Recent mergers between traditional and online advertising firms suggest a deep flaw in the advertising business -- a flaw exposed by Google Inc. (NASDAQ: GOOG)'s evidently unstoppable technology edge. How so? While traditional advertisers deliver open-loop systems, Google delivers a closed-loop solution.
The reason that online advertising is growing is because it offers a closed-loop solution -- a notion that I first described in Net Profit. By contrast, TV and newspaper advertising is an open-loop system -- one in which a company pays to reach a viewer without getting any specific feedback on whether the advertising money leads to increased sales.
By contrast, a closed-loop solution measures the specific response to the advertising dollar -- tracking whether a user clicks on an ad and whether that clicking leads to an online purchase. I call it a solution because it lets the advertiser measure the extent to which advertising expense leads to increased sales. The closed-loop solution's ability to measure return on advertising is an enormous breakthrough for advertisers.
As everybody knows, Google's algorithm for linking tiny text advertising to Internet search has boosted the online advertising business. According to the Wall Street Journal [subscription required], those search-related ads now account for 40% of the $20 billion U.S. internet ad market. And internet-ad sales overall have nearly tripled in the past five years -- to 7% of the $286 billion overall U.S. ad market -- up from 3% in 2002.
Moreover, Google's success is coming out of the hide of TV and newspaper advertisers. For example, in 2006 General Motors Corp. (NYSE: GM) cut its TV ad spending 15% to $1.38 billion and reduced its newspaper advertising 60% to $232.1 million. Meanwhile, GM's online spending rose 16% to $130 million.
Why is Google winning, and will recent deals help traditional media keep up? Here's how I evaluate three recent deals:
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Google/DoubleClick: Good. Google is winning in online advertising because its particular technology for closing the loop offers advertisers the highest return on investment. But even Google felt a need to broaden its online ad reach -- so it bought DoubleClick Inc. for $3.1 billion last month. DoubleClick inserts ads on web pages as users call them up on their computers. It also provides tools and services that help ad agencies to manage online advertising. While it may have overpaid, Google's deal added a new source of revenues and kept it from Microsoft.
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WPP/24/7 Real Media: Fair. Feeling threatened by Google's efforts to take its ad brokering revenues, advertising agency WPP Group PLC (NASDAQ: WPPGY) bought online ad firm 24/7 Real Media Inc. (NASDAQ: TSFM) for $649 million -- which helps advertisers place ads alongside computer users' web-search results. I think advertising agencies will not be able to keep up unless they can develop their own closed-loop solutions. But the deal was a not-overly-expensive way for WPP to kick-start such an effort.
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Microsoft/aQuantive: Fair. Microsoft Corp. (NASDAQ: MSFT)'s 85% premium suggests that the combination of Steve Ballmer's rage at missing out on the DoubleClick deal and a balance sheet with $28 billion in cash are a recipe for overpaying. But Microsoft could not develop a solution that competed with Google's. In buying aQuantive Inc. (NASDAQ: AQNT), it gets systems for helping advertisers, ad agencies and web publishers. aQuantive's Atlas division helps them manage and serve up online ads. And its internet ad network DRIVE Performance Media buys blocks of online ad space and resells them to advertisers. Whether Ballmer can make this $6 billion investment pay off remains to be seen.
Any media company -- whether TV, newspaper, radio, or Internet -- that gives away its content to attract advertising must not lose sight of why companies advertise -- they want increased sales. As the GM example illustrates, competition is shifting now from traditional open-loop systems to closed-loop solutions. In the next few years, media companies will need to race to execute that transition.
But as these recent deals hint, media competition in the future will hinge on which media company's closed-loop solution generates the highest return on advertising.
Peter Cohan is President of Peter S. Cohan & Associates, a management consulting and venture capital firm. He also teaches management at Babson College and edits The Cohan Letter. He has no financial interest in the securities mentioned in this post.
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