What Happens to GOOG/YHOO, etc. In Recessions?

Now that the Fed has rushed to the rescue, this might be irrelevant (but then again, rate moves usually take six months to kick in, so don't be too sure).  In any event, just file it away in your recession-prep-kit.

The problem advertising and technology-driven companies face during recessions is the reverse of what makes them so profitable during booms: operating leverage.  Once fixed costs are covered, most incremental sales dollars fall straight to the bottom line.  This is great news in good times, but it sucks in bad times, when high fixed costs suddenly rear their ugly heads (other industries have this problem, too, which is why earnings get mauled in downturns).

To illustrate potential recessionary impacts, we've run scenarios for Google and Yahoo.  The same concepts should apply to most digital businesses, to a greater or lesser extent.

ASSUMPTIONS

Two things usually happen in a recession: 1) revenue growth slows or declines, and 2) companies can't adjust spending fast enough to compensate.  As a result, top line impact is magnified on the bottom line, often so much that previously profitable companies suddenly lose pots of money.  Within media, in most recessions, advertising spending usually declines, with the decline usually more severe in mature media than in developing media.  (In the last recession, because so many online advertisers went belly up, it was the opposite: online advertising dropped 50%.)  Subscription revenue, meanwhile, usually hangs in there.

We've run three scenarios for Google and Yahoo: GOOD, BAD, and UGLY.  In each case, we've taken Q207 results and annualized them, then applied assumptions about 1) revenue, and 2) expenses.  We have intentionally kept the analysis simple: we haven't made precise assumptions about fixed vs. variable costs, for example.  (All assumptions and details here).

RESULTS

Google. In our "GOOD" scenario, revenue growth merely slows--to 20% a year.  (Google fans will argue that Google's growth won't slow at all because advertisers have perfect visibility into ROI, half of the business is international, etc.  There are counter-arguments to each of these points, but you can make your own assumptions).  Expense growth in this case also slows to 20%.  Google is a supertanker whose expenses are currently growing more than 65% per year, so slowing expenses this much would be very "GOOD." In any case, in this scenario, Google's margins hold and operating profits grow 20%--nice, but short of what Wall Street is probably expecting.

In our "BAD" Google scenario, revenue flattens, and the company reigns in expense growth to 10% year (heroic).  In this case, revenue stays the same, but the operating margin drops from 29% to 21% and operating profit drops by a third.  (Imagine how Wall Street will react to that).  We won't tell you about the UGLY case--you can see for yourself.

Yahoo. For Yahoo, the situation is scarier, because the company is growing slowly even now.  In our "GOOD" scenario, revenue growth slows to 5%, as do expenses.  In this case, operating profit grows slightly.  In our BAD scenario, revenue drops 5% and expenses stay flat, cutting the operating margin and operating profit nearly in half (this is perfectly plausible).  In our UGLY, scenario, revenue drops 20% and expenses stay flat--and suddenly the company loses $600 million a year.

CONCLUSION

Most digital businesses, especially those with advertising revenue, have high operating leverage.  In good times, moreover, investors and executives almost always underestimate the impact of recessions.  You have been warned!