There was a great piece in this weekend’s Wall Street Journal by Andy Kessler (read it here) regarding terribly low interest rates and how that affects the current internet bubble.
Kessler makes a great, but obvious, case for calling the current market a bubble: investors are paying way too much for social media’s future earnings. But why are they paying too much?
He hints around a really important point of internet bubble 2.0, and why internet bubble 2.0 is far worse than the original; advertising is the business model of choice.
Layered Leverage: The Driver of Tech Bubble 2.0
I was around for tech bubble 1.0, and I was happily in the middle of it. Having just recently entered the advertising space, I was just a kid in the middle of a bunch of adult children.
The problem that we had in the first tech bubble is that no one knew what advertising was worth. This was because there was so much demand for advertising, so little supply, and not a single company that could say “hey, advertising is worth $10 CPM!” because every advertiser was losing money on every advertising purchase.
So, in short, tech bubble 1.0 was due to the reality that there wasn’t a single income statement in the black that could place a value on any media campaign. Besides, there wasn’t a very good way to test responsiveness in 2000, anyway. And hell, it wasn’t like anyone actually went online to buy stuff back then. Ecommerce was mostly b2b, since all the b2c firms without customers were hiring b2b firms to bring them customers…they didn’t. Anyway…
Tech Bubble 2.0
Much like the first tech bubble, advertising is leading this tech bubble. But where tech bubble 1.0 can be attributed to our limited understanding about a new medium, tech bubble 2.0 can be attributed to an overestimation of this new medium.
The modern internet business model, which Kessler describes as “give me half” is a major component of the new bubble. Before we get into this, though, we have to understand a few basic things about online commerce, especially publishing and media:
- Advertising is always sold to the highest bidder, and the market is very liquid. That is, where you may have to double up from $500 to $1,000 to bid out someone for TV placement locally, you can bid $.26 a click online and steal adspace against the $.25 bidder instantaneously.
- It costs no more to show an ad that pays $.26 a click than it does $.10 a click. All clicks being equal, rising ad rates remain the best way to buoy the web’s publishing companies.
- Media companies in general are highly leveraged to the general advertising economy.
The leverage of the media companies is very important in understanding how this all comes together. Let’s imagine that we own a web property that generates revenue of $50,000 per month, and has expenses (writers, designers, etc.) of $40,000 per month.
Our fictitious web company makes a profit of $10,000 a month on $50,000 of revenue. But what happens if advertising rates drop by 20%? We make nothing. What if our advertising rates rise by 20%? Our profits double. See? Leverage!
How Online Companies are Building a Bubble
When we look at a modern dot com company, what do we see? Groupon’s business model is dependent on:
- Local small businesses who provide deals
- Attracting subscribers to who it can sell deals
- Getting as many subscribers as possible, at a price less than their projected future value.
Groupon’s business is very simple. It operates in Kissler’s “give me half” model, where they build a list of subscribers to whom they sell daily deals. If we assume that Groupon makes a modest $50 per year, per user in gross profits, then we know that Groupon can afford to spend insane amounts of money online to get more members.
And that’s just what they’ve done.
Check out the cost of putting your message in front of 1000 people by interest: (From 2009 Adify Report)
The year 2009 was an awful one for consumer spending. Look at the precipitous decline in every division in adspend. But wait! Look at those food columns!
Yes, just as Groupon and others were firing on all cylinders, advertising rates in the food category surged. It was only a few months later, in 2010, that other verticals were swamped with “daily deal” advertisements.
You should know there is something SERIOUSLY wrong with the market when the value of advertising related to food exceeds that of “business,” and nearly exceeds that of the “affluentials” category.
Current valuations and business models are based on advertising prices that are not in the least bit sustainable, as they are dependent on an arbitrary price floor set by daily deal companies. I imagine that daily deal companies will wind down ad spend in 2011, and rates will be significantly lower by 2012. Net profit margins for companies like Demand Media, which spew out content by the thousands of articles, will be further in the red, since their model is levered to total digital ad spend.