Monday Note

The brutal recession reveals how flawed the current Internet business model is. As advertising-only business models are falling apart, even the Google ecosphere is under stress. The search giant’s preservation of its margins at the expense of its media partners’ revenue stream could be shortsighted.  –First of two parts.

Sorry to be blunt, but Internet advertising sucks. Most campaigns are an incentive to install AdBlock software, the most popular Firefox plug-in (45m downloads in 3 years).  “Splash”, “pull-down”, “sliding block”, all sorts of ads suddenly invade your screen. They are nothing but a nuisance. If you’re fast enough, you close the ad before it finishes loading.  And we have the most irritating form of banners, the ones with the sound always loudly on when you inadvertently mouse-over over them.

These bad economic times do not improve this picture. Large, unsold inventories create endless repetitions of the same ads. Budget cuts discourage agency creativity and smart targeting is still underdeveloped. As I write this note, I visit a well-known French news site: after four seconds trying to read the lead article, five modules of all shapes and sizes occupy at least a third of the page, hiding part of the story. Last week, I performed a random test on friends and acquaintances who use Gmail: none of them remembered clicking on any text-ads, the ones supposedly relevant to the message they were working on.

An Internet user is exposed to more than 2000 ads a month, according to ComScore. The resulting situation is easily summed up: more ads at a lower price.

- Overall this year, we will see little volume growth, if any. In the US market last year, online ads grew by 10.6% for the full year, the worst performance since 2002. But growth slowed down to 2.6% for Q4 2008 (by comparison, Q4 2007 growth was +24%). And, last week, for 2009, Nielsen halved its prediction to 4.5%.

-  Prices and yields are falling. In the French market, for instance, big media sites I know of, were used to get a 10€ CPM (cost per thousand impressions) per module; now they only get 8€ or 7€. According to the marketing firm PubMatic, CPM decreased by 48% between Q4 2008 and Q4 2009.

- The share of ads dumped through networks is rising, especially within the cash-panicked news media sector. This year, many sites will dump about 50% of their unsold pages to ad networks at fire sale prices.  In France alone, 150 companies vie to sell your Internet ads, an inefficient and scattered market.

- Predictably, the click-through rate is not improving (except to close the window). Since the pay-for-performance ad segment is increasing, the poor click-through performance applies further downward pressure on prices.

Look at the pie chart below. It shows the distribution of ad types (source: IAB).

All three big components representing 80% of the revenue stream are in jeopardy or experiencing major shifts:
- Banner ads: they are shrinking for all the reasons stated above (poor creativity, random targeting) to the benefit of the search ads — I’ll come back to that later.
- Classifieds: significantly impacted by the economic downturn; in 2008, classifieds were already down 4% on the internet; expect worse in 2009. And, with the rise of free, Craigslist-like, classifieds, total market revenue will shrink dramatically (but nice margins are guaranteed for the survivors).
- Search is both the largest revenue format (it might count for more than 50% this year) and the fastest growing segment (+20% in 2008, twice the rate of the entire ad sector on the net). But this strong performance comes with declining prices and a growing imbalance in Google’s favor, at the expense of its partners (i.e. media sites).

The search ad segment is indisputably Google’s fiefdom. The Mountain View giant controls 70% of the business in the US alone, according to eMarketer. The percentage is higher in some European countries.  Whatever the metric or the region, Google does control the search ad market in terms of volume, price and technology (its ability to serve relevant ads to a large chunk of the 188 millions sites in operation worldwide).  The key figures are: in 2008, Google’s revenue was $21.8bn, operating income $6.6bn and net income $4.2bn. 51% of the revenue came from outside the United States.

The company draws its revenue from two main sources:
- Two-thirds come from the Ad Words system, in which brands buy keywords through a complex (and opaque) auction system under Google’s sole control. In return, the brand (an online business or a media) gets traffic it will monetize through advertising or e-commerce.  As an example: I manufacture hot air balloons; I buy — expensively if there are many bidders — the right keyword(s); each time someone searches for hot air balloons, my text-ad will appear on top of the results page. In the chart below, this is the Search (AdWords) line.
- A bit less than one-third comes from the AdSense program in which sites allow Google to fill boxes with text-ads in exchange of a fee repaid by Google to the host site.
in the chart below, this is the Network (AdSense) line.

Now let’s have a closer look at the trends, by the quarter:

We see three things:

1. Of course, like everyone else in this recession, Google is feeling the pinch. For the last quarter of 2008 versus 2007, growth is “reduced” to +18%, to be compared to +51% between Q4 07 and Q4 06.
2. Revenue streams show uneven growth: the biggest one, the AdWords system, representing 2/3 of Google revenue, still grows at +22%  for Q4 08 vs. Q4 07. For the Q4 06/07, the growth was +58%. This is the most controlled and obscure part of Google’s business. The search engine sets prices in a totally opaque way, by assigning a complex (and arbitrary) “Quality Score”. See The Register tech site for details.
3. In the meantime, the revenue stream Google shares with partner sites (for instance media sites with tons of text-ads) is comparatively shrinking: only +3% in Q4 08 vs. a year before, a big drop from +37% between Q4 07 and Q4 06.

You get it: media are getting less and less advertising dollars and euros from Google. As many say, perhaps without realizing it, without intent, see the company’s Don’t Be Evil motto, Google is killing the golden goose as it preserves its fat (38%) operating margin. For many websites, especially small ones, working with The search engine becomes less attractive.

Is an alternative looming? Between the impenetrable alchemy of its keywords auction system and the shrinking revenue channeled back to its partners, even the very successful Google model needs to adjust to these difficult times.  —FF

Next week, How to reinvent a sustainable advertising model.

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