The Google Exposure? Considering Google and The Advertising "Bubble"

I recently came across Doc Searles' article over at Linux Journal entitled "EOF - The Google Exposure" in which he discusses; "Advertising is a bubble. If that’s a true statement, Google is a bubble too. And if that’s true, many of the goods we take for granted on the Web are at risk. Let’s run down some evidence."

If you're interested in reading the article (I suggest you do) you can find it here:

http://www.linuxjournal.com/magazine/eof-google-exposure?page=0,0

The topic of whether or not trees grow to the sky is one near and dear to me. It's a very important question we have to ask ourselves about the life cycle of various systems (organic, economic, organizational, etc):

"when do these systems enter into a state of decline? when is growth finished?"

The bubble theory in economics tells us about rapid, unsustainable growth which has a catastrophic or precipitous and instantaneous decline. We might even call it a Malthusian catastrophe, where an entity (be it organic or economic) grows so fast that they gobble up all of the available resources and commit a form of organizational suicide. In many cases though, bubbles grow because of behavioral motivations (speculation) and as a result, over valuation. Put simply; for whatever reasons, these companies or industries don't obey standard supply and demand economics. Sometimes the bubbles burst, other times there are series of less catastrophic "corrections".

Is Google in a bubble? Perhaps. But every organization, empire, economy, life form, etc follow patterns of birth, growth, maintenance, decline and death. How many industries, organizations or technologies are you aware of that don't obey the standard product or organizational life cycle? Where is the VHS? Where are BBSes? Where is Woolworth's? Google is a corporation like the millions of other corporations on this planet. Like them, Google will eventually enter into a period of inevitable decline. Will this be soon? Will it be precipitous? It's likely impossible to tell. We may argue that there is some kind of thermo economic model where we can predict Google's entropy and probability of organizational stability at any given point in time, but that argument is highly specious without any empirical models to back it up.

In any case, it's not like Google burst onto the scene and as a result has some expected high value of volatility. They had a relatively long idling time and growth phase and are now likely either entering into a phase of maturity or continued growth. I don't think there is any evidence (thermo economic or otherwise) (yet) of any precipitous decline. Sure, Google's numbers sound impressive and possibly unstable with their millions of servers and billions of pages, but look at Walmart or Starbucks or McDonalds; they serve millions (if not billions) of people annually, have massive production and operations environments and are likely orders of magnitude larger than Google in terms of organizational complexity.

I also find it somewhat facetious that some assert that disruptive technologies may kill or save Google. Firstly, those technologies won't simply burst out on the scene and destroy Google or disrupt their business catastrophically (say within a year or two). In order for a technology or paradigm to be disruptive to that degree there are numerous conditions that must be met, not the least of which is Google losing their agility (I don't think that's happened yet). Additionally, we can't assume Google is sitting on their hands (not saying anyone is suggesting that), although their revenues don't show very much diversification. In fact revenues from "other sources" have barely budged beyond 1-3% of their total revenues in the last few years.

Also, lets be clear, there are lots of innovations out there that could threaten Google's business model or their advertising model in general. But most of those technologies or companies are in their seed stages AND more importantly, Google has the entire industry hamstrung (the industry cannot innovate beyond Google's capabilities). For instance, lets look at Adobe's Flex technology for a moment. Google's worst nightmare would be for that technology to become pervasive and ubiquitous overnight since it virtually eliminates their ability to crawl documents and create search indexes.

I'm not talking about compiled swfs with static content and the like. I'm talking about service driven RIA apps that have no "crawlable" structure. The content all lives in databases and distributed systems inaccessible to Google at the moment. However, no one is going to implement these technologies because they can't make money from them until Google says so. You can't effectively integrate adsense or banner ads in a RIA application right now. First of all, as you may or may not know, Google needs to be able to inspect your content for ad context. They can't do that in a RIA app. Secondly, the ads would need to be triggered by developer code (Google certainly doesn't want that). So where is RIA? It's at a standstill, relegated to widgets and proprietary apps. So lets make an assertion; technology will follow the money (it already has). If Google controls the money, they control the technology. No sensible business owner will bite the hand that feeds them.

However, I will agree Google is in a theoretically risky position since I agree there may be some logic behind suggesting that their reliance on advertising as their (essentially) sole source revenue is also a source of risk. While I also agree that display ads may be losing their efficacy in some iterations, that industry is constantly innovating and creating new ways to interrupt our conversations and content. It has simply become a game of quantity, not necessarily always quality. There are a lot of very profitable companies out there making a lot of money from display ads. As such there are a lot of consolidation or acquisition targets for Google (e.g. Demand Media, Federated Media, etc). On the other hand, Google could simply invent a technology to disrupt their business models and own the supply side.

The industry-wide problem isn't that people wouldn't have once paid for these free products. They certainly would have at one point. However, the advertising industry became a proxy for value and conditioned everyone to believe information and it's tools of sharing should be free as in gratis. It's tough to break that kind of conditioning overnight.

However, let's look at things in a slightly different way. Facebook was rumored to be heading for $500,000,000.00 in revenue for 2009, I have no idea if they actually made it there, but lets assume for a moment they did. With 400 million users that is an absolutely dismal $1.25/yr per capita income. No business should be proud of that. Now if Facebook converted over to a pay model, they only need a small fraction of their users to pay $5-10/month for an ad-free service (let's say around 8 million or 2%). Really, if you can't get 2% of your users to pay, you haven't got anything of value to them and have already failed.

Similarly, Google's $26 billion in revenues may seem significant, but when taken across their entire user base it's a small price that only a fraction of their users would have to bear.

I personally find the whole system rather convoluted, since as we're all aware, consumers are funding the "free" business model with the brand tax on their purchases (all of their product purchases). It's irrelevant if they use Google or not. If they buy one of Google's advertiser's products, they're supporting everyone else using Google.

Moreover, if we look at industry wide conversion rates on CPC advertising (say around 1-2%) it's fair to say that only one or two percent of users who actually convert from ad units are - in a very real sense - paying for the other 98% of users who do not click on ads to use Google. Whatever the average conversion rates are, I'm sure we can agree that the vast majority of ad impressions on the Internet DON'T convert into a sale. Saying online display advertising is "tapping into the supply side" is like saying tapping a straw into a dam is giving you access to all the water on the other side. Display advertising is a very poor solution to a very big problem. One day it will likely go away, but until then, whoever controls the vast majority of eyeballs also controls the revenues and technologies that emerge in that environment. Google has become endogenous, i.e. what emerges from Google affects the rest of us, not the other way around.

I've also heard arguments that converting over to a pay model will harm Google's innovation, but that's simply an unfounded argument built up around social proofs based on others who have failed to convert to pay. We don't know precisely *why* some companies failed their customers after converting to pay models. There are plenty of reasons companies fail miserably at otherwise rational pursuits. The real reason no one can succeed at pay right now is that there is very poor differentiation and innovation in the marketplace. That is to say there are lots of search engines, lots of free email providers and therefore lots of potential Google competitors. Additionally, whoever converts over to a pay model will (in theory) see the vast majority of their consumers migrate over to their competitor that offers a similar product for free (all other things being equal).

So, is there an advertising bubble? Perhaps. But the very real likelihood is that there is no bubble, and here's the most important reason why.

As we examine Internet based businesses (well most businesses in the world really) we see a Pareto distribution of wealth emerge. That is to say that the top 20% own 80% of the wealth. In my research, I see a distribution trend in many Internet niches closer to 5% owning 95% of the wealth. As such, even if display advertising enters into some sort of state of decline, we'll simply see the distribution of impressions industry wide shift deeper back into the head of the curve. Larger companies such as Google will own a larger percentage of the economy. Distribution will likely follow a traditional consolidation trend where the smaller players will either die off or be consolidated into acquisition targets.

Before anyone jumps on me with the long tail argument, let me just assert that long tail may certainly be effective in certain retail strategies (i.e. Amazon, Netflix, etc), but Pareto distribution will still emerge in the business environment. There will be only one Amazon, one Netflix, one Facebook etc at any given time until something disruptive comes along, at which time we may see an equalization trend in market share, but once the technology environment homogenizes we'll see a trend towards Pareto distribution again.

Now even if this industry were in a bubble state or in a state of decline, It is very unlikely that Google will be the first to die, nor very likely that there will be some catastrophic end to Google's dominance as a display advertising leader. In my estimate, Google also has a very enviable cash position and massive retained earnings. This is reflected in their relatively strong performance in the markets. Will this trend continue indefinitely? Perhaps not, but it's hard to find empirical evidence to suggest that Google's position is weakening significantly or that their risk exposure is beyond tolerable limits.