Listed Digital Agencies: A Broken Business Model?

Everyone's heard it, digital is the fastest growing medium in history. So why have no listed digital agencies made any money from it?

Back in 2000 at News Interactive, there was much high-fiving as digital ad spend finally outstripped some other media spend. I forget which one it was but we all took this to be validation of the future of digital.

Ten years later, digital ad-spend is set to top $2 billion in Australia this year and be in the region of 17% of total ad spend. So it’s grown a lot and that’s a decent amount of money in anyone’s language.

Yet the listed digital agencies in Australia have effectively made no money from this growth and according to the share market’s valuations of them, they never will.

Just to be clear, I am talking about the agencies, not businesses such as realestate.com.au or Seek. Or Google. They obviously do work as businesses. Here I am talking strictly about digital agencies who have sought to profit from the move to digital.

After ten years in operation for some of these companies, they are still not worth anything. The reasonable question to ask is, why?

So what is a company actually worth? A company's valuation is generally a multiple of its earnings. BHP is currently trading at around 17 times earnings. Qantas is trading on 25 times. Westpac is at 12.75 times.

Photon (PGA) is trading at 6 times. And this is while the shares are suspended. When they can be traded again it will probably be around 3 times. Or even less.

Hyro (HYO) is trading at 1.8 times. And its shares are $0.018. 2009 was the first time since listing in 2000 that it had positive earnings at all.

Here is a graph of what has happened to $10,000 invested in Hyro in 2000:

It's hard to remember what Blue Freeway's earnings were but since they were taken off-market at $0.03 after being well above $2.00 at one point it's safe to assume not much.

Q Limited (QXQ), another listed company specialising in digital has a multiple of 1.35. It has had positive earnings twice since 2000. So during the entire period that digital gained supremacy a company singularly devoted to digital managed to make money in two of those 10 years.

Here’s the same graph for Q Limited:

So effectively the market has decided - correctly, looking at the historical earnings - that listed digital companies aren't worth a red cent.

Depressing news if you are thinking of offloading your up-and-coming funky digital shop to some listed juggernaut so you can retire to the Cote d'Azur.

Going back to Photon, on the 28th of June they issued their much-anticipated statement to the market. In it, they said, "One-off costs and non-cash impairment charges are expected to comprise ... approximately $90 million in non-cash intangible impairment charges relating entirely to the Internet & E-Commerce division."

Non-cash intangible impairment charges basically means that where one day they said their digital division was worth $90 million, the next day it wasn't.

Investors are prepared to pay a multiple of earnings because the way they see it, that represents a fair valuation of the future cash flow of that company. BHP has the right to dig up a lot of iron-ore that they haven't dug up yet. People will always need to fly around and a lot of them will choose Qantas.

So from an investor’s perspective, the future cash flows of the digital agency look far from secure. There’s no dirt in the ground, there aren’t a million customers who just can’t be bothered changing their mortgage account and there aren’t a series of hospitals with beds just waiting to be filled by Australia’s aging population. So why would you pay a multiple for future earnings when the past ones have been negative?

Q Limited’s earnings multiple is currently 1.35. So the market is basically saying it has zero expectation that Q Limited will turn a profit next year. Or the one after that. Or the one after that either.

The IAB report that total digital advertising expenditure is forecast to be in excess of $2 billion for 2010 with the expectation of continued growth next year. (Click here to view the press release)

The rational investor in the market place currently predicts that the listed online digital agencies will not be able to translate one cent of that into a profit in the near future.

They haven’t been able to in the past so that is probably a reasonably rational prediction.

From an investment perspective it’s an industry that is seemingly incapable of making money. The dot com boom was a decade ago now and everyone got a little silly then but there’s really not much excuse for a prospective investor these days to believe the hype about why they should invest in a listed digital agency. The return is just not there.

The obvious question is, why?

Why is it that these listed digital companies have basically never made any money from a sector that has seen spend grow from not much in 2000 to a lot in 2010?

There are probably numerous reasons involving staff costs, client budgets and retention. All contribute to this but if Rio Tinto made no money for 10 years at the same time as there was massive demand for iron ore, someone would make them go away and look at their business model.