Online Advertising Is Still a Growth Opportunity

There are very few independent ad-supported Internet companies worth more than $500 million, and it should be assumed that the types of valuations recently offered by acquirers have come down for good. The threats to VC investors in Internet media come mainly from their own practices of overcapitalizing companies and burdening them with unrealistic expectations. That said, in the bleak advertising landscape of 2009 online advertising is expected to grow around 10%, and will enjoy a resumption of strong revenue growth after the recession.

Tough times for over-leveraged traditional media companies should be an opportunity for financially strong Internet companies to grab market share. Yet stories abound with panicked calls for Web 2.0 portfolio companies to batten down the hatches. By retrenching now, VCs may miss a prime opportunity to consolidate the middle market in Internet media.

Lay of the land

The online media industry is in transition from high growth to mature growth. During a high growth phase, the number of competitors increases, drawn in by the seemingly limitless growth potential of the industry. High valuations and high-profile acquisitions lead to countless “me too” company launches. Eventually reality sets in. Competition intensifies, prices fall, capital dries up and companies fail. Consolidation ensues as companies seek to eliminate competitors, build scale and improve pricing power. The secular rise in industry penetration and revenue continues and the survivors enjoy rising profit margins.

The transitional problems for the online media industry are exaggerated by the huge supply of content relative to the revenue opportunity. While some of the excess supply comes from the low barriers of entry that enable bloggers and the like to create content for free, much is due to the excess of capital that has been invested in the industry during both the late 1990s and the middle of this decade as VC funds put their large capital pools to work.

The Web 2.0 boom is in many ways more farcical than the original dot-com boom. With e-commerce, there was a tangible revenue opportunity in selling goods. Web 2.0 companies often don’t even try to produce revenue and assume they’ll be bought by a large company for their traffic alone. VCs and large tech and media companies sitting on big piles of cash have routinely over-valued and over-capitalized these types of companies for the past several years. Given the current capital drought it should be assumed that this game is up for good.

How should VCs look to profit from the remaining growth in the online advertising business? In effect, they should think more like private equity investors.

Think PE

So how should VCs look to profit from the remaining growth in the online advertising business? In effect, they should think more like private equity investors.

First, be realistic about the revenue opportunity and exit valuation. Currently the only public, independent ad-supported Internet companies worth more than $500 million are Bankrate, eBay, Google, Monster, ValueClick, WebMD and Yahoo. Add to the list a handful of independent companies and non-independents owned by big media companies and it’s pretty clear that it’s difficult to profitably get more than $100 million in revenue. According to information leaked on the Internet, Web 2.0 giant Facebook has less than $300 million in revenue but is not profitable, while darlings Digg and Twitter have less than $10 million of revenue combined.

Second, stop swinging for the fences with horizontal traffic plays, and focus on media verticals. Google dominates pay-per-click advertising, so the remaining opportunity is in display advertising and video. Premium display and video advertising are used for brand-building. Brand marketers are looking to reach certain demographics, which get aggregated with high-quality vertical content. Buy leading sites, extend the brand, use scale to effectively sell advertising inventory, and focus on generating valuable content and a sense of community.

Online media is still media. Draw users to content and sell advertising against that content, generating strong profits relative to invested capital.

Tyler Newton is a partner and director of research at Catalyst Investors in New York City. He may be reached at tyler@catalystinvestors.com.