Internet Outsider

Internet Recession Watch: Google Sees Ad Cutbacks

New Item 9/21: Google reports anecdotal advertiser cutbacks from mortgage crisis (though not on Google). This is the first acknowledgment by a major media company that some advertisers are cutting back.  Earlier this week, CBS and Viacom said they had seen no signs of cutbacks.  Timeline of data points below. 

Summary. We continue to believe that we may be in the first stages of a cyclical downturn for advertising and the Internet sector--one that will affect not only start-ups and second-tier players but majors like Google (GOOG), Yahoo (YHOO), AOL, et al.  Such downturns do not begin suddenly, and they are not instantly obvious (except in hindsight).  Rather, as with the housing market, the environment changes gradually, over many months, with early signs slowly becoming a steady torrent of bad news.   

For the past two months, we have been tracking and analyzing data points that we believe could be early warning signs (along with some offsetting, positive ones). Taken together, we believe these signs paint a clearer picture of the changing environment.  It's always possible that this will be a "blip," but these cycles usually take years, not months, to play out.  So we think it's smart to expect tougher times ahead.

Recommendations/Ramifications

Sep 18:     VC Fred Wilson: The Coming Downturn
Aug 17:     Dear Internet Industry: Brace for harder times
Aug 17:     What happens to Yahoo, Google, et al, in recessions?
Aug 1:      The market's crashing: Are you recession proof?

Timeline

Sep 20:    Google reports anecdotal ad cutbacks from mortgages (though not on Google)

Sep 14:    First online ad estimate cut for mortgage crisis.
Sep 13:    Countrywide gets life support, but we still worry about online ads.
Sep 12:    Ad network Burst Media reports cancellations from "budget constraints"
Sep 11:    Mortgage giant Countrywide fires 12,000, WaMu sees "perfect storm"
Sep 11:    TNS reports two quarters of decline in US ads--first since 2001.
Sep 10:    Online mortgage ads remain strong in August: Good sign or false signal?

Sep 6:      Countrywide crumble and stock foreshadows Yahoo, Google, et al?
Sep 5:      OpCo "cautiously optimistic" about mortgage mess.  We're not.

Aug 30:    How Bad Could Mortgage Mess Get for Google, Yahoo, et al
Aug 29:    Will mortgage crisis hurt web ads?  Sure looks that way.
Aug 29:    Bankrate CEO call provides more reason to worry about online ads.
Aug 27:    Cracks in Manhattan's commercial real-estate market?
Aug 22:    JupiterMedia CEO Meckler says every Internet company now for sale.

Aug 17:    Dear Internet Industry: Brace for harder times
Aug 17:    What happens to Yahoo, Google, et al, in recessions?
Aug 16:    About that crashing stock market
Aug 3:      Bankrate confirms online ad market strong, print weak
Aug 1:      The market's crashing: Are you recession proof?

July 20:    Google blows up the stock market

Google Not "Immune" to Mortgage Crisis

From Silicon Alley Insider: We worrywarts are getting some company.  Barron's Mark Veverka rounds up a few opinions on Google's exposure to the mortgage crisis, one of whom offers the sound supply/demand logic that the "Google is immune" crowd usually breezes right past:

[The argument that Google is a crucial source of mortgage leads] doesn't explain how Google has managed to protect a big piece of a smaller pie, says a money manager at a major East Coast hedge fund. "It is inconceivable that mortgage-related advertising revenue isn't shrinking," the manager says.

It's hard to argue with his logic. The number of advertisers is diminishing as mortgage originators, brokers and affiliated businesses fold their tents. Hundreds of small operators that used the Internet as a way to play the housing boom have gone away. Numerous big financial institutions are getting out of the business or are scaling back their home-mortgage operations. For loyal advertisers still open for business, it only makes sense for them to slash their ad budgets as their revenues slide because of industry woes. On top of that, the going rates in key-word auctions are plunging because there are fewer eager bidders. Thus, the prices Google fetches for paid search are probably declining, especially as fewer Internet leads turn into actual transactions, the hedge-fund manager says...

Even if the ad cost per loan application is lower, the end-customer pool is drying up. The customers generated by Web ads are people who won't be able to afford homes under tighter credit and won't be able to refinance after having tossed their house keys back to the banks.

Of more concern to us than Google's mortgage exposure, moreover, is the possibility that the mortgage industry will be just the first of many industry dominoes to fall.  The "virtuous cycle" of ever-rising house prices that has turbocharged the economy for the past 5 years may reverse into a "vicious cycle"--the same way that tech and telecom spending in the last recession did.

If this happens, a lot more than "mortgage companies" will be affected.  The home builders have already been crushed.  But then there are home-supply retailers, construction companies, broader financial services companies (you think shutting down whole mortgage divisions is good for their overall finances?).  And now that the "home equity withdrawal ATMs" that goosed consumer spending for the last decade have finally been emptied, consumer spending could take a hit.  And that will hurt the rest of the economy (even Google).

Not a happy scenario, and certainly not a given.  But Google fans (and Google itself) won't do themselves any favors by hallucinating that the company is "immune."

See Also:
Recession Watch: Google Sees Mortgage Cutbacks

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.

Google: YouTube Now 35% of Users--Watch Those Margins

According to JMP Securities analyst William Morrison's analysis of Comscore data, Google continues to gobble up global market share at a fantastic rate.  From July06 to July 07:

• worldwide users +20%
• US users +18% (now 22% of 552 million global total)
• time spent on sites +113%
• page views +56%
• Google Maps: blows past Yahoo to 682 million pageviews/mo +98% (vs. Yahoo's 397 million, +32%)

Even more startling: YouTube now accounts for 28% of total minutes spent on Google worldwide and an astounding 35% of global users.  This bodes well for Google's continued video dominance, but it also suggests the company's overall profit margins are likely to continue to decline significantly. 

As described here, YouTube's profit margins are likely to be vastly lower than those in Google's core business (and even in the AdSense business).  Although profit dollars are more important than profit margins, declining margins are generally hell on stock prices.  The bigger YouTube gets as a percentage of users and minutes, the more Google's profit per user/minute is likely to drop.  This could create a major headwind for the stock.

See Also: Economics of Online Video: One Tough Business, Economics of Online Video: Unit Cost Structure

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 ([email protected]), 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 ([email protected]).  We will refine as we get additional input.

What Mortgage Crisis? Financial Ads Keep Pouring Online.

From Silicon Alley Insider: We've argued that the mortgage crisis is likely to trigger a slowdown in online ads that could have ugly repercussions. One of the many counter-arguments is that even as the home loan business blows up, both mortgage companies and other financial advertisers will continue to pour money into web advertising -- because they need to keep lending money and because it's cheaper to attract customers online than anywhere else.

Well, a new report from Nielsen/NetRatings on U.S. Web advertising appears to support the more sanguine thesis. In July, four mortgage/financial advertisers showed up on Nielsen's list of the top 10 Web advertisers (PDF). All four show up in the August list released today, and three of the four increased their ad budgets -- including imploding Countrywide Financial, which increased its ad spend from $34.8 million to $35.4 million. 

So are we wrong about the risk the mortgage crisis represents for the Web advertising business? We hope so. But we're not abandoning the gloomy thesis just yet.  Countrywide's implosion did not begin until mid-August, when Merrill Lynch downgraded the stock to SELL and Countrywide sucked down an emergency $11.5 billion on its credit lines.  (And it wasn't until last week that the company began firing employees). The month-to-month rate of growth of Countrywide's online ads (per Nielsen) slowed in August, with a $30 to $35 million jump from June to July, which could be the first sign of a change in trend.  Lastly, we continue to worry less about what has happened than about what is yet to come.  But all that said, Nielsen's August report certainly did not provide additional cause for alarm.

Related:
Will Mortgage Woes Spread To Online Ads?
Will The Mortgage Crisis Hurt Web Ads? Looks That Way.
How Bad Could Mortgage Mess Get For GOOG, YHOO, RATE

Apple's (AAPL) iPhone Refund Confirms: Sales Below Plan

From Silicon Alley Insider: Whining works! Thanks to "hundreds of emails" complaining that Apple slashed the price of its high-end iPhone by $200 just two months after its launch, the company will offer early adopters (who paid up to $600 for a phone now priced at $400) a $100 store credit to make up for some of the difference. A more sincere apology wouldn't require iPhone buyers to spend their refund with Apple, but, as Jobs told USA Today, "well, that's what happens in technology."

In an open letter to consumers today, Jobs is a little more contrite. He describes the "technology road" as "bumpy," and apologizes for "disappointing some of you." Then he insists that cutting the price was correct.

The real issue isn't Jobs' PR-foul up -- a rarity for a man blessed with astonishing showmanship. The bigger issue is Jobs' obvious misjudgment of the market for a flagship product. This is a 33% price cut in 2 months -- rare for any consumer electronics manufacturer, let alone savvy Apple -- followed up by a reactive apology and partial refund. This price cut clearly wasn't planned. Meaning iPhone sales are missing Apple's internal targets. Bumpy, indeed.

See Also: iPhone: Flaky Device Overrated, Expectations Out of Hand, Analyst: iPhone Price Cut Is Good News, and Apple Snubs AT&T, Hoses Early iPhone Buyers

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: [email protected].

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."