Date created: 12/4/07
Last modified:12/4/07
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John Quiggin

Open slather on the net

Australian Financial Review

27 October 2005

The news that the share market valuation of search engine Google has topped $100 billion brings back memories of 1999, when speculative mania pushed the NASDAQ share index past 5000. Admittedly, we are nowhere near the absurdities of the dotcom era, when companies with neither earnings nor revenues could be valued at billions of dollars, and investors seriously entertained business plans based on absurdities like home-delivered petfood.

Nevertheless, there’s plenty of optimism in the market. Google’s current market valuation is around 40 times annual earnings. That would make sense if investors believed that Google was going to wipe out its competitors in its core market, for search and internet advertising. But Google’s main rival, Yahoo, commands a similar multiple, and Microsoft is also doing well, at least in part on the strength of its MSN business.

Just to match the return on government bonds, Google and its competitors need to double their earnings, then sustain them at high levels. Despite some impressive growth in recent years, that’s not as easy as it might sound.

The only significant revenue stream from which growth can be expected is advertising. Although Internet advertising has recovered from the slump that followed the dotcom crash, the potential for growth is limited. Most people in developed countries, and nearly all of those who are attractive demographic targets for advertising, are already online. So growth relies on getting more advertising to the same market.

An even bigger challenge will be sustaining profits over the period needed to justify high valuations. The Internet is changing all the time, and no single model can be sustained for long. In particular, the phenomenal growth of primarily noncommercial productions like blogs and wikis is transforming the landscape.

Blogs (or weblogs) have come from nowhere five years to play a significant and growing role in the media landscape. Many accept advertising, but their large numbers (around 20 million at last count) make them tricky to handle. Already a large proportion of new blogs are ‘splogs’, spam blogs designed specifically to manipulate Google’s pageranking algorithms and attract advertising dollars.

An even bigger challenge is Wikipedia, the collaborative online encyclopedia.Wikipedia is increasingly becoming the first port of call for the kind of general query that Google made its name by answering better than its predecessors. If you want to know, say, when Alexander Downer was first elected to Parliament, Wikipedia will give an accurate answer. Google points to Wikipedia first, then gives dozens of mostly useless links. Since Wikipedia is resolutely noncommercial, there is no prospect of advertising dollars here.

The main response from Google and its competitors is to to offer a bundle of services so compelling that, they hope, users will freely provide large quantities of information, thereby enabling the provision of precisely targeted advertising. To this end, the major players are engaged in a complicated minuet, seeking to buy or sell strategic assets like internet messaging and telephony services, social software and so on.

But this general strategy has been tried before, and failed. The superstar of the dotcom boom was America Online, with its ‘walled garden’ strategy aimed at keeping its millions of users focused on AOL sites. The peak of the boom was reached in the merger between AOL and Time Warner, which valued the company at around $150 billion. But with the arrival of broadband, users began drifting away. AOL is now a mere bargaining chip in the negotiations between the big players, likely to sell for around $10 billion.

The Internet has made a huge difference to our daily lives, and has been a major contributor to productivity growth over the past decade. But sustainable profits from Internet ventures have proved elusive.

The fundamental problem is encapsulated in the slogan of the first-wave Internet ‘information wants to be free’. That is, given that information can be shared without any loss, networks based on free distribution are likely to outcompete those that put barriers in the way of access, even the requirement to read an advertisement.

In the Internet of the late 1990s, the claim that information was naturally free was only a half-truth. Once created, information is a public good, but the creation of information (or ‘content’) had to paid for. The explosion of blogs and wikis has shown, however, that many people are willing to provide information (some useful, some not) free of charge. Google and its competitors must adapt to the new reality or die.

John Quiggin is an Australian Research Council Federation Fellow in Economics and Political Science at the University of Queensland.

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