Could Internet advertising withstand a recession?

Fears of a recession seem to have blown away with the autumn leaves. Nevertheless, it's worth taking a look into what might happen to Internet advertising expenditures if the worst-case scenario of a recession were to occur.

A common concern among Internet investors is that, in a recession, Internet advertisers will reduce the amount of money they spend in the sector. Internet advertising is still in an experimental phase, the argument goes, and therefore it will be the first budget line-item to be eliminated when money gets tight. The counter arguments are that Internet advertising still constitutes only a tiny portion of overall advertising spending, so cutting it wouldn't be worth the bother; and that "developing" media tend to experience fewer ill effects from recessions than mature media.

Internet media stocks have benefited from almost uninterrupted good news since the dawn of Internet time, but it would seem that a recession might change that in a hurry. Internet advertising has plenty of well-known problems--its effectiveness is largely untested and unproved, it is expensive relative to other impression-based media, it is complex and subsequently hard to measure--and during recessions, companies tend to spend their precious money only on the things they absolutely have to fund.

Internet investors always have acted as though the Internet is the greatest thing to happen to advertisers since television. (With America Online now trading at three times what ABC/Capital Cities sold for a few years ago, the Internet is perhaps the greatest thing to happen to advertisers since advertising itself.) However given this optimism, and the valuations it has produced, the slightest blip in the forecast might crack the storm clouds and douse the parade.

With a recession appearing possible, therefore, it makes sense to determine what happens to overall advertising spending during a downturn, what happens to advertising spending in developing media--as opposed to mature media--during recessions, and what Internet advertisers think will happen to their spending if a recession occurs.

Effect of recessions on total advertising spending
Since 1950, total advertising spending typically has grown slightly more quickly than gross domestic product--between approximately 5 percent and 10 percent per year. This growth, however, clearly has been affected by recessions. During or shortly after recessionary periods (defined as any quarter-to-quarter flattening or decline in GDP), total advertising spending typically has flattened or declined, then resumed its growth the following year. If this were the only data point to consider, the outlook for recession-afflicted Internet companies (and Internet stocks) would be bleak. Fortunately, however, it isn't.

Effect of recessions on "new" media vs. mature media
"New" or "developing" media--those that still are growing more quickly than advertising expenditures as a whole--exhibit fewer recessionary effects than traditional media. More specifically, advertising spending on "new media" does not decline before, during, or after recessions, it simply grows less quickly than during normal years. This trend was clearly visible in the growth of television advertising during the recessions of the 1950s and 1960s, and in the growth of cable advertising during the 1990s. One explanation for this effect is obvious: during the development phase of any industry, there are two main revenue growth drivers: new buyers and increases in spending by existing buyers. Even if a recession curtailed the expansion of budgets at existing advertisers, therefore, it is likely that the addition of new ones would continue to expand the overall pie. In mature media markets, by contrast, one of these revenue drivers--the addition of new advertisers--is, for all intents and purposes, gone.

What the advertisers are saying
My conversations with a few Internet advertisers confirmed the theory that Internet advertising spending likely will continue to grow during a recession, although perhaps at a slower rate than during more flush times. One of these advertisers summed up a sentiment I have heard repeated by others: "This is a critical area for us, so our spending will continue to grow. We will be more careful, however. We will hold more feet to the fire."

So what does this mean for the Internet companies--and, more importantly, for their stocks? Because Internet stocks are valued on performance projections that are, in many cases, extremely optimistic, investors presumably would not need to fear a "reduction" in Internet advertising spending to begin bailing out of them--a mere slowdown in the growth of spending likely would suffice.

In my opinion, however, Internet advertising spending is growing so rapidly that a slowdown might be barely perceptible, or at least might be hard to attribute to a "recession." If the "normal" or non-recessionary growth between 1998 and 1999 were to be 100 percent, for example, recessionary growth might be 70 percent. Since no one knows for certain that the non-recessionary growth will be 100 percent, however, I believe that 70 percent growth still will look pretty good, especially when, as is suggested by the analysis of total advertising spending, other media might experience year-over-year declines in spending.

Although Internet stocks clearly would get hammered along with the rest of the market if a recession looked imminent (as it did a month ago), I think the battering would be the result of investor panic rather than a poor outlook for industry growth. Valuations in the industry are staggeringly high, and it usually only takes a hint of bad news--or even a hint that there might be bad news--to knock them down. I believe, however, that the stronger Internet stocks would recover faster than the rest of the market, as they did last month, because once they realized the Internet wasn't "over," investors likely would be willing to pay up for growth (as they always have been with these stocks), instead of poking around looking for "value" in the stocks of more mature companies whose revenue might be flat year-over-year.

If a recession were to adversely impact any companies or stocks in the Internet sector, I believe it would disproportionately hurt the smaller ones--the companies that are fighting to grow as fast as the market overall. The advertiser's comment that his company might be "holding more feet to the fire" suggests that it might end up consolidating suppliers, meaning that the lower-quality companies would suffer more than the higher quality ones.