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This article was published Monday, July 6, 1998, in the San Jose Mercury News, and is republished here with permission.

Most companies launching a business on the Web for the past three years have had a simple strategy: Spend whatever you've got to make your site a market leader, and cling to that position until the number of visitors kicks up enough advertising and other revenues to generate a profit, probably by 1998.

Well, it's 1998, but nearly every business Web site is deep in the red. For many of the prominent sites, the more money they bring in, the more money they lose. Advertising rates are down for the industry, meaning profits will continue to prove elusive for at least several years.

And that's going to squeeze some sites so hard over the next year that they'll run out of financial resources. Many companies are likely to decide over the next 18 months that they can't afford to keep their cyberspace shops open.

Web sites today generally make money by selling advertising and by charging money to other Web sites for a high-profile link designed to funnel visitors to the paying site. Industry boosters point to the standard figure of nearly $1 billion in advertising revenue last year as evidence that the market is growing strong enough to actually show a return on the billions invested.

But several recent reports challenge that figure, suggesting that it's wildly inflated because it includes a vast amount of noncash barter arrangements. The true figure, some say, is closer to half a billion, or even $336 million, according to a study by Burst Media LLC of Burlington, Mass., which sells advertising on the Web.

In addition, since January the price of Web banner advertising has been steadily decreasing, which has translated into less cash for those selling advertising. Advertising rates, typically expressed as cost per thousand, or CPM, have plummeted on the Web.

"CPM's over the past six months have probably dropped at least $5, depending on the category," said Chris Charron, an analyst with Forrester Research Inc.

Taken together, those figures don't offer much comfort to Web site operators.

"What you're finding is advertising-driven content sites that have staked out interesting territory are looking for rich uncles," said Jeffrey L. Dearth, managing director of DeSilva & Phillips Media Investment Bankers in Boston. "There's no question that there are a lot of sites up right now that are sucking air."

Sites give up the ghost all the time, of course. In April, for example, BigBook, an interactive Yellow Pages directory that was once the model Web company, sold its directory site to GTE, after its incoming cash couldn't keep up with necessary expenses.

But what a lot of people are expecting is a large wave of such activity over the next year, as money to keep sites independent — or even alive — dries up.

While there is actually a little more advertising out there, the growth in advertising hasn't kept pace with the growth of the Web. Sites are constantly adding Web pages, but the number of ads available for those pages isn't keeping pace.

"For many of the sites we talk to, the inventory sold rate — the amount of available space they actually sell — has dropped from 40 percent to 30 percent," Charron said.

Too Much Inventory

One reason for those figures is simply too much inventory; it's a buyer's market. But there's another more ominous problem: The vast majority of advertising on the Web is for other Web-based products.

There are two basic reasons people advertise a Web site on the Web. One is to develop brand recognition, so that consumers think of your site first as the place to go for something. The other is to drive traffic to a site, usually to actually sell something.

"The typical Web content site will continue to be unprofitable for the next two years, and lose $2-million annually"

Unfortunately, people haven't been buying on the Net. Number crunchers generally give $2.5 billion as an estimate for retail Internet sales last year. That might sound like a lot of money, but retail sales topped $2 trillion; even low-tech catalog sales have approached $100 billion. And that's caused some people to pull back from Internet advertising.

"Many advertisers today are direct marketers that are only interested in results," Charron said. "Now they have results, and the results are lower than expected, and that's manifesting itself in lower CPM, which means lower profits for people relying on advertising."

Charron argued that the typical Web content site will continue to be unprofitable for the next two years, and lose $2 million annually. Some will simply walk away when confronted with such a distant horizon before seeing a return on their investment. But companies who can afford it — particularly traditional media companies — will be compelled to stay in the space and eat the losses simply because within five years the technology will change the way society deals with information, and they can't afford to be left behind.

Independent sites that have burned through a couple rounds of financing, each time promising their backers that the break-even point is just over the next hill, will find it a lot more difficult to sell that same song and keep the enterprise afloat.

"There will certainly be a shakeout for many content sites when they go for their third round," Charron said.

Some sites are reevaluating the market, calculating their chances of success, and thinking about merger and acquisition.

"I am seeing a lot of my clients talk about (merger and acquisition) activity," said Eric Goldman, a lawyer with Cooley Godward LLP in Palo Alto. "But I don't think we'll see consolidation in the market immediately. Very few of my clients want to get out now; they all think their valuation today would be too heavily discounted."

Goldman said there is plenty of money sloshing around the Internet, fueled largely by increasingly frantic attempts to build brand recognition. Traditionally, the way that starts is by paying a hefty fee for a prominent link to your site from another Web site where a consumer is likely to begin browsing the Web.

Premium Placements

These so-called "portal" sites — such as those run by Netscape Communications Corp. and Yahoo Inc. — don't just make money on banner advertising. They sell what's known as premium placement, a clickable link that's prominently displayed on their site and designed to drive traffic to your site, and lots of people think the portals have the best chance of getting profitable in a hurry.

But those premium placement deals are becoming staggeringly expensive for a medium hailed as the last best chance for one person to set a claim and get rich.

"At this point, it's becoming a seven-figure proposition to get premium position on a portal site," Goldman said. The idea is to make sure that when people buy books online, they think of one site, like Amazon.com. Yet some sites have begun questioning the value of such arrangements, over the long and the short term.

Pricey Keywords

For example, search engines such as Yahoo will sell "keywords" to advertisers. When a visitor types in a keyword during a search — like variants of "automobile" — an advertisement tagged to that topic will appear on the results page, at the top of the listings for Web pages containing the search terms. Ads are linked to the topic, and will say something like, "If you're looking for a new car, click here to check out the new Z3!"

Those keywords don't come cheap. Businesses can pay $10,000 to $25,000 a keyword. Some say that's insane, given the amount of sales you can expect from such ads.

"We were thinking of buying ten keywords, to, for instance, tell people that if they were looking to buy a Nirvana record, we'd sell it to them." said Kristin Lieb, executive director of Newbury Comics Interactive. "But the cost meant that was just not a viable method at all. I could never sell enough Nirvana to make that worth it."

"We're on the cusp of one of what is probably going to be the most significant new markets the world has ever seen. To expect the rules to be clear in the first few years of the market is unfair"

Lieb and others argue that up till now there has been a fundamental disconnection between what Web portals want to charge and what some companies are willing to pay, compared with the payoff. At some point, they warn, people just won't be able to pay those prices any more.

"The only companies that are following that strategy are companies that are more than willing to throw away other people's money," Lieb said.

But Goldman and others argue that, in the long term, sites will prove profitable, and that's what investors are betting on.

"We're on the cusp of one of what is probably going to be the most significant new markets the world has ever seen," he said. "To expect the rules to be clear in the first few years of the market is unfair. The point is that right now there are people who can afford to pay that kind of money, to make that investment, or depending on your perspective, that gamble."

John F. Shoch, a general partner with the Palo Alto firm of Asset Management, argues that there are people making money on the Internet. It's just not usually Web sites. "It's mostly the infrastructure guys: telephone companies, equipment vendors and Internet service providers."

As for the Internet in general, however, most analysts are waiting for a contraction. "We're waiting for a shakeout on a day-to-day basis," said Marc Johnson, with Jupiter Communications LLC in New York. "At the same time if the stock market keeps fueling them, this could go on for quite some time."

That's a big if, however. "Whatever is driving the valuations on Wall Street, it's certainly not tied to immediate, short-term or even mid-term revenues," Johnson said. "I can only guess that investors are betting on the really, really long term. But at Jupiter, we look at Wall Street and are mystified."



Dave Wilson recently returned to Washington DC, where he writes about technology policy for the San Jose Mercury News, the daily newspaper in Silicon Valley. He moved to California to cover the Internet for the paper last year, leaving the Chronicle of Higher Education, where he helped found the Information Technology section in 1991 and became a specialist on Internet security issues. He's spent most of his 16 years as a journalist in the nation's capital, including stints as a columnist with Congressional Quarterly and National Journal. You may contact him by e-mail at dwilson@sjmercury.com.