Big Trouble for Babylon as Its Rivers of Money Dry Up

The translation company's lost contract with Google and problems with Yahoo could signal looming trouble for other download companies.

Google's announcement last Wednesday that it would not renew its contract with Babylon when it expires at the end of this month was the online translation company's worst nightmare come true. The reaction came swiftly and brutally, as Babylon's stock plunged 62% in Tel Aviv Stock Exchange trading the same day on an enormous NIS 90 million in turnover. The plunging share wiped some NIS 990 million off the company's market valuation and puts its planned merger with IronSource at risk.

Google, which pays Babylon for each user referred to its search engine, accounted for 43% of Babylon's revenues in the second quarter, or NIS 70 million out of a total of NIS 163 million. Investors fear not just the loss of the Google contract, as well as another key agreement with Yahoo, but that the company's troubles will prevent it from signing agreements with other search engines, most notably Microsoft's Bing.

The news has also exacted a toll on other companies belonging to Israel's so-called "Download Valley," the nickname for a group of companies that develop and market free Internet software distributed through toolbars. Perion Network, which recently merged with Conduit's toolbar division, shed 10% of its market value the same day, while shares of WhiteSmoke, an online English-grammar checker that also refers users to the Google, Yahoo and Bing search engines, fell 11%. Somoto, which went public on the TASE in August at a value of NIS 135 million, took a 24% dip on Wednesday to finish the day with a market cap of just NIS 81 million. Somoto earns 26% of its revenues through Babylon's toolbars.

Google ditched Babylon following complaints from users of its Chrome web browser, which is installed on 60% of all personal computers worldwide. Just a week-and-a-half earlier, Yahoo, Babylon's second-largest client, threatened to sever its ties with the company for similar reasons. After the publication of its second-quarter financial report, Babylon told analysts that it had revenues still unbooked amounting to about NIS 150 million, presumably all or most of them from Google. In its announcement about Google last week, Babylon did not say whether this income would be affected by the end of its contract with the search engine giant.

Nevertheless, in an interview with TheMarker, Babylon's controlling shareholder Noam Lanir said too many questions remained unanswered to draw any conclusions about the company's future. "It's still too early to estimate the impact on revenues," he told TheMarker on Wednesday. "I have no doubt this announcement will have a wide-ranging effect over the industry. There's a new reality and we need to study and internalize it and understand how to move forward from the same point."

What do you think will happen to the IronSource merger?

"I can't talk about the merger. The people at IronSource are close friends of ours. At times like these I am open to receiving their good advice to make myself totally available from a sense of partnership."

Babylon CEO Alon Carmeli has left and IronSource's Tomer Bar-Zeev was supposed to take his place. Who will be the company's CEO?

Babylon will release its [third-quarter] financial report in November and address the question of who will lead it. I can't elaborate further.

Why did Carmeli sell all his stock?

"I bought all Carmeli's shares from him."

Have you profited from your investment in Babylon?

"Babylon earned hundreds of millions of shekels over the years and also distributed dividends. We have a large amount of cash on the books, excellent human capital and are ready to move forward."

In an official communiqué to the TASE, departing CEO Carmeli said that "the events experienced by Babylon in recent days don't only relate to Babylon but to the entire industry. As industry leader, we are the first to undergo these events to such a degree." Others in the industry beg to differ, however.

Josef Mandelbaum, the CEO of Perion, said Babylon's problems are its own and don't reflect trouble for the rest of Download Valley. "I don't know why the CEO of Babylon is speaking in the name of the industry. This isn't an industry problem. The problem is Babylon's," he told TheMarker.

Is Perion as aggressive about monetization as Babylon is?

"Perion renewed its contract with Google last May. Conduit, the company with which we are about to merge, renewed its contract with Google in September and it is for four years. I was at Google a week-and-a-half ago. The relations between our companies couldn't be better. Google sees that we are operating according to the standards it has developed. It appears that others in the industry weren't."

Since Lanir transformed the company from a simple online translation business, Babylon has generated its revenues by referring Internet traffic to major search engines while gathering user information that can help advertisers pinpoint their target audience.

"The installation of toolbars was all to Google's benefit," a senior industry source, who asked not to be identified, told TheMarker. "What bothered it was mainly Babylon's contract with Yahoo. As soon as most of Babylon's user traffic switched to Yahoo, Google became suddenly aware that the user experience was impacted."

The feeling among Babylon's management and staff is that the chances of the contract in its current form being renewed are slim. Over the past year, Google has been tightening standards for cooperation. Last January, it began enforcing rules among its partners regarding the extent to which users could be "taken advantage of" in an effort to alleviate their exposure to an onslaught of ads and information. Google demanded that its partners change their methods. Users would have to actively consent to download software by checking the appropriate box on their screens and Google insisted that software providers eliminate all hidden add-ins.

Google's stricter conditions drove Babylon to adopt a diversification strategy at the expense of its bottom line, resulting in the four-year agreement it signed with Yahoo last April. Together, Google and Yahoo control 78% of the online advertising market. Babylon knew it was losing money in the short run with Yahoo, but hoped the American company's market share would expand and help boost its own income over time. Under the agreement with Yahoo, Babylon's share of advertising income would increase as the volume of operations with Yahoo grew. In the contract Babylon also committed itself to providing a minimum level of activity or risk losing income.

This strategy was meant to provide Babylon with a safety net against the risk that its income from Google would shrink. Up until that point, Babylon's dependence on the Internet giant was absolute. The new contract with Yahoo balanced the situation to a certain degree. Google's share of Babylon's revenues declined from 84% in the second quarter of 2012 to 66% in the first quarter of 2013. Market insiders believe that Yahoo supplanted Google as Babylon's main source of revenue in the third quarter.

But Babylon's association with Yahoo hasn't been free of glitches either. Two weeks ago, Yahoo issued the Israeli company a severe warning that it was considering terminating the contract due to violations by Babylon. Yahoo management asserted that Babylon had inserted ads into Yahoo pages without permission by means of its software-distribution system and had also permitted "click fraud" to fictitiously inflate the traffic count that forms the basis for referral income. This activity didn't directly diminish Yahoo's revenues, apparently, but it refused to accommodate such a blatant violation of the rules by a business partner.

Babylon, adopting a defensive posture, located the violations and stopped them from occurring. Babylon's management explained to Yahoo that the source of violations was activities by other commercial partners. In any case, out of fear of losing the contract, Babylon reduced its investment in acquiring new users by about 70%, a move that would have an immediate impact on revenues. By doing so, Babylon signaled the market that it thought its contract with Yahoo was in imminent danger of cancellation.

Investors took this as an extremely negative message that would harm Babylon's earnings and the stock began to collapse. Within a week Babylon shares lost 30% in value and a week later they had already sunk by 75% altogether.

Ofer Vaknin