The on-line media sector is in disarray. In the wake of failed revenue models and the NASDAQ Stock Market crash, powerful incumbents such as Disney, Dow Jones, and NBC (the National Broadcasting Company) have been struggling alongside attackers such as the investment adviser TheStreet.com and the on-line magazine Salon.com to generate returns on the billions of dollars invested in them. New investments are being curtailed, and the temptation to abandon the World Wide Web is great.

The lesson to be drawn is that off-line business models—founded mainly on interruption-based advertising and subscriptions—don’t work for incumbent media companies in the on-line world. On-line audiences largely ignore advertising and rarely pay subscriptions, because a free substitute is usually only a click away. So what are incumbents to do?

They should be patient: all new media models take time to achieve success. Meanwhile, they should look carefully at their properties and sustain, even reinvent, those that will respond best to promising new business models. Eventually—in a broadband world—traditional interruption-based advertising might bring better rewards. More promising in the near term, though, is an emerging advertising model known as contextual advertising, which targets the consumer who plans to make a particular purchase and is thus more likely to be responsive. Not all media companies have the kind of specific content that lends itself to such advertising, however, and those that don’t must look to other marketing and cross-selling opportunities to increase their revenue.

Remember, too, that incumbents are in a better position than their pure-play competitors to absorb short-term losses in hopes of finding a long-term audience. Indeed, we expect 95 percent of pure-play on-line media companies to fail within the next two years (see sidebar "About the research").

The old model teeters

Advertisers know that interruption-based banner ads offer poor value; hence the media companies’ low revenues on-line. The fact is that on- and off-line economics are different.

Supply races ahead of demand

Scarce supply is the foundation of traditional media economics. The number of off-line media outlets is severely limited by the cost of producing mass-circulation print publications or by the need to hold one of the few national broadcast licenses granted by governments. Entry to the Internet costs about one-tenth of what is required to enter the off-line media.

This state of affairs has created two fundamental differences between on-line and off-line economics. First, far more companies are vying for the available advertising dollars on-line (Exhibit 1). Second, most Web sites that pursue subscribers face direct competition from sites that replicate the model of broadcast television by supplying free parallel content, their hope being to attract enough viewers to make a profit from advertising alone. Sites offering "adult" content make money through subscriptions. So do sites with clearly unique and enduring content, such as ConsumerReports.org, which at virtually no additional cost to the publisher, the US-based product-testing organization Consumer Union, makes available all of the reports it publishes in the magazine Consumer Reports. Other kinds of sites languish.

Where is the value?

Uncompetitive pricing and a lack of innovation haven’t helped. Too quickly, banner advertisements became the standard on-line format, and click-through rates (the proportion of site visitors who click on an ad to reach an advertiser’s Web site) became the principal, though unsatisfactory, metric (see sidebar "Stuck on standards"). Even by that criterion, banner ads have proved ineffective: click-through rates have more than halved—to less than 1 in 200, from more than 2 percent—and the decline continues. The result is that under many pricing schedules, the cost to an advertiser of one on-line contact from a content site is greater than the cost of the off-line alternatives.

Most big advertisers, then, largely ignore the Web: last year, the top ten Fortune 500 companies accounted for only 2 percent of total advertising on it. About three-quarters of the almost $6 billion spent on Web advertising went to the ten sites that had the highest traffic, with a little more than half going to the top three portals: America Online, the Microsoft Network (MSN), and Yahoo!

Faced with such economics, even sites that deliver plenty of traffic can’t attract the revenue needed to cover their fixed costs. At current visitor rates, a typical pure-play content site makes $1 to $2 per user each month, compared with total costs of about $2 to $3 per user (Exhibit 2). Such a site would have to attract about ten million unique visitors a month to break even. Although incumbents can spread their costs among sites or across on- and off-line properties, the traffic volume they need is still higher than expected.

Get relevant

Off-line, media companies create and package content, gather an audience around it, and then interrupt the audience with paid commercial messages. The advertising message isn’t necessarily related to the content—a car commercial during a televised football game, for example, or a cruise ad in a magazine—though some general demographic targeting is possible. This model works because the content generally captures the readers’ or viewers’ interest and can’t be substituted immediately. On-line, however, users take a more active role and are much less tolerant of interruptions. As a result, research shows, most Web users simply ignore ads.

It isn’t clear whether any kind of interruption advertising will work in the long term, though broadband technology will probably allow some media companies to deliver content that captures the attention of audiences for specific periods. Streaming video is the likeliest winner; examples could include live Webcasts of concerts, out-of-town sporting events, or exclusive fashion shows. Since these would be viewed in real time rather than downloaded for later viewing, the audience couldn’t click to a substitute, and since the content would be unique, there might be greater tolerance of advertisements shown before the Webcast or during breaks in the action. Like television commercials, such ads could also be more emotionally compelling to the audience.

The key to making advertising relevant lies in contextual marketing. This model works off-line in trade and special-interest magazines, where reading the ads is part of the experience. Advertisements in a computer-gaming magazine, for instance, offer information (about, say, an upcoming game release) that is related to the editorial content. Readers of such publications know the difference between the ads and the reviews, of course, but are more willing, in this context, to accept ads as relevant information, not just as interruptions. Advertisers therefore gain a more limited but also a more targeted audience.

People coming to a site prepared to buy specific products are quite receptive to ads for them

Contextual advertising is particularly suited to Web sites. The Internet is an immensely rich contextual medium, awash with people searching for information to help them make immediate purchases. In this environment, advertising can be tailored to the context in which it is displayed. CNET.com, an on-line source of reviews and information about electronics products, offers the best example of a site developed with contextual advertising in mind. People go to CNET for information about technology products. Since these people are often prepared to buy, they are already receptive to ads for specific products. As an interactive site, CNET also links buyers to on-line stores or vendors’ sites, thus making transactions seamless. As a result, CNET generated in excess of $5 of advertising revenue per unique user last year, significantly more than most other content and community sites.

CNET’s tech-savvy user base and natural set of advertisers gave it a head start in contextual advertising, but other media companies that consumers turn to for advice when deciding what to buy could benefit as well; the possible product categories include cars, fashion goods, office products, personal-finance products and services, and travel. Thus Barry Diller’s USA Networks, besides taking a majority stake in the on-line travel firm Expedia, has said it will launch a new cable station (the USA Travel Channel) and acquire the National Leisure Group (which provides fulfillment services to sellers of vacation packages and cruises). USA Networks already owns the Home Shopping Network, the Hotel Reservations Network, and Ticketmaster. For a media company to get paid more for the ads it runs, a link to transactions is essential.

But most traditional media sites can’t take advantage of contextual advertising. The on-line properties of publications sustained by interruption-based advertising—such as the Web sites belonging to Newsweek and People—as well as the Web sites of traditional broadcast channels such as NBC, don’t offer content relevant to buying. CNET aside, the low ad revenues and high costs of operating a content site mean that even trade publishers still prefer ad-based off-line media.

However, media companies that choose contextual advertising—and those capable of doing so include the personal-finance area of Yahoo! and MSN’s auto area (Carpoint)—must strike a delicate balance to succeed: they have to be seen as providing neutral advice accompanied by paid messages rather than as relentlessly pushing their advertisers’ products.

What should incumbents do?

Since contextual advertising will work only for some media companies, larger ones must cast a cold eye over their range of on- and off-line properties and pursue several courses of action.

Restructure assets as the market consolidates

To find out how near sites are to breaking even, their managers must map their current revenue per user and overall traffic against a curve on which net revenue per user covers fixed costs (Exhibit 3). Whatever action—restructuring, reducing fixed costs, increasing traffic and revenues, and so forth—may be needed to break even can then be assessed clearly.

The economics of some media sites might improve if they were combined with others and with off-line properties. Consolidating the infrastructure of a company’s sites might help cut costs, as could partnerships or the purchase of external sites with potential synergies in editorial, sales and marketing, and back-office operations. In a consolidating industry, strong incumbents should be able to negotiate favorable deals.

Restructuring could also clarify the role of Web sites that offered benefits other than revenue. Such sites might be necessary for magazines, let us say, to satisfy readers who wanted to experience them in both on- and off-line versions or to meet the demands of advertisers that wanted to run integrated media campaigns across several channels. These sites should be maintained at minimal cost and regarded as a supplement to off-line operations and, perhaps, as an additional channel for subscription sales.¹ Trying to change such a site so that it offers an exhaustive range of information will almost certainly lead to losses.

Keep innovating

Whatever the benefits of contextual advertising, consolidation, and cost cutting, they are unlikely to help most media Web sites make a profit. In this case, the only alternative to more losses is more innovation.

For large media businesses such as Yahoo! and AOL, innovation means using interactive platforms to help companies reduce the inefficiencies inherent in all of their interactions with consumers—interactions through such means as promotions, brochures, coupons, physical locations like bank branches and car dealerships, and consumer-service call centers. In addition to the advertising dollars that on-line media sites aren’t capturing, companies such as Coca-Cola, Pepsi-Cola, and Procter & Gamble spend a large part of their overall budgets on marketing, sales, and service expenses with well-known inefficiencies and with returns that are often hard to quantify.

Media companies can improve their value proposition to marketers by leveraging the Web’s low-cost, high-touch qualities to raise the efficiency of these investments. AOL, for example, recently teamed up with Coca-Cola, and Yahoo! with Pepsi, to shift bottle-cap promotions to the Web—a departure from the era when some bottle caps could be redeemed for prizes only at stores; buyers can now enter the redemption codes from their bottle caps on-line to find out if they have won a prize. Both Coca-Cola and Pepsi-Cola say that in this way they have saved money and time (3 months to create a promotion, down from 18).

Media businesses could capture nonadvertising marketing expenditures (and position themselves to boost their advertising revenues) in other ways as well. First, they could help marketers test the effectiveness of planned national off-line advertising campaigns by providing targeted on-line audiences. They could also use information gathered on-line to identify the most valuable customer groups and to help advertisers plan and execute more finely targeted off-line strategies. One media company increased a food manufacturer’s sales by identifying office workers in its audience and sending them targeted on-line ads for spaghetti sauce at the end of the workday, when they might be thinking of buying food on the way home. This approach substantially refines targeted advertising, but, unlike contextual ads, it relies on a timely message to a specific demographic group rather than on a message linked to a site’s content.

Large media companies could even host marketers’ Web sites, which, after all, are essentially media platforms; media companies such as AOL have the scale and skills to manage them more efficiently than does, say, a consumer products company. In addition to managing operating costs—everything from network connections to content management—AOL could help such a company place ad banners effectively within AOL’s broad media site. Thanks to the breadth of AOL’s off-line media products, it could also offer the company an integrated, cross-media marketing program.

Learn new skills

To host sites and offer bundled marketing services, media businesses need to have skills in three key areas. First, they must be able to define—and clearly—the new value proposition being offered, by showing how the value of a consolidated service might outweigh that of a campaign mounted by a consumer products company on its own, buying piecemeal. Second, media businesses will need to have sales forces that really understand the new services, as well as how to communicate their value to potential customers and to negotiate contracts for them. Third, media businesses will have to transform the sales process, for in the beginning the media buyers at advertising agencies—whose job it is to purchase ad pages in magazines and ad time on television for their clients, the marketing companies—will not be expected to negotiate these complex deals and have no genuine incentive to do so. As a result, America Online, for example, negotiated the bottle-cap promotion program directly with high-ranking executives at Coca-Cola.

Create tiers of value

Finally, incumbent media companies must capture a kind of value that has largely eluded them: the sale of tiered value bundles, similar to the Green, Gold, and Platinum offerings from American Express. For traditional publishing companies, as well as for companies such as CNN and MTV, this opportunity is far more valuable than chasing on-line advertising dollars. We would go so far as to say that the creation of tiered value propositions for consumers may be the biggest opportunity that media brands have missed so far.

Publications such as Time and the New York Times, for instance, could offer varied levels of access to information—such as archives, forums, access to authors, and book clubs. A strong off-line brand associated with a fashion magazine could be extended into a variety of valued services offered and organized on-line, such as guided packaged tours (arranged by a fashion editor) of Paris boutiques. Integrated on- and off-line product offers appealing to consumers who had a strong affinity with the publication’s brand could be tiered with different levels of services and bundled with print subscriptions at different rates. The cost of creating a Gold or Platinum subscription level that included services delivered over the Web would be minimal compared with the bottom-line impact of even a modest increase in subscription renewal rates.

CNN wasn’t built in a day

Media companies need to be patient with their on-line investments. The fast riches of the Internet boom may have led many people, media executives included, to develop false expectations about on-line investments. We, by contrast, believe that the development of on-line media will be similar to that of their off-line counterparts: acceptance—and profits—will take time to develop, and only a small number of companies will succeed (Exhibit 4). Advertisers, remember, are extremely slow to move their spending from one medium to another (Exhibit 5); ESPN and CNN each took more than ten years to break even, though television was an established medium.

In at least one respect, incumbent media businesses have the advantage over their many pure-play competitors: they have the resources to take the long-term view of their on-line investments. Although this should not foreshadow a return to investments based on unsound economic principles, it does mean that the incumbents’ managers can orchestrate on-line experiments and prepare to play a role in the longer-term transformation of media by interactive platforms.