It has been the conventional wisdom in the online advertising sector that while the display ad business was headed for rough time as the economy eroded, search-based ads would hold up better. The theory is that display ads, paid for on a CPM, or cost per thousand basis, where you buy eyeballs, are less efficient than search ads, where you pay on a CPC, or cost per click basis, where you only ring the register when someone clicks on an ad.
But what if that’s wrong? In a fascinating series of reports Friday, new Canaccord Adams Internet analyst Jeff Rath takes a close look at the Internet advertising sector, and concludes that the CPC model is more vulnerable than some people might believe. Rath launched coverage Friday on 7 Internet stocks, starting 5 of them with Neutral ratings - Google (NASDAQ:GOOG), IAC (IACI), Marchex (NASDAQ:MCHX), Local.com (NASDAQ:LOCM) and Answers Corp. (NASDAQ:ANSW). He has a Sell rating on ValueClick (VCLK), and his sole Buy rating on BankRate (NYSE:RATE).
For Google, he has a price target of $300, below the current level.
“We believe the tide on performance-based advertising as a counter-cyclical ad format better able to weather a downturn has shifted, and we expect to see CPC pricing and the density/volume of clicks to decline,” he writes. “Our checks support the thesis that while Google continues to have various levers at its disposal to meet estimates, revenue estimates estimates could be at risk with search representing the company’s primary source of revenue.”
He goes on to assert that Google could be reaching “the inflection point of its product cycle,” and that “margin contraction could be significant.” He writes that Google “has tremendous alternative product opportunities in its pipeline that could reinvigorate the product cycle,” but that he does not expect any of those to contribute materially in the near term.
Here are few of Rath’s other observations about the Internet ad environment:
- He sees CPM rates dropping “precipitously” in Q1, with prices potentially falling by 15%-20%, “as checks indicate budget cuts around branding campaigns are the first to be pulled.” (That would be bad for Yahoo (NASDAQ:YHOO), among others.)
- He expects CPC rates to be weaker than expected; he thinks CPC growth could turn negative over the next several quarters due to weaker demand; he says pricing could come down due to “weak bid density on keywords.”
- December quarter and 2009 consensus estimates “are potentially at risk due to recent foreign exchange volatility that has seen the U.S. dollar strengthen materially.”
- He thinks 2009 EPS for the sector could show modest to zero EPS growth.
- Another risk, he says, is reduced interest income, with cash balances yielding next to nothing.
- The ad network space is over-crowded, with more than 300 players. He expects them to see “severe competitive pressures,” and notes that increased integration of DoubleClick by Google and aQuantive by Microsoft could place further pressure on the independent networks and lead to “aggressive consolidation.” (Ergo, the Sell rating on VCLK.)
- He expects TAC, traffic acquisition costs, to trend higher due to competitive pressures from competing search engines.
GOOG Friday closed down 6 cents, or 0.02%, to $310.17.