• by Diane Mermigas , June 5, 2008

CBS' ongoing Internet land grab is either a stroke of strategic genius or a defensive scramble for interactive positioning to assure its independent survival. The hand CBS plays best could be determined by an eventual merger or acquisition by a media giant, as is widely speculated.

The hubbub surrounding a steady flow of online deals, led by CBS' new video-sharing arrangement with Yahoo and its recent acquisition of CNET, masks a dilemma for CBS and other media concerns: How to close the gap between the diminishing revenues from their core traditional businesses and the ramping of Internet income.

In the second quarter, CBS is expected to report a year-over-year 5% decline in total operating income and a 10.6% drop in earnings on 1.5% lower revenues, according to Bernstein Research. The second quarter has not been boosted by the syndication and strike savings that drove the company's first-quarter upside--with operating profit growing 25% on virtually flat revenues--despite a 33% decline in prime-time ratings and a 2% decline in related ad revenues, according to Bernstein analyst Michael Nathanson. He estimates that all of CBS Digital, which has not had much quarterly impact, will generate $11 million in operating income on $113 million revenues in 2008.

The bigger issue for Wall Street is CBS' mixed financial picture. CBS will have a dramatic reduction in its $2.3 billion cash reserves and its stock repurchasing power as a result of buying CNET for $1.74 billion in cash, which is more than quadruple the $410 million it spent on acquisitions in 2007. It has pledged up to $300 million annually to develop CBS Films. The sustainability of CBS' television segment profit growth is in doubt as it continues to contend with double-digital ratings declines, despite cost savings from scaling back upfront and pilots.

A weaker domestic economy, on which 72% of CBS' total revenues are advertising-dependent, and even softer CBS network ratings could result in short-term makegoods and lower upfront commitments. Morgan Stanley this week predicted that CBS will gain 7% in CPM pricing, but a 9% decline in revenues per spot for an overall 5% decline in upfront dollars. (All the broadcast networks are expected to sustain a decline in revenues per spot.) CBS will not benefit from an expected shift of upfront ad dollars to cable, where it has few investments, although increased unique visitors to its Web sites will allow for more lucrative bundling of Web ads in its upfront sales. The organic revenues for its core broadcast businesses are in decline: down 7.5% for CBS-owned TV stations in the first quarter and expected to be down 5% for the entire CBS network for the full-year 2008.

CBS Audience Network deals with some 300 Web sites, led by Yahoo, Joost and YouTube, are designed to be a new source of advertising and revenue-sharing income. CBS program clips reach 90% of the Web, an effective alternative distribution to NBC and Fox Hulu.com. The big question: when will CBS' collective online efforts deliver meaningful income?

CNET will generate at least $15 million in cost savings and more than $400 million in revenues, although its initial contribution to earnings will be virtually nonexistent. Goldman Sachs projects that it will account for 10% of CBS' growth through 2011. CBS has made good use of some Internet acquisitions, such as Last.fm , but concedes that it hasn't figured out how to monetize the financial social network Wallstrip. However, CBS.com grew its market share by 41% in the prime-time TV season that ended May 24, according to Hitwise.

CBS has selectively toyed with alternative video ad formats that frame a diminished content screen, show up as logos in the corner or as tickers running across the bottom. It is only now getting into the embeddable video clips on other Web sites and blogs. It recently inked a "first look" deal with the creators of the Web hits" lonleygirl15" and "Kate Modern," and has made a killing on NCAA March Madness as well as streaming video of other rough-and-tumble sports.

CBS Interactive chief and former Allen & Co. deal maker Quincy Smith has been connected enough to secure acquisitions and partnerships, which must now produce significant financial returns. Even News Corp. has been struggling with ways to squeeze growth revenues from its diverse Internet holdings.

So just how dangerously wide can the gulf between core revenue losses and new revenue gains become before CBS must resort to a bigger strategic deal? Rampant speculation includes an eventual roll-up into a merged Microsoft-Yahoo, being acquired by Time Warner, merging with The New York Times, or being bought by Warren Buffett's Berkshire Hathaway, which once owned Disney/ABC.

Some say CBS and Viacom could co-bid for Joost (in which they both have an equity interest). Controlling shareholder and chairman Sumner Redstone has ruled out a reintegration of CBS and Viacom, which were split several years ago. Alternatively, CBS' slow-growth prospects could prompt it to go private to essentially opt out of the public glare, while it recasts its core broadcast businesses and its balance sheet. When the next year's conversion takes the entire television business into unknown territory, CBS could be wrestling with its own shadow.