Putting valuations on Internet companies has an otherworldly quality these days: It's a time when losing money can be a badge of success for a company, while making money can be a sign of a lack of imagination. But most Net folks--and non-Net folks--agree that gaining market share is crucial. That's because once a Web surfer forms an attachment to a site, luring him or her away to a competitive site can often be very difficult.
While hundreds of Internet companies are using a variety of ploys to become the market leader, heavy spending on marketing seems to be the real key to achieving dominance. For most companies, marketing costs are by far a company's largest single expense, often representing the difference between generating a profit or a loss.
But simply shelling out lots of marketing bucks isn't the whole story. A Net company has to spend those dollars efficiently. Most Internet companies are investing heavily to fund marketing programs. But are they really creating a brand that customers will repeatedly turn to?
And are these cybercompanies creating a strong enough business to be gradually able to decrease marginal marketing costs while boosting revenues? Furthermore, what if one day some companies lose access to the capital markets? At that point, marketing efficiencies will become even more critical.
To examine how effective these companies are in generating revenues from marketing expenditures, BUSINESS WEEK selected a sample of 15 public companies, which derive virtually all of their revenues from the Internet. After consulting several Internet analysts, we created a simple model: A company's 1997 and 1998 revenues were divided by marketing outlays. The resulting ratio shows how many dollars of revenue are being generated for each marketing dollar spent.
Return on marketing varied widely (table). America Online Inc. generated close to $7 in revenues for every marketing dollar it spent in 1998, up almost 75% from the previous year. iVillage Inc., however, created only 53 cents in revenue for every dollar spent, a decline of 23% from the previous year.
In the BUSINESS WEEK table, it's interesting to note how competitors stack up. For instance, Onsale Inc., an auction site (and the most efficient company, according to our table), got more than $8 in revenues for each marketing dollar it spent, compared with eBay Inc.'s $2.39. The portal Excite gets $2.47 of revenue per marketing dollar compared with $1.60 for Lycos.
Companies that are just starting to build their franchise usually have low revenue returns. But any mature company that gets less than a $1 of revenue per $1 of marketing spent for several years straight should be concerned. "Ultimately, it's a losing proposition if you can't create revenues that are multiples of your marketing dollars spent," says Doug Sundheim, head of business development at Interactive8, an Internet advertising agency in New York City.
What's an example of a strategy that didn't turn out to be efficient? Sundheim cites an online mortgage broker that advertised its services on Web sites geared exclusively to home-financing topics. But eventually, the broker realized that such expensive advertising was far less effective than advertising on Web sites that catered to a much broader population.
The BUSINESS WEEK table, to be sure, is only a rudimentry snapshot of a rapidly moving target. But Abe Mastbaum, chief financial officer at American Securities lp, a New York money-management firm, says: "This index could be a good way to predict who the future winners are going to be, based on their ability to grow revenues as a function of their marketing effort."
DEEPER POCKETS. For many companies, marketing efficiency seems to be declining. "There are a lot of Internet companies out there that are finding they have to spend more and more money to generate an additional dollar of sales," says Steven Shapiro, president of Intrepid Capital Management, a technology-focused hedge fund in New York. "Unless those trends reverse...this may be a strong indication that these are not good businesses and over time won't be good investments either."
Not everyone is a fan of this sort of marketing return model. Gary F. Bengier, chief financial officer of eBay, says that nailing down marketing returns is a difficult task at best. He says that BUSINESS WEEK should have used quarterly revenues instead of annual ones in its table. And instead of comparing revenues to marketing costs he would have preferred to compare revenues with the number of new users who signed up in the quarter. "It's users who drive revenues," says Bengier.
Perhaps. But our analysts are arguing that eyeballs don't necessarily translate into dollars. And while many Internet experts claim that marketing efforts materialize into revenues the following quarter, using annual data gives Internet companies the benefit of the doubt.
Creating successful marketing programs to lure targets to Web sites could get a lot harder. "Many [Internet companies] got the easy ones early.... I expect that, for many people, the last customer is more expensive," says Harvard business school Professor Howard H. Stevenson. Sundheim agrees. "Amazon.com and Yahoo! got a tremendous amount of free publicity from Day One just because they were among the first Internet brand names. It's tough to even put a dollar amount on what it would take to build those brands today."
Marketing efficiencies will become even more important as Internet growth begins to slow. According to Merrill Lynch & Co. Internet analyst Henry M. Blodget, even while the Internet world is still growing at the speed of sound, "we are beginning to see a shift. The early hyper-growth of companies such as Amazon and Yahoo! is settling into a steadier growth phase....As the market becomes more competitive and dominated by a few companies, weaker players are getting decreasing returns on marketing."
The table confirms this development. On average, revenue returns for every marketing dollar spent declined from $3.37 in 1997 to $2.70 in 1998, a 20% drop.
While our revenue/marketing expense model tells a lot about the propects of Net companies, eventually these businesses will have to be judged on their ability to produce profits. "Any company that has a high price-earnings ratio must ultimately justify it in terms of its prospective franchise," says Martin L. Leibowitz, chief investment officer at Teachers Insurance & Annuity Assn./College Retirement Equities Fund (tiaa-cref) in New York, and author of Franchise Value and the Price-Earnings Ratio.
That means the world will right itself: The badge of success will be making money and losing money will mean just plain failure.