North of Boston, there's a town called Lynn that was once associated with an unfortunate tagline. As the saying went: "Lynn, Lynn: the city of sin. You never come out the way you went in."
The phrase comes to mind as I consider during this deepening recession a topic near and dear to me: online advertising. How the industry emerges from this slump has become a matter of fierce debate.
Gloomy Statistics for Online Ads
One interpretation of data from the online ad market points to doom and gloom. Warning signals have emerged since at least mid-2008, when a study by the Interactive Advertising Bureau and Bain & Co. indicated remnant inventory—the ad space Web sites are unable to sell directly and turn over to ad networks, often for resale at bulk rates—had increased to 30% of sold inventory in 2007 from a mere 5% in 2006. The upshot is that a lot of ads are getting sold for a lot less.
To understand why, consider the difference between direct ad sales and those that are sold through ad networks. Hint: It's a lot like the difference between retail and wholesale. Ad networks sell remnant space at about 60¢ to $1.10 per 1,000 times the page on which the ad appears is viewed, or what's known in industry circles as a cost-per-thousand (CPM) basis. Ads sold directly can fetch $10 to $20 on that same basis. Mind you, this price range was standard for the industry before the demise of Lehman Brothers and the ensuing financial market collapse.
Now, researchers and media blogs are abuzz with reports of more apocalyptic developments, with newer data to support their arguments. EMarketer has knocked down numbers for 2009 online ad growth to the single digits. So have many Wall Street analysts. Most alarming, pricing for remnant inventory fell to an average CPM of 26¢ in the fourth quarter, a penny below the third quarter, across the more than 5,000 sites that work with PubMatic, which consults with companies on ad placement. The fourth-quarter CPM rate was down 48% from a year earlier.
Rethinking the Problem
The Lynn Dictum would suggest that online advertising went into this recession one way (alive) and will come out another way (dead or dying). So maybe we should just call it a day.
But this conclusion overlooks another angle that is no less sobering, but a lot more encouraging. The change we're experiencing may be radical, but it bodes well for the medium. As many have argued throughout the history of advertising in general, it's high time we change how we evaluate and set prices so that they're based on effectiveness of an ad. For online advertising, that means relying less on the number of times the page containing the ad is viewed, and more on the ad's ability to elicit a response, or action, from the person viewing it.
Let's start by clearing up misconceptions about why online ad prices are dropping. It wasn't so long ago that high-priced management consultants were advising clients of an imminent shortage in online ad inventory, saying that before long there would be too few opportunities to place online ads! Turns out, they were flat-out wrong. The reason online display advertising is losing its pricing power is because there's too much of it, not too little.
According to comScore's (SCOR) 2008 Digital Year in Review, the number of display ads served to consumers in the U.S. last year was down slightly from the year before, but the total still came to 4.5 trillion. Pity the poor online user! That's 2,000 ads per person a month, or nearly a hundred ads per person every business day. No wonder we've learned to screen out standard display ad units (like banners) and despise the more aggressive ones (like pop-ups and pop-unders).
It's also no wonder that so few sites "sell out" their inventory of display ads. Indeed, analysts expect online ad sales to drop 30% to 80% in the first quarter.
CPC vs. CPM
Next, let's take a closer look at those PubMatic numbers. Not every site is seeing the same degree of downward pricing pressure. PubMatic is seeing the highest average CPMs at 61¢ on its smallest sites (those with fewer than 1 million page views a month), CPMs of 30¢ on its medium-size sites (1 million to 100 million page views), and CPMs of 17¢ on its largest sites (more than 100 million page views).
One way to interpret this pricing disparity is obvious: The smaller the site, the more targeted the audience. The more targeted the audience, the more relevant the ad message. And the more relevant the ad message, the greater probability of impact—as measured by user click-through in response to an ad message. You might argue that the higher CPMs for smaller sites are a proxy for a different kind of metric: one that tracks the probabilities of users taking action based on ad messaging.
Which brings us to the rationale for changing the way we look at setting prices for ads online. Some companies and ad networks sell advertising based on the number of times a person clicks on an ad, a so-called cost-per-click (CPC) basis, or on the number of times a person takes another action, such as making a purchase or filling out a form. This is known as a cost-per-action (CPA) basis. Turns out, sites that sell on a CPC or CPA basis are growing pricing power and overall revenue even as the online display ad market teeters on the precipice of a bottomless chasm.
Consider the case of the world's largest CPC player, Google (GOOG). That company recently surprised the Street with better-than-expected fourth-quarter numbers, and analysts now predict its core business, search advertising, will grow 15% in 2009.
In January, the overall CPC sector saw average prices of 37¢ per click-through for retail, 45¢ per click-through for automotive, 58cent; for travel, and $1.37 for financial services, according to researcher Efficient Frontier. Meanwhile, some estimates show Google's AdWords averaging CPC rates of more than $1.50.
Think: Direct Marketing
Bottom line: You might conclude we're measuring online advertising in a perverse way. Yes, the Web is effective for brand building, but in dwelling relentlessly on display advertising and CPM pricing, we're losing focus on the Internet's real power as a medium for direct marketing and eliciting a response.
And don't forget that a lot of people are seeing those CPC ads who are not clicking through, which means that marketers are building brand and message awareness essentially free of charge. In fact, they're paying only when online consumers take action—and, miraculously, moving them one step closer to actually buying something.
To understand the implications for pricing, try this thought experiment: If CPC advertisers pay only when consumers act, what's the cost-per-thousand on click-throughs? Grossed up, the CPC rates cited above establish a CPM-equivalent price range of $370 for retail to $1,500 for AdWords. Now that's pricing power!
Perhaps that's why reporter Abbey Klaassen of Advertising Age calls the "spray and pray" mentality of online advertising will soon be over.
Taking its place is something radically different. It's what we might call accountable media: advertising you pay for only when it works. What a concept, especially in an economy where pressure on marketing to generate measurable return on investment is greater than ever. That's how online advertising will come out of this recession in a different way than it came in—more robust and much improved.
Jeffrey F. Rayport is founder and chairman of Marketspace, a digital strategy and customer experience practice affiliated with Monitor Group. Rayport was previously a faculty member at Harvard Business School.