Q: How do you approach researching the Internet companies? What aspects of the Internet do you focus on?

A: My coverage area is called Internet media, which means that I follow companies which generate the majority of their revenues through advertising. They typically resemble the traditional media companies, but their business is done online and some are mere content aggregators rather than original content producers/ developers.

This universe doesn’t include companies like eBay or Amazon, for example, because the majority of their revenue comes from commerce. But it includes companies like Yahoo!, which also has an e-commerce element in its business model, but still relies mostly on advertising to generate revenue. A typical example of an Internet media company is Google because it generates 99% of its revenues through advertising. Until it starts to diversify its income stream, it remains an Internet media company, and probably one of the easiest to define.

Q: How large is the universe that you follow? How many Internet media companies fall in it?

A: The total is probably 30 companies and the number seems to be shrinking because of the recent acquisitions. For example, in the advertising and marketing services space both aQuantive and 24/7 Real Media are being acquired. aQuantive was just acquired by Microsoft and 24/7 Real Media was acquired by WPP Group in December.

Q: What are the main differences between the Internet and the traditional media companies in your view? Would you highlight some of the major trends in the Internet media space?

A: A major differentiator of Internet media companies is that advertising can be measured all the way from click to conversion of the actual sale. That can be done through a few simple analytic software tools. So, the popularity of Internet media is largely due to the fact that it is easy to measure a marketers’ ROI, which makes it easier to justify an advertising budget and marketing spend. Some, such as search, advertising online is priced on a cost-click basis, so you only pay for the people who click on your ad and visit your site.

The recent trends in the video advertising space are driven primarily by consumers’ adoption of broadband. Since almost 50% of the U.S. households already have broadband at home, new formats of advertising are becoming possible. That trend is opening up new opportunities for brand advertisers to come online as they can utilize sound and video to develop TV-like ads that accomplish similar marketing objectives, such as brand building and awareness.

Overall, we see more consumers spending more time online and attracting advertisers. In addition, broadband is enabling advertisers to expand the formats that they sponsor. Growth is also fueled by the fact that in today’s marketing environment marketers are held more accountable for return on their advertising activities. Additionally, analytics and metrics help marketers justify their spending.

Another trend that we see is the creation of advertising networks. Companies like Google, Yahoo!, AOL, ValueClick, and Advertising. com have all created publisher networks. A publisher can be part of a network and leverage it as an additional ads sales force. Such networks are also very usefully for small publishers like bloggers, who don’t have their own in-house sales force.

So we have to keep in mind that there may be a lot of money going towards Google, Yahoo!, and MSN, but a percentage of that revenue is shared with the publisher partners. The revenue is split with the publisher who used Google to populate the text box on its site. If the user clicks on that text box, then Google shares the revenue committed by the advertiser with the publisher.

I would say that there are many similarities between television, especially cable, and companies like Monster.com, TheKnot. com and Bankrate.com which are very specific in terms of content. I call those companies vertical content providers because advertisers can go to Monster.com with very specific demographic target to reach. Vertical content providers are getting more popular as they resemble the outdoor channel, the sports channel, or the music channel in the cable world. At the same time, Yahoo!, Google, and MSN resemble the broadcast networks like ABC and NBC—you could almost say that the publishers within their network are similar to affiliate stations.

Q: Google and Yahoo! seem to hold very high gross margins in those networks, somewhere in the range of 65% to 70%. Is that typical in the sector?

A: Yes. The majority of the revenue is still going to them, but the market is getting more and more competitive. Yahoo! used to outsource its paid-search advertising to a company called Overture, as did Microsoft. Overture was the company that actually developed this business model. But, when Google came to the marketplace, it did not outsource this function and instead offered a more competitive revenue share agreement than Overture’s. That’s how they attracted many of the publishers to the Google network.

Effectively, Yahoo! and MSN were behind in developing their own sponsored search business. Now that revenue split has become more competitive and has shifted in the publishers favor.

Q: How fast is the Internet media market growing and is it already a real competitor to offline media?

A: The total marketing and advertising budgets are not growing that fast. The growth is less than 5% annually. At the same time, we forecast Internet advertising to grow at an average of 28%, so the share of Internet advertising in the total market is increasing. I don’t believe Internet is stealing a dramatic portion of share from television yet, because there is still limited supply of TV-like content and subsequent advertising online. That’s partially due to the fact that about 42% of the households have broadband access and not all of them are using it to watch videos online—and the professional video content providers are not yet distributing content online to the extent that they are broadcasting on television. At the same time, TV penetration is as high as 98%.

Internet media is increasing its reach, but reach from video advertising is still limited. The content providers have yet to figure out their Internet distribution strategy and related business models. As such, there are still many issues to overcome but, nevertheless, Internet media advertising is growing six times faster than the traditional media. Right now the Internet media represents less than 10% of the total market, or $22 billion from a total marketplace of almost $290 billion. The companies that I cover average a 20% revenue growth rate annually.

Q: What specific challenges do you see for the companies in this industry, especially for the most popular ones like Yahoo! and Google?

A: So far the shift from offline to online media refers mainly to the transition from print and yellow pages to online classifieds. In other words, the transition is mostly local and hasn’t affected the large TV campaigns. So while this shift is occurring, it is much stronger in the local and direct response type of media than in the brand-based and TV media.