Ready for the second dot-com bust?

Sometime, somewhere, somehow, even internet companies have to make money.

Web 2.0 is being billed as a revolutionary transformation of the internet and investors are excited about dot-com companies again. YouTube was bought for US$1.65 billion. Yahoo offered Facebook $1.6 billion and was turned down. It is indisputable that the Web 2.0 movement has opened up the internet to a wider group of people who are now producing content.

However, the purchase price of some of these companies makes one ask how they are making money and how are they valued? Google's stock price skyrocketed once it went public and it now has a market capitalization of $171 billion. Is Google really worth more than Boeing?

These companies generally only have on source of revenue and that is advertising. Google, specifically, makes loads of money by placing "context appropriate" ads within the body of its search results, its services, or on webpages that share advertising revenue with Google. Other Web2.0 projects like MySpace and YouTube also make money with advertising. Individual bloggers make money with Google or other advertising services and even video producers can embed advertisements in their videos. Notably, Ask a Ninja embeds advertisements for Ask.com and his own store in each video. These companies and efforts capitalize on the large number of users they have to offer advertisers the ability to reach a wide audience quickly.

However, there is a danger for any company that sells only one product. If that product fails, the entire company goes with it. Amazon.com knows this. They not only sell books, but also publish books (through BookSurge a company they own). They have a C2C (consumer to consumer) marketplace, and sell far more than just books. The single-minded approach to business operations is one of the reasons the first dot-com bust occurred.

The dot-com era was characterized by fadishism, excess and a failure to deliver products that sold. Rewind to 1995: if you said the word "website" people perked up and listened. People thought the web would change everything and that no one would shop in person anymore. It was a time remarkable for an excess of enthusiasm and a deficit of common sense. It should have been obvious that people will not buy most of their food on-line, but investors spent millions trying to make exclusively on-line grocers. It didn't work.

Lastly, the ratification of the dot-com bust came with companies that failed to deliver profits. Despite the influx of billions of dollars, most of these companies simply failed. A day of reckoning always comes. The vision of eventual profit does not counteract a series of perpetual losses. Is that day coming for Web 2.0 and Google?

Just recently, eBay briefly stopped using Google for advertising -- they only saw a modest drop in their traffic. This is part of the growing awareness that advertising on Google might not be all that is cracked up to be. Part of this is the still under-addressed problem of click fraud (people setting up Google ads on their website and then fraudulently clicking ads to artificially increase their income) and part is the problem of web advertising in general. There are dozens, if not hundreds, of services that will artificially increase advertising revenue with click fraud or other schemes.

However, the fact that eBay, a large internet company themselves, have shunned Google advertising and suffered little for it indicates the lack of value that other companies will surely realize eventually.

Web advertising needs to be somewhat discreet. For instance, pop-up ads are generally looked on as abuse. Some websites have full page ads that come up before you can get into the site and those aren't well-liked either. The ads one ends up with are discreet -- and easily ignored. Commercials on television can't be easily skipped or blocked (although you still can go to the bathroom). Internet advertisement is often so discreet that tools have been developed to suppress it entirely.

The other problem with internet advertising is that it presumes orders can take place on-line and that people will buy the product that way. While brand recognition is helpful, ultimately a company wants to make money. There is a limited demographic that shops on-line (about half of US adults) and there is a subset of products that are purchased on-line. This means there is only a certain subset of advertising that is likely to be effective on-line.

According to the June 11th BusinessWeek feature of "indata", there has been great growth in social networking and content sites, but the numbers are still quite low (less than 5 per cent of on-line users create content and 12 per cent use social networking). The growth is great – but it will not continue indefinitely. There are only so many people on-line.

Lastly, there is a growing awareness that many Web 2.0 companies have a systemic left-wing bias. While this might not matter for social networking sites, it is important for other sites like Google, YouTube and even Wikipedia (which has an admitted left-wing systemic bias problem). If another segment of the population feels alienated from the services, they will not be watching the ads.

Without advertising, many of these services are simply not self-sustaining. Wikipedia, which doesn't have ads, requires an influx of donations to keep it going. If that advertising dries up, these companies have no other source of revenue. Google may survive because of its size but it would have to make drastic cuts, such as cutting non-revenue-generating services. Other companies like MySpace, Facebook and Twitter will simply fade away.

This all adds up to a threat not only of over-valuation of these companies, but of collapse. And because of the large amount of investment, it is likely that a collapse will have far-reaching economic consequences. Dumping money into unprofitable companies based on fadishism helped bring about the dot-com bust. Haven't we learned from that bitter experience?

John Bambenek is a freelance columnist and blogger at Part-Time Pundit. He also writes for several other popular websites such as BC Magazine and the Internet Storm Center.