Why The Online Advertising Business Makes Me Uncomfortable

Bob is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

When I buy a stock I have to feel comfortable, not in where the stock price might be headed but in the company's business model. Having confidence in the model is necessary to project future operations and a resulting fair value.

Yet, some of the most highly regarded and investor loved companies have a business model that makes me the most uncomfortable. These companies, web search leader Google (NASDAQ: GOOG), competitor Yahoo! (NASDAQ: YHOO) and social network leader Facebook (NASDAQ: FB) all seem to hang their prospects on profiting from the sale of online advertising.

I'm so uncomfortable with this current online ad business model that I have doubts it will last. Here are three reasons why:

1. The scale and source of online ad revenue are uncomforting.

Google is clearly the online advertising leader. The company posted fantastic results for the last year with ad related revenues of $46 billion, 21% growth from the prior year and a net profit margin of 21.3%

The competition is also showing good results. Yahoo! is expected to post roughly $5.0 billion in revenue for 2012 and Facebook is expected to post a similar $5.0 billion for last year with expectations of $6.6 billion in 2013.

These companies basically generate revenue from the sale of ads relating to search results or web content on their or partner websites. Most customers pay on a cost-per-click basis, which means that an advertiser pays only when a user clicks on one of its ads.

The scale of online ad sales is interesting. CBS Corp., who owns the most watched TV network in the U.S., generates roughly $8.7 billion from traditional advertising.

That means that Google is currently doing over 5x the advertising business of the owner of America's number one television network and about 9x the business of its nearest online competitors. This in itself might be exceptional enough to consider carefully, but when taken in conjunction with how these revenues are sourced in the industry it becomes very uncomforting.

Measuring the actual number of occurred clicks would seem critical since online advertising is paid per-click. It is somewhat startling that those firms who benefit the most by reporting the highest number of clicks are the ones that determine that figure.

I cannot help but have doubts on the future of a business model that relies on generating revenue from ads that generate clicks that are determined by those that receive the revenue. That model would seem to have, at best, an inherent conflict of interest. At worst, it's hard to imagine that the business model isn't vulnerable to some serious manipulation.

2. The limited evidence that online ads work is uncomforting.

There are questions about the effectiveness of online ads. Software maker Adobe Systems recently put out research about online advertising.

The results show that roughly 30 percent of consumers think online advertising is not effective, while more than 50 percent believe web banner ads don’t work. The poll also indicated a sizeable 66 percent of consumers believe TV commercials are more effective than online ads and that the two most preferred places to look at an ad are print magazines and when watching a favorite TV show.

While that data is disputed by those in the industry, there does not seem to be much evidence that brands are meaningfully built via online advertising. On the other hand, there is plenty of historical evidence of brands being built via traditional advertising.

3. The future of online ad profits is uncomforting.

The online ad business is starting to mature. Facebook only recently become public and Yahoo! has finally become serious about increasing their clout in the market.

This increased competition may reduce profitability and the trend could only be beginning. Twitter, the online favorite, is said to be planning a 2014 IPO and looks reliant on online ad revenues. Amazon, the feared competitor, seems to be building a web-based ecosystem that looks like an optimum environment for advertising.

All these players need revenue growth but, even without increased competition, the format for online advertising may not support it. Web browsing is not best for the necessary increase in ad volume. Greater ad numbers would seem to quickly fill the relatively small viewing screen and would even be more noticeable via smaller mobile device access. Increased online advertising will also not increase its popularity or effectiveness. I doubt the reaction would be positive if, in the middle of a Facebook session, a viewer was forced to watch a 1 minute spot of advertising.

To meet such headwinds to industry growth, firm's like Google, Yahoo! and Facebook look like they have to capture significant dollars from traditional advertising. But that means dealing with more sophisticated and experienced customers than those currently supporting profits. These sophisticated clients will increasingly want to be given proof that their dollars are being well spent and I believe the current pay-per-click model doesn't come anywhere close to that obligation.

It looks like the business model of making money through online advertising has been given a pass so far, but I'm not at all comfortable that this model will continue longer term. A change in business practice is a significant event for any company and investors might want to consider, or at least be aware of, that possibility for those who are in the online ad game.


grahamsway (Bob Chandler) has no position in any stocks mentioned. The Motley Fool recommends Facebook and Google. The Motley Fool owns shares of Google. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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