Is an online-ad firm really worth $6 billion?

Commentary about business and finance.
May 24 2007 6:35 PM

Gouging for Eyeballs

Is an online-ad firm really worth $6 billion?

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Last month, big establishment online company Google bought online-ad firm DoubleClick for $3.1 billion in cash. Last week, big establishment advertising agency WPP bought online-ad firm 24/7 Real Media for $649 million in cash. The next day, big establishment tech company Microsoft bought online-ad firm aQuantive for $6 billion in cash.

This trio of deals would seem to bear all the hallmarks of a classic fin de siècle blowout. You've got a big company doling out cash to make an acquisition at a huge multiple—Google reportedly valued DoubleClick at 20 times last year's revenues, not earnings. You've got a non-tech second mover and a seemingly panicked reaction by the slow-footed behemoth. Microsoft offered a whopping 78 percent premium for aQuantive. What's more, each of these companies could have been had for a fraction of the price a few years ago. The private equity firm Hellman & Friedman paid $1.1 billion for DoubleClick in the spring of 2005.

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Or maybe not. For this may be less a case of the market being irrationally ahead of the industry's economic reality and more a case of the market being behind rational expectations for the industry.

In the past decade, we've witnessed what is likely to be an irreversible revolution in media consumption. There are powerful, popular new venues for advertising (online video, games, Google). Meanwhile, the established channels have suffered a series of setbacks: Craigslist is taking a bite out of newspaper classified ads, many magazines and newspapers are struggling with circulation, and the widespread use of DVRs allows TV viewers to skip ads. Trends can reverse or slow down, of course. But taken together, they add up to a pretty powerful paradigm shift, especially for younger consumers.

Now look at the data on how advertising funds are spent. (Here's the same report in more detail.) It shows that Internet advertising spending was $16.9 billion in 2006, up 35 percent from the year before and more than double the 2001 amount. Impressive numbers? Sure, but Universal McCann ad forecaster Robert Coen last year projected that total 2006 ad spending was $286 billion. The Internet garnered slightly less than 6 percent of total U.S. advertising spending in 2006.

Does this sound right to you? Does only 6 percent of purchase-influencing media consumption take place online? If you're reading this column, you probably spend more time online than you do watching television, or reading a newspaper, or listening to the radio—all media that get far more advertising dollars than the Internet.

Television, magazines, and newspapers may be hanging on because they are more powerful media for reaching the consumers companies most want to reach. But I suspect they're hanging on for another demographic reason. Advertising is supposed to be a with-it, hot, trendy, tomorrow-based industry. But at root, the business of advertising is one of allocating capital, not cooking up clever jingles. And the people who make the decisions about how to allocate that $300-odd billion in capital each year—CEOs of consumer products companies, Fortune 500executive vice presidents, media buyers, brand managers, agency heads—well, they're old. It takes time to climb the corporate ladders to get to the rungs where really important decisions are made. Of course, these people, most of whom came of age as consumers in the 1960s, 1970s, and 1980s, use the Internet, spend a lot of time on it, and buy stuff on it. But they don't understand it intuitively the way the younger crowd does. Do you think the CEOs of Ford, Citigroup, or Procter & Gamble are uploading photos to their MySpace pages, downloading music, and blogging?

For top corporate executives, the Internet is a place where they work, access important information, check stock quotes, and read e-mails. But with each passing year, for a larger number of consumers, the Internet is a place where they hang out, meet friends, do schoolwork, watch videos, plan weddings, start businesses, play games, and listen to music—in short, it's where they live.

The present value of online commerce and online advertising may not justify the valuations. Forrester Research reports that e-commerce was a $219 billion industry in 2006 and is projected to grow 18 percent to $259.1 billion in 2007. That makes e-commerce a small fraction of the massive economy. But remember, online advertising isn't just for e-commerce any more than TV advertising is just for Ginsu steak knives and K-tel records. Today, the Internet is one of the key venues where brand images are constructed and polished.

The stock market is famously a futures market. So, the question for people who invest in the stocks of online-advertising companies—as Google, WPP, and Microsoft have just done—isn't just whether online ads are the way to reach consumers today. No, the question is whether online ads will be among the best ways to reach consumers in five and 10 years, when today's twentysomethings will be buying cars and houses and kitchen appliances and pharmaceuticals. More important, in 2012 it's possible to imagine that the brand managers and executives responsible for making advertising-spending decisions will be people who grew up with the medium, who didn't need a consultant to tell them how it works. It's a reasonable expectation that online advertising will continue to gain market share and that more and more capital will slosh into this sector. The big companies paying top dollar for online ad firms have just bought some expensive buckets.

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