Why bigger is better for online advertisers

The reason lies in network effects of the online search + advertising industry.  Imagine you’re an ad buyer which is to say you have a service you want consumers to find online.  Unless you’re a huge company, you have limited energy to expend buying your ads.  So rather than buying and managing separate ads from each Microsoft, Google and Yahoo, you’re likely to just deal with a single ad publisher.  The sensible ad buyer will choose the ad publisher which gives them the most value for limited effort. 

Right now the clear choice for an online advertiser is Google.  Because they have the most search traffic, they are best able to reach customers.  Combined with their adsense network, Google clearly has the largest inventory for an ad buy making them the natural choice for anybody not willing to spend a lot of energy managing their online advertising.  This logic underlies the recent acquisitions of Doubleclick, AvenueA/Razorfish/whomever, and now Yahoo!  Network effects in advertising mean that the largest network will be the most sucessful.  So the mergers will continue as far as the anti-trust regulators allow them to until a handful of bitter enemies remain.

This much might be obvious to some of my readers.  But I felt like sharing this analysis since I’ve read nothing in the common press that explains the basic economic motivation of this deal.

Wrinkles, twists

An irony of the network effect comes from the auction nature of keyword buys.  Advertisers bid for the right to get their message in front of customers.  When more advertisers are competing for the targeted eyeballs of consumers, the prices for advertising go up.  This means that prices will tend to be higher on the larger ad networks.  So bargain seekers can get more advertising for their dollar by seeking out smaller networks.  This appears to contradict the logic that bigger is better for ad networks.  But many advertisers are limited not so much by budget but by the ability to reach highly qualified customers.  If you are selling poodle tattooing services in the pacific northwest, odds are you will not hit max out your advertising budget on any of the ad networks simply because not that many people are searching for your services.

I could probably fill pages with speculation about the culture clash between Microsoft and Yahoo and other reasons why it will or won’t work.  But if you’re interested in that stuff, I’m sure you’ll have no problem finding it in the backwaters of the blogosphere.  I can’t help but drop a couple relevant ideas though.  First, from what I hear, the executive management at Microsoft is so dysfunctional right now, Yahoo will provide fertile new ground for their turf wars.  If the top bosses are adept, they will use the many iterations of re-orgs to sluff off ineffective execs to projects where their overall damage can be minimized.  Second, I think I hope Microsoft has evolved enough humility to understand that they’re better off simply shutting down Yahoo’s services than forcing everything to port over to NT servers.  Right, guys?

Disclaimer

I feel compelled to point out that the opinions expressed here are mine and mine alone.  In no way does this article reflect any official position of my employer.  This is my personal analysis of the economics behind the industry I work in.

Economically, companies should be valued at the present value of their free cash flows.  That is to say, project forward all the possible ways the company might behave, and take a probability-weighted average (expectation value) of the total dividends the company would pay in each of these scenarios.  Discount these cash flows by an appropriate discount rate and you’ll get a fair market value for the company.  This is called fundamental analysis.

Now anybody who’s tried their hand at such financial calculations will know there’s a lot of judgement calls involved.  Small differences in numbers like discount rate or growth rates have huge effects on the results, and these numbers are hard to judge.  So it’s definitely possible to come up with a believable (by some) model of future cash flows that will value any currently successful company at whatever huge valuation you want.  But that doesn’t make it correct.  Is Facebook worth $300 per user?  It’s not possible for me to click on a $10 CPM ad every day for 100 years, but maybe they can add more users to grow into that?  Maybe?  It sure seems high.  I think there’s something else going on.

For context, think back to March of 2005 when Yahoo bought Flickr.  IMHO that made Google feel bad because Picassa wasn’t doing so well.  I think they saw this as a big missed opportunity to help organize the world’s photos.  I think this was big on their minds when they paid too much for YouTube.  And Google is still very far from monetizing this investment.  But they now control the dominant way that videos are communicated on the net.  This has to help them feel good about getting closer to their corporate mission of organizing the world’s information.  Since it’s not clear right now how they’re going to achieve that goal for photos.

Now consider Facebook.  Left and right, Facebook’s internal applications are surpassing total usage of th best dedicated net applications.  Their invitation app gets many times more usage than evite, and I believe their photos app is actually well beyond flickr in terms of usage too.  I don’t know where they stand for videos right now.  But it’s clear that they are a force to be reckoned with.  As I’ve written before, their application platform is potentially game-changing because it’s very attractive for information service developers and democratizes the process of product development in a novel and powerful way. 

For all these reasons, I think Facebook has the potential to dislodge Google as king of the hill.  No, Facebook isn’t going to become the dominant search engine, or even the dominant deliverer of internet advertising.  But I think Facebook could become the dominant way the humans communicate with each other using computers.  This could be the leverage they need to claim the crown of innovative thought leader on the internet.  If I were running Google, I’d be concerned about this possibility.  If I were running Microsoft, I’d be excited to get a piece of this.  Any piece.  Because even a tiny piece (like <2%) means that Google can’t take control of Facebook.  And yesterday, Microsoft got their foot in that door.  So, the game is on.  It’s gonna be fun.