John Gilliam's  Instablog

There has been much talk about an online advertising recovery going all the way back to Google’s (Nasdaq: GOOG) last quarterly report where we first saw what appeared to be at least a “leveling off” in pricing trends.  Now that most analysts covering this space appear to be expecting a recovery in online advertising spending in the months ahead, should investors consider investing where they spend their time online searching and shopping - is it time for investors to put their money where their mouse is?

Such a discussion has to start with Google, the largest player in the online advertising space and the company who is expected to reap the greatest benefit from a rebound in online advertiser spending.  Google’s stock traded below $400 in the days leading up to its second quarter earnings report in July where the company reported revenues grew at the slowest pace in the company’s history.  Google’s performance in Q2 was widely understood to be hampered by a pullback in online ad spending.  Google CEO Eric Schmidt’s commentary in the post report conference call suggested that online ad spending had likely stabilized, but the lower revenue growth and year over year average cost-per-click declines left few ready to call a recovery. 

Fast forward two months and we have Google’s stock hitting new 52 week highs almost daily and quickly approaching the $500 level again as analysts almost universally are now expecting Google’s Q3 report to portend a recovery in online advertising.  Some of this goodwill and expectation that a recovery in online advertising will lead the economic cycle has started to flow to Yahoo (Nasdaq: YHOO) as well, which has just been upgraded by several analysts.

Since Google’s stock is now up substantially from the lows leading up to its Q2 report and Yahoo is up about 20% off its lows from the summer, have investors who failed to jump on the bandwagon missed the parade entirely?  While we would never bet against rocket scientists who work and play at the Googleplex, the large increase in Google’s stock price in such a short time makes us wonder if much of this recovery is already priced in and whether investors might do well to look a little farther down the food chain to see what other companies might get a boost from an ad spend recovery.  Given our belief that any turnaround in online ad spending will be experienced first and best within the Google ecosystem, we decided to take a look at the publicly traded companies who most benefit when Google’s advertisers begin to spend more on advertising. 

These companies are part of the Google “Search Partners” network and they have guaranteed minimum revenue share payments based on their achieving defined performance terms, such as number of search queries or advertisements displayed.  Thus, a rising tide in ad spending at Google should raise all of the Google “Search Partner” ships who have a significant part of their revenues/earnings tied to the Google network. 

The largest Google Network partners include Time Warner’s (NYSE: TWX) AOL and Interactive’s (Nasdaq: IACI) Ask.com.  One could surmise that each company’s stock will perform well over the next few months as we should expect to see gains in revenue for each as a result of advertisers choosing to spend more with Google.  The difficulty with such a conclusion is the same with both companies though - both AOL and Ask.com are just subsidiaries of much larger companies that have exposure to many different revenue streams that are impacted by a wide variety of factors.  Until TWX completes the spin off of AOL to its shareholders and when/if IACI decides to do the same with Ask.com, any stock price increase from an uptick in spending on the Google network may be muted due to happenings with one or more of the many other movable parts.

We think investors might do well to take a look at some of the smaller Google Network partners, given that their results are so heavily driven by Google Search Network revenue.

InfoSpace (Nasdaq: INSP) derives the majority of its revenue from the Google Search Network and a full 95% of their Q2 2009 revenue was derived from a combination of Google and Yahoo search network payments.  With no debt and $200 million in cash on the books, INSP’s is currently trading only 12%  higher than it was when Google reported in July, thus its returns are somewhat less than the +20% gains we have seen for Google, Yahoo and even Interactive.

Answers.com (Nasdaq: ANSW) is another small cap company that should see a benefit from an uptick in advertiser’s spending through Google.  Answers derives nearly all its revenue from Google including 91% of the company’s total revenue during the most recently reported quarter. Like InfoSpace, Answers has no debt, a significant (relative to its $60 million market cap) cash hoard ($20 million) and its Wikianswers.com site appears to be growing rapidly.  Additionally, Answers.com stock is actually trading about 10% below where it was trading when Google last reported quarterly results, so there could be some nice upside of the company experiences strong growth in its Google driven revenues.  

The smallest of the Google Search Network companies that should benefit is a microcap company called Vertro (Nasdaq: VTRO) that offers the ALOT.com home page, toolbar and desktop search products.  Like the other small cap names mentioned, VTRO has no debt and a nice cash position ($8 million) relative to its market cap ($18 million).  VTRO could be among the biggest beneficiaries of an uptick in Google advertiser rates because it is so small, the company derives more than 95% of its revenue from Google and it has been experiencing significant internal growth in the number of searches across its network.  VTRO actually outpaces Answers.com in terms of Google Search Network revenue earned with trailing twelve month revenue in excess of $30 million.  Even more importantly, VTRO management recently reported that their ALOT.com Home Page service has experienced a 60% increase in unique users since the end of June, they now have over 5 million active toolbar users and that searches across their entire network increased from 58 million in June to 72.4 million for the month ended August 31.   The combination of a significant increase in the number of users of Vertro’s search services combined with  improving cost-per-click rates within the Google provided paid search results could make Vertro the biggest “bang for your buck” among stocks that will get a boost from increased advertising spend across the Google Search Partner Network, if you can stomach the volatility that goes with microcap investments.
 
In summary, we believe it is quite likely that we are on the verge of a secular trend towards higher online advertising spend.  As such, investors would be well served to “put their money where their mouse is” and feel that Google and its Search Partners will likely be the biggest beneficiaries. 

Disclosure - author is long GOOG, YHOO, INSP, VTRO, ANSW

Notable chatter over the weekend about the possibility of a GLU Mobile (Nasdaq: GLUU) engagement to one of several well heeled suitors.  Of course, all the usual suspects are involved - Electronic Arts (Nasdaq: ERTS), Activision (Nasdaq: ATVI), Nokia (NYSE: NOK) and even Apple Computer (Nasdaq: APPL). This is not the first time we have heard such, but this time we are seeing the kind of volume that lends much more credence to the talk. With the overall market getting bruised badly today, GLUU shares were up 23% on nearly 10x their prior 10 day trading volume.  Such a spike in trading volume is fairly common in the days leading up to a merger announcement and the price action certainly suggests there are investors who want to get into this stock now and do not mind paying up to do so. Past management discussions of sector valuations suggest that Gluu might take a pass on any sub $100 million overtures, so we would expect any deal to price in excess of $3 per share on the low end and we should see the stock continue to trade higher if there is any substance to these rumors.

While we do believe there may be substantial interest from some of these names and possibly a few others, we believe its just as likely that the Street is simply revaluing the Gluu story. With Apple's iPhone set to price at $99 beginning this Friday, there is substantial reason to believe that GLUU's outlook stands to improve markedly between now and year end. We fully expected to see the $99 iPhone price point prior to the Christmas selling season (see 01/12/2009 Seeking Alpha article re: Gluu) and feel it is very bullish for GLUU and other mobile gaming players that the move has been made early enough to allow the "iPhone as a gaming platform" market to develop prior to the big Christmas retail push. GLUU management appears to be executing on its plan of reallocating resources to push much more heavily into the development of games for the iPhone and this combined with their extensive experience with monetizing these assets bodes well for GLUU shareholders.

Another factor that could be pushing GLUU shares higher is the anticipation of the possibilities with the iPhone’s new 3.0 software update, which will allow Gluu and other game developers to charge for items “within a game”. This opens the door to many new monetization possibilities including charges for premium weapons or tools, new levels or cooler gear.  Developers could conceivably just give the game away for free, but make even more money with up sells within the gaming experience.  This offers great potential for greater monetization per user vs. the traditional one time payment of anywhere from $0.99 cents to $9.99, where the average has generally been closer to the $2 level. 

These iPhone developments could be a major watershed event for the mobile gaming industry and GLUU is arguably the purest mobile gaming play among publicly traded companies. With a market cap that (even after the aforementioned run on the shares) is only $44 million in a sector that is likely at the beginning of a secular trend that could make blockbuster profits for those best positioned to take advantage of it, Gluu stands out as one of  the best ways for investors to get mobile gaming exposure. However, the smallish number of shares (float less than 10 million shares) available could make it difficult to accumulate much of a position without moving the stock substantially. 

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