The paid search revenue model is very addictive. New companies are launching everyday, leveraging online paid search engines to drive revenue. This obviates the need for bag carrier or other uncertain, high cost sales models. With cheap, commoditized infrastructure, any Joe and their dog can get into the online game. There has also emerged an enormous lead gen industry of players who simply arbitrage between what buyers (Lending Tree, etc) are willing to pay for a lead and what the intermediary has to pay through search, affiliate, etc to get the lead. Several years ago, you could drive a truck through this margin. In fact, while I could never talk anyone into it, I wanted to set up a hedge fund/trading firm targetted solely at profiting from the online efficiencies. Adteractive has built out a massively profitable business doing this for companies and pocketing the differential. It is rumored that after only 3 years, they were doing over $100m in revenue and dropping tens of million in cash flow.
The beauty and the curse of efficient markets is that everyone else has seen this and jumped into the market. Like hedge funds with stocks, one and two man operations are targetting every niche of the web, seeking out arbitrage opportunities. As a result, search has become perhaps the most expensive online acquisition channel, followed by affiliate marketing. Marketing emails to house files are by far the most profitable and efficient channel.
There are economies of scale to search as well. The larger you get and the more you do it, the more efficient you become. To begin with, Google and crew are continually tweaking their models, resulting in dramatic changes in results. You have to stay on top of these changes, especially for organic. On the paid side, companies grow more efficient through experience. They optimize price vs. word vs. position. This allows the bigger to get bigger at the expense of the smaller players. Niche players can do very well in their core areas (these are usually Affiliates who then resell their traffic on an affiliate basis).
However, the days of wine and roses is drawing to a close for the average mom & pop. As more and more of their competitors come online, two things drive the competition. How big the margin on their product(s) are (e.g. how much money do they have to work with) and their conversion rates. People wanting to win the search game need to enter with a margin advantage which gives them more room to bid. More importantly, conversion determines, often, the eventual winner. If we both spend $10 for traffic but you convert twice a well as I do, then you are making twice what I am on that traffic and can bid more aggressively. This creates a virtuous cycle. Landing pages, page layout, web experience as well as branding drive conversion on the sites. Again, more experienced players know best how to optimize their user experience and drive up conversions.
Interestingly enough, during recessions, search becomes much more attractive as rates fall through the floor. We will see what will happen during the next one (many say next year). During these periods, a well run operation can dramatically build up business by taking advantage of lower ad rates.
Like any market, the search market grows more efficient with each day. People begin to look far and wide for new arbitrage opportunities. As our economy continues to heat up and as Web 2.0 players flood onto the scene, this will eventually become an infeasible channel for many players. If you play this game, realize the key levers in the model and act accordingly. In particular, if you are in the lead gen world, move your model, if possible, from pure arbitrage to a more vertical model where you differentiate yourself on different elements. Some players are moving all the way back to owning product and look more like traditional web businesses. They can then leverage the profits of the business to continue feeding their search crack addition.