SAN FRANCISCO (The Red Herring) - There is no better embodiment of the lofty expectations many have of the Internet than Yahoo!.
Since the company's initial public offering in April 1996, its stock price has climbed by almost 600 percent. And recently, the company (YHOO) was valued at over $5 billion, far more than its direct competitors Excite (XCIT), Infoseek (SEEK), and Lycos (LCOS).
Those who defend Yahoo!'s valuation believe that the Internet will become the dominant mass medium, and Yahoo!, with its powerful brand and strong traffic (its sites receive an astounding 95 million page views per day, triple Excite's rate), will be a principal beneficiary. But traffic is one thing, and revenues are another. Projecting only $147 million in revenues for 1998, Yahoo! has a long way to go to justify its lofty valuation.
Yahoo!'s valuation has given it little choice but to expand its product line. More than a "portal" (the term analysts employ to describe Yahoo! and its rivals, which are most users' gateway to the rest of the Internet), Yahoo! is looking increasingly like an online service--like America Online (AOL) or even CompuServe before the Web. The company is starting to act like an online service, too: it has grown increasingly aggressive with its customers and partners. Yahoo! is becoming a kingmaker, determining which companies are successful and which are not.
Although some analysts suggest that the diffuse nature of the Web will prevent Yahoo! or anyone else from dominating it, many entrepreneurs are feeling the impact of the company's broad, and occasionally stifling, influence. Yahoo! has come a long way from the days when it was just a hobby distracting two graduate students from writing their doctoral dissertations: it is changing the very medium that brought it to power--and must continue to do so to maintain its dominant position.
Jerry Yang, who cofounded Yahoo! with David Filo, readily admits that the company has not yet earned its valuation.
"We devoted the first two years of our life to creating user awareness; the most important thing was growth of new users," he says. "But we've shifted our focus to building relationships with users once we get them."
In addition to its well-respected Internet directory, Yahoo! has piled on new offerings over the past year. Like an online service, the company now provides personalized news, classified ads, online stores, chat rooms, message boards, and email. Although the other portals (which, in addition to Excite, Infoseek, and Lycos, include AltaVista, AOL, the Microsoft Network, Netscape's NetCenter, and c|net and NBC's Snap) all have versions of this strategy, none of the Web-based contenders has been as successful as Yahoo!. Roughly 12 million people have their email and passwords housed in Yahoo!'s databases, a number equal to that of AOL and far greater than those of the other portals.
But a strong relationship with users isn't in itself a business, Yang acknowledges: "The question is, How do we turn 12 million registrations into revenues and earnings? I'm not sure we have the answer yet. So far we've turned awareness into modest revenues, compared with those of most major media companies."
Banner advertising is, of course, the major source of Yahoo!'s revenues. But apart from banner ads, many Internet content and commerce companies fuel their businesses through distribution deals. Although the structures of these deals vary, they usually pair a site that has traffic and needs content (a distributor like Yahoo!) with one that needs traffic but has content or goods to sell (a publisher like ESPN or an online retailer like Amazon.com). The latter often deliver content to the distributors' sites, with the distributor typically taking 40 percent of advertising revenues from the pages on its site or a cut of the transaction revenues. Of 51 content sites surveyed by Forrester Research, 31 percent of traffic came from partnerships with distributors, rather than from the Internet at large.
Yahoo! strikes shrewd deals, often forcing competing content sites to bid for exclusive rights to certain pages. For example, only Autoweb.com and Microsoft's CarPoint have buttons on top of the Yahoo! Autos pages. As Jim Bair, research director at the Gartner Group, explains: "Yahoo! will be as aggressive on pricing as they can, because their capitalization requires it. If they don't take advantage of the business opportunity now, it may go away."
With the emergence of the portals, the smaller Web-based content and commerce companies racing to build market share now have little choice but to rely on behemoths like Yahoo! to increase their traffic -- if they can afford to. As Skip Franklin, CEO and founder of the Zone Network, which publishes a Web site for outdoor enthusiasts, says, "With the big guys bidding against each other, Yahoo! gets big checks, and many of the small guys can't compete. Starting my company today would cost three times as much."
Geoff Yang, the venture capitalist behind Excite, is more direct: "The 'Field of Dreams' Internet--where the assumption was 'If you build it, they will come'--is no longer a reality. Content sites can no longer grow organically, and I give only six more months for most new electronic commerce sites."
Knock, knock...Yahoo!'s there?
The growing dependence of content and commerce companies upon Yahoo! gives the company great influence. "These portals can make or break companies, because they own the people flow," says John Funk, founder and chairman of InfoBeat, an email news publisher.
However, although Yahoo! is compelled to "push the envelope," as Jerry Yang says, the market can be squeezed just so much. How many companies have the money to be crowned by Yahoo!? Funk guesses that "only 50 to 100 companies have broad enough appeal and are willing to put up enough money to do business with the portal sites."
Moreover, Forrester Research analyst Chris Charron suggests that Yahoo!'s ability to aggregate traffic is limited, which in turn limits Yahoo!'s potential revenues from online advertising. Yahoo! sells only 14 percent of its available banner impressions, and, with the number of Web users projected to skyrocket within the next few years, there would seem to be room to grow. But Charron points out that the portals already receive a disproportionate amount of Web advertising: although they command only 15 percent of Internet traffic, they receive 59 percent of Internet advertising dollars. Size matters, Charron argues, and advertisers will pay more to reach many eyes on one site than they will to reach the same number across 20 sites. But the portals' "reach premium" (the percent by which the share of the advertising pie exceeds the share of the audience) of 293 percent is wildly inconsistent with the equivalent in other media (25 percent for television and 22 percent for magazines) and will fall to 50 percent by 2002, Charron estimates. He believes Web advertisers will eventually pay to reach the large number of users they can't get at through the portal sites.
Traffic share and share alike
Charron further notes that although AOL and Yahoo! have increased their share of the traffic that goes through the nine major portals (the two companies' combined total grew from one-third in October 1996 to one-half this January), the percentage of total Internet traffic commanded by all nine portals has remained flat at 15 percent since October 1996 (see chart, below). Although Charron expects this figure to increase, he estimates that, as the Internet expands and changes, it will top out at 20 percent: "Despite claims to the contrary, the portal sites are growing no faster than the Internet. With a diverse audience and no switching costs, it will be difficult to build a site that serves everyone." (For a comparison of technology businesses like Yahoo! with those that can impose high switching costs, see "Gorillas or Kings?") He calculates that the portals' share of the estimated $8 billion in online advertising will fall to 30 percent by 2002. That leaves an unappealing $2.4 billion to be split among the nine existing portal sites, each of which has a hefty valuation to support. A shakeout is coming.
Assuming that Yahoo! prevails--and Charron expects that, given its leadership position, it will--the company may face a more insidious challenge. As Yahoo!'s influence over the Internet grows, there is a risk that the once fluid, organic environment of the Net may ossify. According to one entrepreneur who recently closed a deal with Yahoo! and asked to remain anonymous, "By merit of having a deal with Yahoo!, you can finance your company, but it's very difficult for entrepreneurs to eke out a viable return on investment. With all the leverage in the portals' camp, our ability to negotiate is limited. They risk creating a backlash."
Ready for the next wave
That backlash may come in the form of content and commerce companies looking to other forms of distribution. "Some people argue that the Internet got started in part because AOL played this distribution game," Funk explains. "By comparison, the Web was incredible because there was no cost of distribution." Jerry Yang acknowledges the threat posed by some other network or means of Internet access: "The Web started out being a little wave, and it kept on getting bigger. The question is, Is there another wave? It could be something like standards for digital broadcasting or a new device that enables you to get on the Internet in a different format."
It could also be PCS telephone services, cable modems and TVs, PalmPilots, or even, as Funk suggests, some form of email, which already bypasses the Web. Yang says that the key for Yahoo! will be to use its viewers: "Not only Microsoft but a ton of other players that may ultimately control access to high-bandwidth services, including the cable companies, are better positioned than we are. But after they've sunk hundreds of millions of dollars, they'll want to take our awesome base of users and inject it onto their platform."
Though the barriers to entry are growing, this new environment creates advantages that will strengthen the Internet as a medium. "End users win because they don't want 1,000 portals," says the Zone Network's Franklin. "As fun as anarchy was, people like a semblance of order." Geoff Yang suggests that by aggregating eyeballs, the portals will create business opportunities that weren't possible before, like the integration of Web sites with television programming.
The anarchy of the Internet is coming to an end, made orderly by several portal sites with increasing power. Are they kingmakers? Yang says that competition prevents Yahoo! from holding this divine position: "We can't be a kingmaker unless we are a monopoly. We can make companies knights so that they compete. We can't make them kings so that they rule." That may be splitting hairs, but for Yahoo! the challenge is clear: although it has thrived in chaos, it must now learn how to rule in order.
YAHOO! AT A GLANCE
CEO: Tim Koogle
LOCATION: Santa Clara, California
OWNERSHIP: Public (Nasdaq: YHOO)
PRODUCT: Web-based online services
PARTNERS: AT&T, CDnow, GeoCities, Inktomi, Intel, MCI Communications, Microsoft, Reuters, Visa, Ziff-Davis
COMPETITORS: Excite, Infoseek, Lycos, CNet, America Online, Microsoft, Netscape
REVENUES FY97: $67.4 million
REVENUES 1Q98: $30 million
MARKET VALUE: $5.2 billion