Portal addiction

Faced with rising competition, plummeting market values and depleted cash reserves, online businesses are being forced to re-evaluate the wisdom of their megadeals with high-traffic portal sites.

7 min read

Can cash-strapped merchants survive without links?

By Sandeep Junnarkar
Staff Writer, CNET News.com
May 3, 2000, 4:00 a.m. PT

To many online merchants, the idea seemed irresistibly simple: More traffic means more money, so it made perfect sense to get the most exposure possible on the largest Web portals, regardless of cost.

There's just one problem with that strategy: It works only if businesses have an endless supply of money to pay for such deals. And many of those merchants--as well as the portals they have been paying--have awakened to this unforgiving reality in recent months.

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Faced with rising competition, plummeting market values and depleted cash reserves, online businesses are being forced to reassess their multimillion-dollar payments for advertising, linking arrangements and other valuable placements on high-traffic portal sites. The portals, in turn, are grappling with the prospect of losing sizable revenues as these deals collapse in a kind of digital domino effect.

Herein lie the dangers of traffic addiction.

"Now, these deals look incredibly irresponsible or shortsighted," said one executive at an online content and commerce firm that has had deals with America Online, Lycos, Snap and other portals. "You wonder how sane, rational business people justified them, but you have to ascribe that to the market mania at the time that rewarded people for doing that."

The plight has become increasingly common for many Internet firms, which are lowering their sights with less expensive deals. In response, the portals are publicly playing down the significance of this shift but are rapidly looking for new revenues and advertisers whose livelihoods do not rely on the fragile Internet economy.

But codependent addictions can be difficult to break. Lycos has marketing alliances with CDNow, AutoConnect, iVillage and ChipShot.com. Yahoo has deals with CDNow, Autoweb and many others. On Monday, AOL cut a deal with Homestore.com hoping to bring in more than $200 million over five years, including equity and $20 million in cash--although the retailer is trading well below its all-time high.

During its conference call with analysts last month, AOL said it had $2.7 billion in advertising backlog for its first quarter, up from $330 million in the previous quarter. The online giant has deals with Musicmaker.com, 1-800-Flowers.com, PlanetRx.com and a slew of others.

"We saw some bad deals signed, deals that didn't make any economic sense," said Darren Chervitz, senior analyst at the Jacob Internet Fund. "These deals have come back to bite some of these companies."

AOL has some prominent teeth marks of its own from a widely publicized deal with Drkoop.com, the consumer health site co-founded by former surgeon general C. Everett Koop that was initially a poster child of successful portal marketing. Drkoop agreed to pay $89 million over four years to be an anchor tenant on AOL, and its stock jumped even before the deal was made public.

Last week, after seeing its stock slide into the low single-digits for months, the company announced it had restructured deals with AOL and Disney's Go.com, saying it didn't have the cash to make good on the agreements because its revenues were far lower than expected. Drkoop.com said it was "clearly disappointed" with its own ad programs, adding that expenses were "higher than forecasted."

Drkoop in effect held both portals hostage, forcing the two companies Merchants pay the price for portals to take a stake in the battered online health site in a desperate attempt to salvage something from the deal. AOL took a 10 percent investment in Drkoop, and Go.com will get an undisclosed amount of cash and rights to purchase shares in the company--part of what Drkoop.com called "the first steps in reassuring our shareholders that we are addressing our cash issue."

Although AOL has a portfolio that includes stakes of anywhere from 5 percent to 40 percent of various Internet companies, this may be the first time the company was forced to make a major investment.

"AOL has traditionally picked and chosen its investments," said Youssef Squali, an analyst at investment bank ING Barings. "I wonder if this new trend will push AOL and other portals to own something they would not have chosen otherwise."

Several online health firms that trooped through the offices at Jacob Internet Fund seeking investments said they placed rival bids for placement on AOL just to drive the prices higher for Drkoop, Chervitz said. "That is the kind of craziness we were seeing last year," he said.

Red flags not always obvious
Yet analysts readily acknowledge that red flags aren't always so obvious in the heat of competition. The environment at the time the deals were signed made it imperative for content firms and merchants to pay big bucks to the major portals. Such alliances helped generate the kind of buzz needed to establish a strong brand identity or to provide the necessary momentum going into an initial public offering.

Now, some online firms have bucked the trend of spending big bucks to plaster their names across the major portals, questioning whether the scarce money is well-spent.

"Three or four months ago, we were being viewed as too staid because we These deals have come back to bite some of these companies. were not going after the megadeals," said Keith Phillips, vice president of customer acquisition at online insurance firm Esurance. "A start-up spends a fair amount on marketing costs, so if you don't show substance in those returns, it's hard to make up for it elsewhere in your business equation."

The privately owned company has avoided short-term marketing pops from advertising on the portals. Instead, Esurance is seeking to build its infrastructure while branding itself at targeted sites where insurance is not necessarily central but still necessary, such as auto retailers.

This evolving caution is a vast departure from the recent past, when private investors pushed for higher marketing budgets, hoping for an explosive IPO.

"A lot of people who funded these irresponsible deals still made a fabulous amount of money on them by virtue of the fact that they had these run-ups," said one online executive. "Those same VCs are now not there to see Drkoop at $2 per share and CDNow hanging on to a thread of viability."

Last month, ING Barings sent an internal note to its brokers warning about the potential for some companies to take a hit, as many of their high-flying partners eventually burn through their cash and face insurmountable odds in raising more capital, Squali said. Taking deadbeat companies to court may serve only to sap funding further.

End to astronomical amounts
Analysts across the board agreed that portals will no longer see the kind of astronomical deals made last year.

"We actually don't have any deals that are in the original terms," said one executive at an online firm whose stock has been battered in recent months. "We did not do anywhere near as badly as some of the folks that way overspent. But now, sitting here in year 2000, there are some things I would not go back and redo from 1998 when we made those deals."

Because of its size, attention is often focused on AOL as a barometer of AOL's squeeze play this trend. The online giant had revenues of $1.8 billion for the quarter, with $557 million, or 30 percent of the revenues, coming from advertising and commerce. Analysts have expressed concerns about AOL's exploding $2.7 billion in advertising backlog, though the company confidently describes this as "almost-guaranteed revenue."

"We have already taken all steps necessary to ensure that we have no financial risk, and we feel very comfortable with our advertising and commerce deals and our backlog," AOL spokeswoman Wendy Goldberg said, echoing AOL chief financial officer J. Michael Kelly's comments during a conference call with analysts last month.

Analysts said AOL is the best-positioned company to ride out the bumps if advertising revenue does fall, largely because it derives nearly 70 percent of its revenues from its Internet service provider subscribers. In addition, the online leader is trying to put less emphasis on its poorer Internet cousins and to focus instead on potential partners and advertisers offline.

Just today, AOL formed an alliance with Coca-Cola--perhaps the most recognized brand in the world--to develop online and offline marketing programs. The agreement follows a similar partnership between Yahoo and PepsiCo last month. But deals with non-Internet companies are still more the exception than the rule.

To counter concerns about reliance on advertising from Net companies, Yahoo Dot-commercials stresses that its income is derived from varied sources. In its quarterly report filed with the Securities and Exchange Commission last month, the portal noted that it had about 3,565 advertisers, with no single company accounting for more than 10 percent of its net revenues. Yahoo had net revenues of $228.4 million for the first quarter, of which $207.1 million came from advertising.

"Yahoo always likes to promote the fact that their advertisers are not just dot-com companies," said Patrick Keane, an advertising analyst at Jupiter Communications. "They tout those figures to support the fact that they are a business that will be stable regardless of the stability or lack of stability of Internet or tech companies."

The second-tier portals, such as AltaVista, Go.com and NBCi, are likely to suffer the most, given their dependence on Internet advertisers. And that presents a classic catch-22 for all involved.

Although struggling merchants and content firms have little choice but to turn to the second-tier portals, analysts say they must also target the top sites for necessary traffic to stay afloat. The portals, meanwhile, continue to rely on revenues from Internet firms, as mainstream consumer companies have remained reluctant to advertise in large numbers online.

"The game has changed, and it has changed quickly," Chervitz said. "It is a painful lesson for both investors and companies."  

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