at which Yahoo is getting its clock cleaned in its global affiliate business, affiliate revenue will soon be so small as to be irrelevant.

All of which is a long winded way of saying, it ain't over yet.  But it will be soon, if Jerry and Sue don't make good use of this latest restart.