Posted: April 18th, 2009 | Author: admin | Filed under: Uncategorized | No Comments »

Finding Internet ad dollars in today’s gloomy environment

Chintu Parikh recently posted an interesting question about “Where to find Internet ad dollars in the current gloomy environment?” on LinkedIn and in his blog:

Check out my blog – Growth sectors for Internet ad spending

When you have a moment pls check out my blog at http://chintu.eparikh.com/ about “Where to find Internet ad dollars in the current gloomy environment?”. It analyzes Internet Advertising Bureau’s 2008 annual report, which was released yesterday, to briefly discuss the industry categories that posted above average growth in Internet advertising spend in 2008. I would to love hear your thoughts.

Blog link: http://chintu.eparikh.com/

This prompted some thoughts I have had on the opportunity for what HBS professor and author of “The Innovator’s Dilemma“, Clayton Christensen, calls “Disruptive Innovation” which might dramatically change the landscape of the Internet Advertising Network marketplace in the future, which I have explained below. But first here’s a brief sidebar for those who don’t know Christensen’s work.

Sidebar: Brief overview of the principles of Disruptive Innovation

For those readers who aren’t familiar with Christensen’s work, let me briefly point out that Christensen defines “Disruptive Innovation” in a very precise and technical way — a way that doesn’t necessarily match the common understanding that people have.  That difference is important to what we have to discuss today.

Briefly, Christensen has collected numerous examples of markets where new entrants havesafely entered protected niche markets within a larger mainstream market and then grew those niches until ultimately the niche markets become the dominant part of the mainstream market.  When that happens the new entrants replace the incumbent market leaders as the new dominant players.  Christensen has collected considerable literature showing how this happened repeatedly in the disk drive market.  The 14″ drives commonly used by mainframes were increasingly replaced by 8″ drives used by mini computers, which in turn were replaced by the 5 1/2″ drives common to desktop PCs, and then by 3 1/4″  drives demanded by the growing portable notebook computer market, and then 1.8″ drives helped power portable hand held devices, such as the iPod.  With each transition in technology, a new entrant became the new market leader.

Christensen holds this is not due to stupidity or hubris of the established leaders — instead, he shows that this kind of market disruption occurs when there exist specific market conditions that make ignoring the initially small niche market, and focussing on a higher profit margin mainstream market the financially prudent way to manage the incumbent company.  In fact, failure to do so would lead to a premature collapse in the market leader’s margins  and would be instantly punished by investors.  For this reason, market leaders willingly cede low profit niche markets to their new entrant competitors. He even cites the case of US Steel who regularly referred customers who wanted low profit items such as rebar to the new recyclers running mini-mills.   US Steel still dominates the integrated steel business, but this is no longer the major portion of the steel market;  the recycled steel mini-mills segment now greatly outproduces the integrated steel producers.

The Coming Disruptive Innovation in the Internet Ad Networks

At XooXooX (www.xooxoox.com) we think that the current turmoil in the Internet Advertising Markets caused by the larger economic downturn makes this is actually a good time for a new internet ad start-up — if the new entrant has the right business model and offerings to take advantage of the massive shifts in the media advertising and in payment models that advertisers are now spending shifting spending to.   When everything is growing, advertisers may be content to try a broad mix — but when sales are shrinking there is always a refocus on advertising performance.

That creates a new business opportunity for a new entrant who is well positioned to take advantage of that shift.  In fact, we think it is a classic example of the “Innovator’s Dilemma” where Disruptive Innovation can allow a new entrant to initially get a foothold in a niche that incumbents think is too low profit. Yet eventually those new entrants just might grow their niche until it dominates the mainstream market, just as steel mini-mills ultimately came be the dominant segment of the steel market, displacing the Integrated steel manufacturers.

What Makes Internet Advertising Ripe for Innovative Disruption?

Let’s face it, most retailers got slammed in the 2008 Christmas season, and with the current consumer uncertainty, poor revenues look likely for the foreseeable future as well. This means that these retailers desperately want to reach potential buyers, yet they also need to keep advertising ads lean and mean.

Advertisers seeking to shift more spending to pay-for-performance advertising

That means advertisers are eager to shift advertising dollars away from pure “ad exposure” based models like broadcast TV or online ads priced in 1000s of ad exposures (CPM).  With increasing click fraud and link spam, even Cost Per Click (CPC) advertising seems less attractive.

What advertisers want to spend their dollars on is ads whose cost is tied directly to ad performance: That is, advertisers want to pay only for ads that result in revenue generating actions (CPA); such as commissions on sales paid to affiliate publishers, or affiliate referral fees paid only for delivering new users who sign up with a real verifiable email addresses or phone numbers.

How incumbent market leaders generate high profit margins

These CPA models are not the business models that today’s incumbent market leaders have embraced. Instead, incumbent Internet Ad Networks have preferred the CPM models — because CPM minimizes their own risk. Because they are paid for showing ads, not for results, it doesn’t matter to the incumbent Internet Ad Networks if the ad generates no sales because of poor page placement, poor ad copy, poor demographic fit, or even a poor product. Whether there is a sale or not, the Internet Ad Network gets paid purely for showing the ads. — Determining why the ad isn’t yielding desired results and the resulting uncertainty and risk is shifted to the advertiser to deal with.

Incumbents whose business models are based on CPM (and to a slightly lesser degree on CPC) have been the most successful at keeping their profit margins high and relatively consistent from quarter to quarter.

The tie between predictability and profitability

By using a bid pricing model, incumbents can earn even higher profit margins whenever they have a good chance of predicting the viewer’s current interest and then display ads for products and services in a matching product or service category.   This predictability turns out to be highest when the user explicitly tells the Internet Ad Network their current interest.  And that’s exactly what happens when users use a search engine and type in keywords.   So it should be no surprise that today the most profitable Internet Ad Networks are those handling the most search requests.

Using demographics and page content to increase predictability

Among the non-search pages, profitability for the Internet Ad Network is dependent on whether the demographics of the page’s visitors are so homogenous that one can precisely target ads for that demographic (for example,  a website for graduating college seniors with degrees in fashion design), or where the content of the page itself (e.g. product reviews of professional digital SLRs) is so predictable that the content itself can be used to predict the viewer’s interests.

Heterogeneity causes low predictability and low profit margins

The least profitable ads are on pages that attract a very heterogenous audience — e.g. news and weather report web pages draw users of all ages, races, economic class, and gender.   And for people whose interests are broad, blogs, facebook and myspace pages, and YouTube videos can be so heterogenous — making prediction difficult — that they are the lowest profit margin segment for incumbent Internet Ad Networks.

Forces that create a safe niche in the least profitable segment

And we know that in Christensen’s Disruptive Innovation market  that it is always in these low profit margin niche segments that new entrants are safe to grow without response by the incumbents.  Instead, to maintain or grow their existing high profit margins,  the incumbents will need to acquire large high profit segments — like fighting for control over more user search requests.

Growth opportunities in heterogenous content areas.

Yet these heterogenous content areas (blogs, news, weather, facebook, mySpace, YouTube, twitter, etc.) are also the fastest growing segment on the Internet.

Yet, because of their low profitability, these are also the pages with the most unsold ad inventory. These unsold ads, in turn, are consolidated by bulk Internet Ad Networks who resell ”run of network” advertising across these consolidated remaindered pages at and extremely low price.  And the low price is appropriate because any ad could run on pages with such widely varied demographics and diverse content that predicting user interest is nearly impossible.  That’s a reason that even the largest Internet Advertising Networks are fighting to control more search requests not more remaindered ad space.

Enter the New Disruptive Innovators

The new disruptive innovator Internet Ad Networks, such as XooXooX, purchase this lowest priced web ad space and find new ways to increase its value.  This is the unsold ad inventory on a host of unrelated web pages that today’s incumbent market leaders find least profitable and are happy to get rid of, just as US Steel once was eager to send rebar customers to the new mini-mills!

In fact, dumping this low profit margin market segment will almost certainly increase the incumbent’s AVERAGE profit margins – by removing the below average segment that pulls the company’s average profit margins down.

Net result: The incumbent then reports increased profit margins — at a time when the industry profitability has been falling.   Guess what that does to incumbent’s stock price in today’s market!

Meanwhile, the new entrants — who are privately held and who are so new that they didn’t have any profits in the past — are happy to get what little profits they can out of this least desirable market segment. Even a little profit is better than none!

Disruptive Innovators find ways to increase the profitability of the bulk ad market

And to extract the most profit they can from this segment, the disruptors create innovative new solutions that allow them to increase their profit in this segment above what the incumbent networks were able to do.  Now these improvements might still be substantially lower than the average margins of the incumbents — so those incumbents are still going to be content with the decreasing amounts of remaindered ads they are handling.

An example, XooXooX

For example, the XooXooX Internet Ad Network doesn’t try to guess which ads will appeal to its users as incumbent leaders do.  Instead, XooXooX enables its users  to customize and personalize the ads they will  see — so every XooXooX web ad is like a user directed window shopping opportunity for products that the user actually wants to track.

Users are naturally curious to see which product offers their XooXooX Personalized Shopping Assistant found for them based upon their own self-expressed interests. That means these users pay attention to XooXooX ads while ignoring most other web ads that they have no control over.  And this combination of higher awareness and higher interest yields higher purchase rates.

To capitalize on this difference, XooXooX has adopted a different revenue model than the incumbents who rely on CPM and CPC business models. XooXooX uses a CPA model; XooXooX’s profit margin is the difference between what it pays for the unwanted ad space that incumbent Ad Networks eschew, and the revenue it earns from commissions and affiliate fees for products requested by it members, that it shows in those ad spaces.

Win, Win, Win: How the new entrant’s niche begins to grow

As more users fill out personalized XooXooX shopping lists, the purchase rates achieved with XooXooX ads begins to grow. And this enables XooXooX to move up market into higher and higher priced ad space. Moreover, the new incumbents, like XooXooX, establish relationships with advertisers that not only increase the advertisers sales, they also reduce the advertiser’s risk, since ads are only paid for if they generate sales.   This creates a Win-Win opportunity that comes from an alignment of network and advertiser interests that doesn’t exist in the incumbent market, and this will also help the new entrants’ segment to grow.

Similarly, the new entrant now has also established more relationships with its growing user base. Once again, a second Win-Win opportunity arises from the alignment of network and user interests; in this case, the user wants to see only ads that are for products that they are interested in tracking, and the network only wants to show them ads they want to see.

And while the new entrant’s profit margin might be less than the incumbent advertiser’s AVERAGE profit margins, it is still substantially higher than what the mainstream advertisers were earning on that remaindered market they are surrendering.  That marginal improvement in profitability allows new entrants to pay a little more to web publishers for their unsold ad space than the publishers would have received from the incumbents.  And remember the segment that incumbents find hard to monetize due to its heterogeneity is precisely the fastest growing category of web pages!

The higher price for remaindered ad space attracts more publishers to the new ad network, a third Win-Win opportunity.

The End Game

As the new entrants win over more publishers in the fastest growing content areas, and more advertisers with higher sales, and more web viewers with more personalized ads,  these disruptive innovators start to control more and more of the least profitable (but fastest growing) portion of the mainstream market until ultimately that segment the new entrants control becomes the majority of the total market.

Meanwhile the new entrants are safe from attack from above — since competing in this segment would lower incumbent’s average profit margins.  Instead,  the incumbents watch their AVERAGE profit margins increase as they shed more of the low margin customers. They wind up owning the most profitable segment — search — but it is a smaller percentage of the total market; a total market containing much more hard to monetize content.

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