Bubble 2.0: Why Most Analysts Are Overestimating the Size of Google's Total Addressable Market for Internet Advertising

I am sick and tired of hearing analysts make wild projections about Google's growth prospects based on wild projections about the size of Google's total addressable market. I call it Bubble 2.0, while some call it Web 2.0.

The logic goes like this:

"The offline advertising market is $300 billion and only $30 billion of it is online. Therefore, we (a very respectable and highly paid investment bank) argue that if only 10% more of it went online, Google's addressable market would double and go to $60 billion. Therefore, the stock is worth mega $$$,$$$,$$$,$$$ (billions)."

I made up the $300 billion number for sake of argument. But this argument (from the very respectable investment bank) is fundamentally flawed for several reasons.

1) The investment bank has failed to segment the offline advertising market properly and market segmentation is crucial when it comes to projecting Google's ad revenues.

The offline advertising market is 80% brand advertising spend and 20% direct marketing spend. What is the difference between brand advertising and direct marketing and why does it matter for investors in Google?

The distinction is important because Google's customers are primarily direct marketers (which is the smaller peace of the pie) - they are the annoying people who in the offline world would send you junk mail and call you at dinner, and who in the online world get you to click on their ads on Google. Direct marketers spend money to sell you a product immediately. They care that when you click on their ad, you also make a purchase. More importantly, they care that the amount they spent to get you to click on their Google ad is less than their gross margin. They know exactly how much they are paying to get you to their website and they won't pay a nickel more - because they are highly price sensitive and they stop spending if they know they can't get you there for cheap. For instance, if an online shoe company knew that their gross margin were 15% and that their average order size is $100, then they know their gross margin per customer is $15. That means they will not spend more than $15 to acquire a customer on Google. (In marketing parlance, a $15 CPA is the max they can spend. If CPAs go out of control on Google or Yahoo or MSN, they kill the spend.) This might sound complex, but you just need to leave with one thought

2) Direct marketers are math geeks and direct marketers are very price sensitive to their customer acquisition costs and they make up the bulk of Google's Customers. They love Google.

Brand marketers (who form the larger piece of the advertising pie) on the other hand couldn't care less about cost acquisition costs because they are not there to sell you a product immediately. Examples include TV spots by Budweiser or sponorship advertising by Coca Cola. Brand marketers spend money for creating liking or familiarity with their product - Kraft, Pepsi, Coke. The ROI of brand marketing spend is very very difficult to quantify. In fact, it is nearly impossible to quantify how much money it costs to make you like Kraft Cheese or Coca Cola. If you can figure that out, you'll be the next Bill Gates. And that is why you don't see Kraft spending big bucks on Google. For instance, if you typed in a query for "Kraft Cheese" on Google, there is no Kraft ad because buying the Google keyword for Kraft Cheese will not enable them to make you like Kraft Cheese more. Type in "Coca-Cola" and you see an occasional ad by "Coca-Cola" - but the clicks are minimal because people don't go online to buy Coca Cola. If you are confused, just leave with one thought

3) Brand marketers are liberal arts majors who can't do math. Brand marketers don't know the meaning of customer acquisition costs and they don't care. They don't know what to do with Google.

So, why does the distinction between brand marketers and direct marketers matter so much for Google?

Google is a direct marketer's wet dream because customer acquisition costs can be calculated in real time. But it is a brand marketers nightmare because they don't know what to do with it or how to use it.

Google was popular and grew tremendously fast because it offered a "MORE EFFECTIVE" source of ad spending for direct marketers. Unfortunately, even though Google was an effective form of direct marketing 3 years ago, today, direct marketers are running for the hills. Google's golden days are over because spending ad dollars on Google keywords is no longer cost effective. Listen to the e-commerce conference calls from the big shops like Amazon, Overstock, and ProFlowers, and you will hear repeatedly that the biggest headwind to their growth in revenue is increasing CPAs (cost per acquisition for those who don't know advertising). This is alarming especially when CPAs are rising 10-20% per quarter for some of Google's largest customers. There is no golden goose or "MORE EFFECTIVE" ad spend - at least no longer on Google. I will grant you that initially it was "MORE EFFECTIVE" - but when everyone has figured out that buying Google keywords is cheap, the no-arbitrage condition is being proved correct again right in your face.

4) Google's biggest customers (direct marketers) are no longer finding it cost effective to spend on Google and its smallest customers (brand marketers) have no need for it

If we take $300 billion as the total size of the offline advertising market, then direct marketers will comprise $60 billion of it and brand marketers will comprise $240 billion. Brand marketers (who comprise 80% of the offline advertising market) have no use for Google and will never use Google. You ask why? I ask you this - Tell me how you would convert a searcher for Kraft cheese into a paying customer and I will rest my case. I typed in "kraft cheese" into Google and I saw no ads for Kraft. Know why? Because no body clicks and buys cheese online. Brand advertising is incredibly ineffective on Google. Only direct marketing works on Google. I will repeat again - Google is a direct marketer's wet dream and a brand marketer's nightmare.

5) $240 billion of the $300 billion opportunity will never go online

This means that the $300 billion market opportunity is actually a $60 billion opportunity and our young analyst at the venerable investment bank has made an order of magnitude rounding error in sizing up the market opportunity in front of Google. He (or she) has also nonchalantly forgetten to mention that not all of that $60 billion will go online and that the part that does go online will be split among the top 5 players - Yahoo, MSN, AOL, Interactive, Google.

After reading the rubbish published by the venerable investment bank, I respectfully called and encouraged our analyst in question to go back to the drawing board and correct the $240 billion mistake. By the way, the picture at the top of this post is not meant to be the likeness or name of the firm that made this multi-billion dollar rounding error. It is only meant to represent a venerable investment bank. I apologize that I am not particularly good with computers.

Mr Wave Theory