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Friday, March 18, 2005

Victims of pay-per-click ad inflation

The most striking theme that ran through the Q4 financial results of Internet companies, irrespective of size, was the impact of rising pay-per-click ad prices. The winners were the ad brokers - Google and Yahoo. The losers were companies that rely on advertising to attract traffic, as their marketing expenses grew faster than their revenues.

This is a critical theme for investors (rather than short-term traders). Do you own stocks in companies that are dependent on advertising and helpless in the face of rising costs? Here's a list of the victims, with the relevant stats and comments from The Internet Stock Blog's write-up of their Q4 results or recent SEC filings:

nVictims of PPC Ad Inflation

AMZN - Amazon.com

Marketing expense up 44% year over year to $58 million. Net sales up 26% year over year excluding exchange rate impact, 31% including exchange-rate impact.

Although Amazon's marketing expense is relatively small (the company's strategy is to allocate marketing to lowering the price to customers of goods or shipping), it's highly significant that Amazon's marketing expense grew much faster than revenue (44% versus 31%).

Question: Amazon says: "We expect absolute amounts spent in marketing to increase over time." But why? If Amazon has the most efficient infrastructure and the strongest brand, that should allow it to offer the lowest prices and to boost revenue without marketing.

BFLY - Bluefly

Sales, marketing and fulfillment costs up 13% to $4.28 million. Revenue up 3.7% to $14.5 million.

More evidence of increased online marketing costs? BFLY's customer acquisition costs were up 34.1%.

DIET - eDiets

Sales and marketing expense rose 14% to $7.2 million, an astonishing 74% of membership revenue.

eDiet's challenges: (1) the cost of acquiring customers is rising (due to rising online advertising prices); (2) eDiet's suffers from high customer churn; (3) the company doesn't make enough money from each customer during the subscription period; (4) barriers to entry seem to be very low, and (5) other online diet companies seem to be outspending eDiets.

DSCM - Drugstore.com

The CEO said: "We have proven our ability to grow net sales, but I was brought on board to take a hard look at this business, and to leverage its sales growth and produce long-term, sustained profitability. I very strongly believe that drugstore.com has an exciting opportunity, but we need to invest in our brand, marketing and technology. Our fiscal 2005 guidance reflects that plan."

Companies' guidance for Q1 and full year 2005 is revealing which Internet companies are capable of attracting traffic, generating revenues at reasonable mark-ups and thus predicting strong profitability, and which are dependent on pay-per-click ads that are rising in price. Guidance from Drugstore.com and Monster Worldwide is the flip side of the coin of Google's guidance: the better Google's search busienss does, the more expensive traffic generation is for e-tailers that advertise.

EBAY - eBay

Although seeing "Bubble-like" search pricing, eBay plans on keeping marketing expenses in a 20%ish band of revenue.


SG&A of $5.6 million rose to 9.6% of revenue from 8.9% a year earlier. The reason? "Additional advertising and promotional expenses that led to the Company's strong customer growth, higher personnel costs to expand eCOST.com's management team and additional regulatory costs of being a public company."

Advertising costs up 53% year over year to 3.6% of sales. In Q3 they were 3.2% of sales.


Note: revenue growth of 36% outpaced growth in marketing expense of 24%.

INSW - InsWeb

INSW's marketing expense woes are typical of the industry-wide rise in advertising costs. INSW reported in its Q4 results that direct marketing costs rose 95% to $2.45 million from $1.26 a million year earlier. Direct marketing costs accounted for 63% of revenue in 4Q04, versus 30% a year earlier.

LGBT - PlanetOut.com

Sales and marketing was $2.6 million versus $1.5 million. Revenue of $7.1 million was up 34%, in line with consensus.

Noted: Yet another Internet company with rocketing marketing costs. From the press release: "The company increased marketing activity in 2004 as part of its strategy to provide long-term benefits to its brands, particularly Gay.com. As a result, sales and marketing costs for full year 2004 were $8.8 million, compared to $6.6 million for full year 2003. Sales and marketing costs were $2.6 million in the fourth quarter of 2004, compared to $1.5 million in the fourth quarter of 2003." And later: "Guidance for first quarter revenue, Adjusted EBIDTA, and net income (loss) reflects several factors, including seasonality in advertising revenues and increased marketing expenses related to its "Come Together" campaign."

MNST - Monster Worldwide

Monster said Q1 EPS would come in at $0.16-$0.17, lower than the  consensus of $0.18. Q4 results were strong: online revenue rose 28% organically (64% including acquisitions) year over year and 9% sequentially, and operating margins widened to 23% from 18% a year earlier. But the revenue growth came from targeting small and medium businesses and increasing Monster's sales force, and those factors raised projected expenses for Q1.

Here's what the company said about guidance in its press release: "Expense levels in the first quarter are expected to increase due to seasonally higher marketing and promotion expenses in North America and a strategic investment in marketing activities in Europe. As a result, earnings are expected to be in the range of $0.16 to $0.17, an increase over the $0.11 reported in the first quarter of 2004."

ODMO - Odimo

Note that marketing costs rose from 9% of revs in 2003 to 12% in 2004. The S-1 comments: "Marketing expenses for the nine months ended September 30, 2004 increased 100.8% to $3.8 million from $1.9 million for the nine months ended September 30, 2003. The increase was primarily due to increased online advertising costs." But it gets worse: for the September 2004 quarter alone, marketing costs increased 247%!

OSTK - Overstock.com

Offline retailers are increasingly focusing on their online channels. Unlike the pure-play online retailers, they are able to drive traffic to their web sites from their stores and circulars. With relatively higher marketing costs than its multi-channel rivals, Overstock needs to offer compelling prices to attract customers.

PCLN - Priceline

Online advertising cost rose to $8.52 million from $4.06 million. (Offline advertising fell slightly to $6.02 million.) Revenue of $195 million up 8.2% and slightly below consensus estimate of $195.13.

PRVD - Provide Commerce

Sales & Marketing at $7.5 million was up from $5.3 million a year earlier, but declined slightly as a % of revenue to 23%.

SHOP - Shopping.com

Online marketing expense rose 61% year over year to 82% of revenue.

SPRK - Spark Networks

JDate accounted for less 2004 revenue than AmericanSingles.com ($24 million versus $35 million) but much more gross profit ($22 million versus $10 million). The reason? Direct marketing costs for JDate were only 7% of revenues, versus 71% for AmericanSingles.com. Subscriber acquisition costs were dramatically lower ($8.09 versus $43.29) and monthly revenue per subscriber higher ($28.42 versus $22.16).

From the S-1: "In general, the costs of online advertising have recently increased substantially and we expect those costs to continue to increase as long as the demand for online advertising remains robust. If we are not able to reduce our other operating costs, increase our paying subscriber base or increase revenue per paying subscriber to offset these anticipated increases, our profitability will be adversely affected."

TSCM - TheStreet.com

Sales and marketing was $3.57 million, up from $1.86 milllion. Revenue of $9.5 million, up 29%, was in line with consensus of $9.51 million.

Note: you can find brief summaries and comments on these companies' Q4 earnings in the Earnings results category. Quotes from Q4 conference calls are in the Conf call quotes category. You can view all the articles about each of these companies by looking under the relevant ticker category.

Full disclosure: at the time of writing I'm long SHOP.

Posted by David Jackson on March 18, 2005 at 10:25 AM in Sector Themes/Outlook, ticker: AMZN, ticker: BFLY, ticker: DIET, ticker: DSCM, ticker: EBAY, ticker: ECST, ticker: EELN, ticker: LGBT, ticker: MNST, ticker: NILE, ticker: ODMO, ticker: OSTK, ticker: PCLN, ticker: PRVD, ticker: SHOP, ticker: SPRK, ticker: TSCM | Permalink


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It is critical for investors to keep in mind that one factor in rising PPC costs is the tremendous influx of what I call "consideration and reach" dollars from non-direct response advertisers. Until 2004, these dollars were not part of the online advertising mix / revenue stream. Suddenly, brands decided to increase budgets and their agencies rushed to form relationships with search firms like iProspect and Performics... and the rest is history. Inventory has become scarce and prices are rising. Again, direct response was not part of the game for these branded newbies BUT for the direct-response ad buyers (i.e. those listed above in this entry) nothing changed.

Long-term, the direct response media buyers will be forced to come to grips with this shortage. Luckily they have/will have many options such as "vertical search" portals offering more targeted audiences. These opportunities may come at a more reasonable cost. Also, tried and true options such as comparison shopping (for the likes of BlueFly and Overstock) and tight-knit marketing partnerships with vertical-oriented media outlets (Priceline, eLoan, eDiets) will yield better results at lower costs.

In the end, this spells good news for owners of other types of online ad inventory.

Posted by: Jeff Molander | March 18, 2005 11:00 AM

Excellent post, and interesting timing. Nielsen//NetRatings happens to have produced some stats for February which tie in nicely here. I posted on this and your excellent work here http://eurotelcoblog.blogspot.com/2005/03/youre-gonna-have-to-serve-someone.html

Posted by: James Enck | March 18, 2005 12:07 PM

There is an essential point to this topic that is not discussed enough - click fraud. We have been buying CPC traffic for a variety of reason's (traffic driving to increase ad inventory, product sales, content sales, etc...) since '98. In that time we have found that wherever we go, whatever we buy, for whatever reason there is always some level of click fraud. It is an epidemic that is only spreading as more and more player enter the game.

As a marketer I know CPC/PPC is a cost effective way to do business, but it could be better if it was a little less slimy.

Posted by: Eric Levitt | March 18, 2005 12:32 PM

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