Disruption is not a sustainable business model

However, it didn’t take long before the rug was pulled out from under companies that were not creating real economic value or able to build a sustainable and profitable business. It feels a bit like groundhog day for the media and adtech sector, where the ‘jig is finally up’ and the state of the market suggests the day of reckoning is upon us.

'The jig is up'

The last five years in advertising has experienced utopian growth; all net-new time spent by audiences, particularly for digital and video. Time spent with video – including TV and digital video – has seen increases largely due to more devices coming on the market, multi-tasking, a voracious appetite for video, and platforms like Facebook shifting to a video-first model.

Subsequently, most media companies with an advertising business model have had to implement new technologies to chase that audience and ensure their video content is available on demand to audiences. Much of the innovation and technology required to capture this growth and monetize it (through advertising) has been funded by early stage investors, or venture capitalists, with new startups providing the technology to chase it.

The big white gorilla in the room however, is that all of this technology results in digital advertising being much more expensive to service and less profitable than traditional media.

Once venture capital’s appetite for ROI has been satiated, you start to see market rationalization. We’ve started to see the beginning of this in 2016.

If you look at the economics of media, once you make the investment of laying the cable, etc, then everything thereafter has marginal-incremental cost, and basically most of the additional revenue goes right to the bottom line – pure profit! Traditional media experiences a tipping point of true economies of scale eventually, but the economics of digital don’t work the same. The fact is, digital is a five-to-ten times more expensive business to service and each additional eyeball has a hard incremental cost to deliver.

The problem of the media industry going forward into 2017

On top of all this is the harsh reality that growth is coming to an end – research shows that in 2017 time spent with media will be flat – there is literally no more time people can spend consuming media. Even Facebook warned of a significant slowdown in revenue growth for 2017 in its latest earnings call.

It’s also wrought with not just cost of doing business, but also with shrinkage, through things like fraud (which absolutely blew up recently) and viewability. So from here on in, the business challenge is going to be different, and the only way we’re going to get to make the media business sustainable is through consolidation. If we look at recent industry developments players with major money to spend seem to agree.

The flaws in the adtech model?

If you look at adtech companies that have gone public and their business models they take a fee off the middle, or off the top if you will, but as mentioned the business problem for these guys is that the pot is fixed. The total amount of time spent with media is slowing, and these companies plus other early stage startups do not serve large media companies today, with a new set of problems, to maintain and retain sustainable growth.

This year has seen a number of reverse IPOs in the adtech sector – and if you believe what you hear many more are to come – the reason being that publicly traded companies have to show not just revenue gains, but profitable revenue gains. And many that have listed on Wall Street have struggled in some way to provide adequate enough profit margins for investors.

Look at what 2016 has shown us

Let’s take a look at some of the more recent deals. Prior to being acquired by Adobe, TubeMogul’s revenue streams were growing, but its profit margins were struggling, which is a difficult pill to swallow for shareholders of publicly traded companies. I suspect the challenge to turn profitable was a contributing factor as to why TubeMogul, only shortly after its IPO, sold to Adobe.

Then you also look at a company like Invidi that was founded 16 years ago, raised well over $100m, and when it finally got bought recently (industry gossip is that this was for around $600m) it seemed like a good exit.

Although in most other sectors, a 16-year runway and with that amount of investment would have resulted in a business that was self-sustaining and could have gone public or remained privately held with very profitable margins.

Neustar being taken over by private equity is also interesting, perhaps reinforcing the fact that the only way adtech and media will see businesses that are sustainable and can become profitable require consolidation.

If you look at Luma’s last business presentation, which shows that all the adtech companies that have gone public have declined in all of their trading multiples over the last couple of months, it reinforces that.

All of this leads me to conclude that early stage companies, and therefore early stage investors, will not fuel the innovation required to help large, publicly traded companies survive and ideally thrive during the current economic slow down we are seeing today; disruption and sustainable growth are different problem sets.

Who’s buying adtech and why?

The deal flow reinforces that, for example some of the larger mergers, like AT&T trying to buy Time Warner. What these deals show is that their long term profitability is challenged, so they’re looking to merge with complimentary profitable businesses that are looking to sustain their growth.

With TubeMogul, Adobe is moving into the value chain, and taking a stab at activation and actually owning inventory. Now it’s trying to build on a marketplace, we’ll definitely see more martech companies take an interest in tech going forward.

So ultimately, if you’re an Adobe, AT&T or Verizon Wireless, have a lot of money just sitting on your balance sheet and then spend a bit of it on an adtech company that results in a 100-to-200 basis points improvement in your profit margin, then you’re doing your job well. Once that extra profit margin goes into next year’s financial reports for the performance of your ad business, the value creation in the capital markets will dwarf the economics of start up investment and acquisition.

It’s all about risk management

If you look at all of this, it’s all about risk management, which also draws in concerns on issues such as fraud – take a look at the recent 'methbot crisis’ on top of reports on how a lot of the traffic from OTT [over-the-top services] is fraudulent – then we can’t really be confident the growth trajectory is going to continue, or we could even be facing an era of decline?

And with the acquirers, it’s not a case of an identity crisis over whether or not they are: media companies; distributors; or technology companies, etc, etc. It’s also about managing their business, and making it future-proof, as well as providing value back to the shareholders.

Those are just two worlds colliding, and that’s why you see the unique nature of the deal-flow with big companies coming in and starting to manage risk – it’s not just about growth any more. And now we’re starting to see this move more into the mainstream with the living room and TV starting to get disrupted. Just how big media companies are dealing with disruption over issues like ‘cord cutting’ is likely to be one of the big trends to look out for in 2017.