Why Silicon Valley Should Be Worried

57 Comments

Updated at the bottom: We have short memories in Silicon Valley, which is both a blessing and a curse. We forget the bad times as quickly as we forget the good times.

At the turn of the century, everything went to hell with the dot-com bust. Then the pendulum started to swing the other way; the pessimism that once reigned supreme was being replaced by wild-eyed optimism. Now Silicon Valley is in for a long-overdue reality check, one that should worry one and all. Why? Because the news coming out of advertising-focused companies is not good.

Yesterday ValueClick, a display advertising network, said it now expects its second-quarter revenues to range from $162 million to $164 million, lower than the previously forecasted $170 million. The company also cut its full-year 2008 sales guidance by about 10 percent, to between $655 million and $675 million. It blamed weakness in its display and comparison advertising business, and flatness even in its lead-generation business.

Time Warner’s Platform-A advertising division isn’t doing so well either, according to some of my sources. The company is instituting wide-scale belt-tightening measures, including freezing travel budgets. Pali Capital in a blog post today forecast, “AOL’s display advertising revenues down about 8% in Q2 (Q1 ‘08 was down about 10% organically), with the back-half down mid-single digits.”

Microsoft, in its fourth-quarter 2008 earnings call today, also admitted that online advertising was tough. “The one proviso to that is in the online advertising space…it was weak in the fourth quarter. There is a direct impact and we’re not immune in the online space, ” Microsoft CFO Chris Liddel said in a conference call with analysts. “The online advertising area is part of the business that we think is most challenging…the online advertising area is very difficult at the moment.”

And if that wasn’t enough, Google just announced spectacular growth in its second-quarter revenues — about 39 percent over the same period lat year — but fell short of Wall Street’s profit expectations. Between The Lines blog notes that Google CEO Eric Schmidt, in his company’s conference call with investors, said they would survive the downturn because there will be a flight to quality, and that they will provide a better return on investment. Maybe! Larry Dignan hit the nail on the head when he wrote:

“Color me skeptical. Anyone that lived through the dot-com bust has heard these lines before and no company is immune if there’s a recession.”

Like him, the skeptical me went straight to the traffic acquisition costs (TAC), which is where I think the real story lies. If you look at the image below you’ll see that Google’s traffic acquisition costs have declined rapidly while its revenues have ballooned. TAC in general and AdSense specifically are like a black box – no one quite knows how much Google gives out. Sometimes it feels like Google can use this “black box” to come up with pretty much any numbers it wants to.

We’ll get a better sense of the overall health of the market when Yahoo reports its latest numbers, but the way I see it, things are sort of troubling. We wrote about this nagging problem back in May. I think that as we go forward things are only going to get worse — and even Silicon Valley can’t ignore what’s been going on in the overall economy.

The housing crisis is being replaced by a much scarier problem: the personal credit crunch. In a recent report, American Express noted that it has started to see a sharp increase in late card payments. Now folks, this is American Express, whose customers skew towards the affluent, especially compared to those of its competitors. The company has boosted loss provisions for its U.S. card business, profits have declined, and defaults are up.

Will these problems escalate? Probably. Consumers struggling with the housing crisis and rising fuel costs — and thus higher basic living expenses — will be forced to cut back on other spending, which will lead to slower sales and in turn, less money for advertising.

We know the housing and financial sector-related ads have already declined drastically, now we’re going to start to see other sectors cut back on advertising, too — and that is going to have a negative impact on everyone from large social networks to ad networks to Yahoo and Google to small startups, including weblogs like ours. I guess Provigil sales are going to take a nosedive in the Valley as we stay up all night worrying about everything.

Update: And there’s more bad news today. The Wall Street Journal reports that General Motors is going to sharply cut back on advertising. GM is one of the big spenders in U.S. — last year the company spent about 32 percent of its $2.3 billion dollar ad budget on newspapers and 11 percent on television networks — but it looks like those expenditures are going to get hacked. It’s not clear from the report how this move will impact Internet advertising.

Photo courtesy of ZDNet

57 Comments

Harish Venkatesan

Agree with Nik’s comment– a smaller advertising pie overall doesn’t necessarily spell doom for companies reliant on internet advertising, as long as they can capture more of that pie… this is not unlikely to happen, as highly effective online advertising is just around the corner.
Companies like 33across that help advertisers leverage users’ pre-existing social graphs and demographic data enable highly granular, targeted ad placement, which is undoubtedly more effective for advertisers than simply placing inventory next to certain content and hoping for the best (an oversimplification, yes, but you get the point). In addition to social and demographic targeting, you have the force of mobile on the other side, which is in itself a highly valuable, albeit unexplored, territory. If you recall, Eric Schmidt made the claim that Google’s mobile ad revenue would soon exceed their online revenue.
The company that figures out how to solve the local advertising problem will be able to create a lot of value for players in the mobile ad space.

ideazinger

Again, goes to show how diversified MSFT and IBM revenues are and robust, compared to the one-trick (or half-a-trick) pony that Google is.

Nick Hebb

I have to agree with Joe Doe. Half my ad campaigns compete against large companies that shovel buckets of cash at advertising for non-relevant search terms. At some point, I have to believe that the large companies (amazon, ebay, et al.) will invest in business intelligence systems to focus their advertising dollars more effectively.

Ranjit Nayak

As a skeptic of the ad-based revenue model from the very beginning, I am not surprised by the facts. With uncertainty in the economy, ad expenditure will probably reduce. I am however convinced that the internet and associated technology do promise to help with targeted ad campaigns, although the market size may be blown out of proportion. As Om suggested this does remind me of the inflated expectations right before the dot com bust.

The entire IT industry however I expect is more secure. An information week article in the July 14 edition, showed that there were 4.1 million jobs in the field in the 2nd quarter of 08 – way above 3.1 million in q2, 2004. The information worker has a lot to offer the economy and society in general. Recessions and downturns probably are the best time to put technology to use and improve efficiencies. This should bode well for silicon valley and creative minds.

Joe Doe

Most of the google advertisement happens through intermediaries like advertisement agencies and ads resellers and at this time most clients are not tracking the return on investment on their google outlays, when they start tracking hell will brake lose……

As a graphic designer have seen 5-6 of my clients try the google ads only one company got positive ROI.

Karthik

Agree that companies that are solely dependent on ad based revenues should be worried given the current economic conditions and the recent earnings announcements. But one would (fervently) hope that the moniker Silicon Valley refers to much more than these companies :)

On another note, I can’t make much sense of what you were trying imply with your TAC chart. I’m afraid TAC (as % of total revenue) is not a useful measure since it combines multiple effects – adsense and direct ad revenue. I generally use TAC (as % of ad sense revenue) to get a measure of how competitive the network advertising market is. If you were to plot that, you would see a very different picture – TAC as % of adsense rev has crept up from 80% to 90% over the same time period. In fact, net ad sense revenue peaked in Q3 2007 and is now comparable to Q1 2006 numbers. My interpretation is either that the market is competitive leading to margin pressure (hard to believe this) or that Google has made some really bad deals (read myspace etc).

Brian Kirk

The WSJ reported a story this morning on their cover page, “Tech Firms Rise Above Economic Turbulence.” The article pointed to recent earning reports from Microsoft, Google, IBM, and Nokia as an example of tech firms with sustained revenue growth. Obviously no industry (especially Silicon Valley startups) is immune to a recession. However, I’m happy to be involved in an industry (telecom & IT) that isn’t responsible for the recession this time & may just in fact be the shining light that provides the country through these tough times.

bill gates

The Technology business in the US is in a long term secular decline. Three things drive this decline: a long term bear market in the stock market, absurd intellectual property laws, peak oil.
In the long run, economies and stock markets are driven by demographics. The baby boomer bulge gives way to the baby bust. The smaller cohort of Gen X , Y and Z is also financially poorer than the boomers at the same age. This argues real estate is not a good investment.
Patent laws are taxes on innovation. They reward bigness over smallness. Small companies are generally more innovative. Draw your own conclusion.
Peak oil will insinuate itself into every dimension of our lives. For an economy, if more money needs to finance raw materials then the corollary would be less money for intellectual / knowledge driven work.
The sum of all this is to paint a future that looks a lot like the past; Say, the 19th century past. The major industries of the future will be local agriculture, mining, railroads, fishing etc.
The World economy based on American consumption is not coming back. You have been warned.

me

Google is not recession proof. Any company with a minimum of one or two adwords competitors and basic skills at tracking ROI will see that their adwords ROI is minimal at best. The days of putting your ad up and reaping the reward are long long gone. The problem is that the bulk of those contributing to google’s profits don’t realize that yet. They will.

Once companies with down economy cash flow problems start to closely examine these expensive campaigns, they will find it is very easy to log into google and instantly pause these minimal ROI campaigns with very little to no hit to profits. I’m sure different industries will be different, but I think this is the beginning of the end for Google’s “stupid money” revenue.

Mary Fallon, DEMO.com editor

During downtimes, often a disruptive technology emerges. Online advertising for the most part isn’t taking advantage of being online. It still follows TV and print in how it presents to customers. Ads often don’t engage and still approach the market as a massive blog instead of the more effective 1 on 1 marketing approach. At DEMO 08 in January, RealTime Content introduced an “adaptive” media technology that has promise for customizing ads to narrow groups perhaps even individuals. By using various online technologies like adaptive media and borrowing some concepts from online gaming as Bunchball of Redwood City suggests, video and display ads online could be cheaper and more effective for any company selling any type of product. Effectiveness of engaging a person with intent to buy could be the tipping point that siphons ad money from TV and print and brings it online. And that could help all of us on online news and blogging survive the downturn.

David Mullings

Ad-only business models have always been risky and I agree with Grant – advertisers have focused on swamping people online instead of working with publishers to generate more QUALITY instead of QUANTITY.

I hope this downturn forces more creativity and I see a bigger shift to product placements and sponsorships, as well as more behavioral targeting.

Even PPC will get hurt because no company wants to spend money advertising to people who don’t have money to spend.

Eric Rice

Om, let’s remember that Silicon Valley is not just software. Our history here is long and innovative, spanning most of the 20th century, and ranging from communications, military, electronics to software, biotech, and beyond.

We adapt so we can continue to innovate throughout all the highs and lows.

Grant

Maybe advertisers will soon realize that most of their target audience is buried in a deluge of advertising, such that very little actually makes it through the noise to make an impact.

Advertising can make an impression in the lulls, when people are bored or actively seeking something new (for most adults, a rare occurrence). Ever notice how kids (the constantly bored) are so hugely impacted by advertising? Anyway, the two that get through to me: Travel and attraction brochures when waiting in a line by myself, without a book. And new ethnic restaurant advertisements.

Francine hardaway

When advertising dries up it does so all of a sudden, as every agency suddenly hears about budget cuts from its clients. I cannot believe that is not beginning to happen, and will not affect the web as well as every other medium. I think you are right, Om.

Dominic Jones

You should go for a stroll on the beach more often :) A timely and thoughtful piece. I tend to agree with the comments that drawing comparisons to the dot-com bust probably is a bit strong, but who really knows.

Still, if I can’t go anywhere because the gas is too expensive and food is cheaper out of a can, then I’ll be reading your blogs more often. Especially since rising costs at mainstream media sites that still have the burden of delivering paper will probably seek cutbacks that will denude the value of the product.

So perhaps we should see this as a big opportunity for company’s like yours. So relax. And go for more walks.

Nik Cubrilovic

Good post Om, though the right online Ad platforms should win in a downturn, as advertisers will look to move their ad spend to more efficient places. In theory the web should take more of the ad slice in a downturn, even as the overall pie gets smaller.

The Goog result is just expectations being set too high. If we reset to normal mode things would be good.

sabat

SV shouldn’t be any more worried than the rest of the country/world. Sad to say, that’s pretty worried.

Roman Geyzer

Silicon Valley revenues will definitely be affected by the recession…its pretty much guaranteed. However, we have to be careful not to equate this to the dot-com bust as this is apples and oranges. In 2000 you had a massive slate-cleaning as the market “revalued” a whole slew of companies. Nowadays, there is more maturity in the sector but it will be interesting to see how it handles the recession. I doubt there will be many sites that prove to be “immune”…even Google. After all, when consumers are not in “commerce mode”, they don’t click on the ads!
Let’s break it down:

Commerce Sites (Amazon,etc.): guaranteed drop as consumers shop less plus rising shipping costs will affect value proposition.

Search Engines : less clicking on ads since consumers are not in “commerce mode”

Social Networks: they’re not terribly profitable even now. CPM rates will drop as advertisers see lower click-thru-rates on display ads. This will offset rises in page views

Subscription services (salesforce, etc.): may see less volatility than advertiser-driven models but certainly won’t grow…they just may not drop as hard.

The one exception are sites that benefit from recessions and penny-pinching consumers. Sites like fatwallet.com and others come to mind. Sadly, I suspect there will be some scam sites that flourish in these unfortunate times.

Hopefully, this will be a brief recession but with the number of market forces at play right now, I won’t be making any bets one way or another.

Srini Srinivasan

Given that the web is becoming more and more social everyday, and not a single social network is profitable from advertising – this added news of TAC increase, and ad spend reduction is definitely looking a major correction to me.

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