Why Web Bubble 2.0 Is Worse than the Original

by JT McGee

Pets.com could be a perfect social networking site for dogs!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:

  1. 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.
  2. 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.
  3. 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.

The internet bubble will burst when media companies stop getting high bids from daily deal sites.

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:

  1. Local small businesses who provide deals
  2. Attracting subscribers to who it can sell deals
  3. Getting as many subscribers as possible, at a price less than their projected future value.

AHA!

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 internet bubble is back on in 2011!

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.

Warning!

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.

{ 8 comments… read them below or add one }

Ravi Gupta June 1, 2011 at 17:05

Very informative post! Sometimes I question the model that we have of selling advertising. Our situation makes me wonder if we will begin to move towards word of mouth advertising. If there is one thing I wholeheartedly agree with it’s that we are in a bubble and I hate to see how the mighty will fall.

-Ravi Gupta

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JT McGee June 3, 2011 at 23:29

Word of mouth is definitely a big part of the next cycle. Just look how important social is, and how much is being spent on harvesting micro-level data.

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Ross @ Go Be Rich June 1, 2011 at 17:54

This illustrates why I’m starting to see the benefit in simply not caring about making money… thereby making money. For example, when you start a blog to make money, you really won’t make any money if that’s what you concentrate on. You instead have to concentrate on caring about your readers, building an online community, and making actual connections, albeit virtual, online connections. This is something that can’t really be faked, and as such, you build actual value into your blog, because people truly value what you have to say and the info found on your blog.

Once you have a following, you simply put together products that you know people will want, in the form of E-books, individual consultations, and other things, and charge a small amount for them. People will pay it because they see the value in it.

There’s no inherent value in advertising like there is in a product that people consider to have value. This is why I think advertising, or at least the advertising on the web as we know it now, may be ready to undergo some changes.

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JT McGee June 3, 2011 at 23:33

Well, I’m not sure that not caring about money will bring in money, but there is definitely something to making your own product vs marketing someone else’s. You have to consider that in an efficient market, everything being equal, whoever is serving up the ads is getting a fat cut that puts you at a competitive disadvantage.

Advertising is definitely due for some new changes, but so is the digital product space. This world needs more ebooks and consultants like I need a kick to the shin. That’s just my biased opinion, though. I’ve never been a fan of either, though I am one of the above. 😛

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Travis@TradeTechSports June 2, 2011 at 14:27

Great article. The CPC model definitely needs some rework. I agree we are in a full social media bubble. As soon as companies and people start borrowing to finance these companies…look out.

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JT McGee June 3, 2011 at 23:36

Ha! I can only imagine 2-10:1 leverage on top of a model that is 5:1 leveraged on another business model that is paying for the future value of an email address.

It’s amazing what cheap money can do, really.

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Adam @ ThisIsWhyImBroke June 3, 2011 at 17:51

This is an awesome post (just discovered you blog btw). Do you think if the bubble bursts it will be as catastrophic as some of the more recent bubbles of the past decade?

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JT McGee June 3, 2011 at 23:35

Thanks, I’m glad you liked it and I hope to see you around in the future. 😀

As for right now, the bubble is still far more localized. I don’t see it spreading like the first one.

Anyone who is getting in on this new boom is an accredited investor who is qualified to make VC-level investments. ($200k income, and/or $1M net worth). So, whereas 1999-2001 was all on the public exchanges–where retail money could get in–LinkedIN is the only company that has yet to move to the retail level. Otherwise, it’s all people with enough money that they won’t be starving when this boom goes bust.

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