Cracking the mobile ad market

January 24, 2013, 5:08 PM UTC

By Verne Kopytoff, contributor

FORTUNE — Paul Palmieri, chief executive of Millennial Media, had a point to make about the future of his fast growing mobile advertising company. Staying independent is perfectly fine for his business, he said, never mind the constant speculation about it being an acquisition target. The rumors, which Palmieri declined to address directly, are an inevitable byproduct of the company’s rapid rise. Since its founding seven years ago, it has emerged as a serious player in the burgeoning mobile advertising industry.

Millennial’s (MM) sales are expected to reach at least $181 million for 2012, a 75% increase from the previous year, according to the company, which held an initial public offering in March. Profits have been mostly elusive, however, as it expands to keep up with the niche’s growth, fueled by more people spending more time on smartphones and tablets. “Advertiser demand usually follows consumers, and we are poised to take advantage of this shift,” Palmieri said.

Palmieri’s timing with Millennial, based in Baltimore, was prescient. He co-founded the company just before Apple (AAPL) introduced its first iPhone. Smartphones, from both Apple and its Google-powered (GOOG) rivals, served as a catalyst for the mobile ad market as did the debut of tablet computers. This year, marketers are expected to spend $7.2 billion on mobile advertising in the United States, a 77% increase from 2012, according to eMarketer, a research firm.

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Millennial operates a mobile ad network modeled after those that have thrived on the desktop Web. The company funnels ads across its network of participating app developers, who get a cut of the revenue. Zynga (ZNGA), The New York Times and the National Football League are just some of them.

Despite rapid growth, mobile advertising still has its issues. Many marketers are only experimenting with the medium or spending relatively small amounts of money. A big complaint is that mobile screens are too small for ads to make an impression on consumers. Marketers also recoil at paying for accidental clicks, whereby mobile phone users mistakenly tap on an ad—an all to common phenomenon known as the fat finger effect.

As a result, mobile ad rates are, in some cases, far lower than for Web-based ads. Mary Meeker, the venture capitalist, pointed out recently that mobile devices account for 10% of all time consumers spend with media, but only 1% of ad spending.

Palmieri, who was previously an executive at Verizon Wireless, described the disconnect as normal for such a new industry. Advertisers will eventually graduate from experimenting to more serious spending, he said. He likened their process to going for walk. “Each advertiser is at a different place in their path,” he said.

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In any case, Palmieri emphasized that rich media ads – those that are more customized and flashy—command similar prices to their equivalents on the Web. Better targeting—based on a customer’s location and past behavior, for example—is helping to make ads more successful.

Millennial’s biggest challenge is its relative small size compared to its rivals. Advertising is a business that usually favors the bigger players because of their reach and ability to cross-sell products. Google is undisputed leader in the U.S. mobile ad market with a 57.1% share this year followed by Facebook with 12.2%, according to eMarketer.

Palmieri said that Millennial’s size—it’s a distant sixth with a 2% share—is not a problem. To prove the point, he said that his company does business with 75 of the marketers on Advertising Age’s list of the 100 biggest advertisers. In fact, Palmieri likes to call Millennial the biggest independent mobile advertising company. It’s true, technically.

That independence makes Millennial, which has a market capitalization just shy of $1 billion, a likely acquisition target, according to Michael Graham, an analyst with Canaccord Genuity. Yahoo (YHOO), which has conspicuously failed to build a mobile ad business, is just one of the potential suitors along with Microsoft (MSFT). Palmieri declined to address the issue. He wouldn’t even say how well he knows Marissa Mayer, Yahoo’s chief executive, out of concern that it would tip-off whether they have held talks. All Palmieri would say is that “we’re building a market leader here,” implying that he’s forging ahead as if there will be no acquisition.

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Millennial’s initial public offering last year, which raised $133 million, most of which went to the company’s coffers, gives it some running room. A subsequent follow-on offering raised another $12 million. Like many new technology stocks last year, Millennial’s shares initially jumped – doubling on the first day of trading. They later settled slightly below their offering price.

Graham agreed to a point with Palmieri that Millennial is well-positioned because of the growth in mobile advertising and the company’s independence. It offers developers an alternative to Google, he said, without any of the competitive baggage.

Moreover, the scope of Millennial’s network—38,000 developers—is attractive to advertisers. Yes, Facebook (FB) and Twitter have more market share in mobile advertising. But unlike Millennial, they don’t place ads on third-party apps. Facebook killed an experimental mobile ad network in December. Twitter has yet to try.

The danger, for Millennial, is that Google or some other company takes greater control of the mobile ad market. Given its size, Google could better afford a price war in which it gives app developers a bigger cut of the ad revenue. Still, Graham voiced optimism for Millennial—that is if Millennial isn’t acquired. “Google definitely has a lot of advantages” Graham said. “But there is space for one or two competitors to Google.”