BW ONLINE DAILY BRIEFING

STREET WISE by Sam Jaffe	September 24, 1999

If you've ever listened to a Web consultant, you've probably heard that you can't make money anymore by selling ads online. Try finding a single Internet company that claims in its mission statement that it plans to gather all of its revenue from advertising. Even content companies such as Yahoo! (YHOO) and InfoSpace (INSP) describe their businesses as "e-commerce-driven," rather than dependent on ads. "The obituary has already been written for the banner ad," declares Alexander Cheung, manager of the Monument Internet fund (MFITX). "It's not going to go awayÖbut it has been overused."

Most money managers are wary of companies that collect the bulk of their revenue from ads. "All of the information we have suggests that ads as a revenue source aren't going to cut it for second- and third-generation Internet companies," declares Jim O'Shaughnessy of O'Shaughnessy Capital Management in New York. "They will therefore have to rely on real revenue lines to make it work."

Despite such gloomy predictions, the Internet ad market is about to take off -- at least according to Forrester Research. The Internet Ad Bureau (IAB) calculates that about $1.2 billion was spent on Web ads in 1998. Forrester expects that figure to more than double this year, to $2.8 billion. That would mean advertisers will spend more on Web ads than on outdoor billboards. By 2004, Forrester sees online ad spending reaching $22.2 billion.

HYBRID PRICING. So why is everyone so down on Net advertising? Mainly because nearly everyone is down on banner ads, those billboard-like rectangles that a scant 1% of Web visitors click on. These ads are paid for based on the number of people who view them (advertisers pay X-amount per thousand views, a measure called cost-per-thousand, or CPM), and their prices are under pressure. "CPM rates have been dropping across the industry every year for the last four years," says O'Shaughnessy.

Everyone agrees that banner ads won't be the advertising vehicle of the future, but few seem to realize that banners have already given way to other types of ads that are enjoying significant growth. According to the IAB, banner ads accounted for only 58% of all ads in the first quarter of this year. An additional 29% of ads were sponsorships, and a further 6% were "interstitial" ads, which include pop-up boxes and ads that show up on the fringes of your computer monitor.

Another emerging trend is the growth of hybrid pricing schemes. For instance, advertisers may pay a Web site based on how effectively an ad campaign attains certain goals, such as brand recognition or prompting sales. Another alternative pricing plan is paying only for ads that have been clicked (an approach most publishers resist since a poor click record could simply reflect the advertiser's inability to produce a good ad).

Such hybrid pricing accounted for 43% of ads sold on the Net in the first quarter, with 51% of all ads sold under old-fashioned CPM pricing. The other 6% was performance-related pricing, and that share of the business is expected to grow the fastest. "Charging for performance will be the dominant trend in the future, and it's already happening today," says Charlene Li, senior analyst for Forrester Research.

WHO NEEDS PRIVACY? The future also holds the promise of advances in technology that will make online advertising more effective, and therefore more expensive. The most notable change on the horizon is the advent of broadband Net access, which will allow multimedia graphics and high-quality streaming video on ads. "Internet ads will become more dynamic and have more multimedia in them," says Munder NetNet fund (MNNCX) manager Paul Cook. "That has a long way to go, but it's going to make them much more useful."

Another technological advance on the horizon will allow retailers to market directly to individuals on a level never before imagined. "Say that your Dodge Durango is five years old and an ad pops up that says how much the trade-in value of that car is and what you can buy with such a trade-in," says BancBoston Robertson Stephens senior analyst Keith Benjamin. "You're probably a lot more likely to click on that ad than if you just saw a banner ad with the Dodge symbol on it." That assumes, of course, that you aren't furious at the advertiser for how much it apparently knows about your personal life.

Giveaways are another trend that will affect ad spending. Companies will reward consumers who agree to look at ads. For instance, Internet service provider NetZero gives free Web access to anyone willing to be bombarded with ads. Similarly, FreePC gives away computers to people willing to watch ads while they Web surf. Most analysts think such campaigns won't syphon much money away from other forms of Web advertising. "It's a new model, and it will attract different advertisers," says Forrester's Li. "The people who use free ISPs will still see Yahoo!'s ads also, so it won't cannibalize the existing network of ads."

WHERE TO INVEST. As more advertisers spend more money on the Web, the biggest benefactors will be the big sites that already dominate the business. According to the IAB, the top 10 Web publishers got 75% of all ad dollars spent online in the first quarter. That number grew from 71% in the fourth quarter of last year. "We think that a few large companies like Yahoo! and AOL (AOL) will continue to do very well generating advertising revenue," says Henry Blodget, an analyst with Merrill Lynch. "We also think that some small, targeted companies can survive on an advertising-only model."

In picking stocks to play off the growth of ad spending, an easy way in is to buy stocks of companies that sell the most advertising, chief among them AOL and Yahoo!. A good way to find future winners is to identify sites that are raising ad rates, even though prices are falling across much of the Net. AOL doesn't publicly release ad rates, so it's hard to tell how much it charges, while Yahoo! is rumored to have raised its rates an undisclosed amount in August (though other rumors have it cutting what it actually charges). Computer Web site CNet (CNET) announced this month that it would raise rates 15% to 20% on some parts of its site.

"It's all about scarcity," says Thomas Weisel Partners analyst Faye Landes. "The reason the back-page ad on Vanity Fair costs so much is because it's so scarce. Sites that can come up with a very focused demographic will be able to charge more because that's so scarce." Analysts who cover CNet expect it to earn 29 cents per share next year vs. a loss of 57 cents this year, according to Zacks Investment Research. Be forewarned, though, this is not a cheap stock. Its estimated price to earnings ratio for the year 2000 is 166.

The best investing play on higher ad spending, though, might be the companies that sit between advertisers and the big sites that sell most Web advertising. "Our No. 1 pick in the advertising space is DoubleClick (DCLK)," says Benjamin. Consensus estimates are that the company, which sells the software sites use to place and rotate ads, and will even do so-called ad serving for sites, will become profitable sometime in the second half of next year, after losing an estimated 47 cents a share this year. The company's revenue grew by 162% in 1998, to $80 million, and it expects similar growth again this year. And since DoubleClick's industry is rapidly consolidating, it isn't inconceivable that it will acquire other companies -- or be acquired. So, while the banner ad may already be past its peak, Web ads overall are just coming into their own.

Jaffe writes about the markets for Business Week Online

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