While Google (Nasdaq: GOOG ) is my favorite search engine, its valuation gives me the heebie-jeebies. Since Rick was kind enough to respond to my original article, I thought it was only fair to respond to his, albeit belatedly. Of course, I still think Google is quite overvalued, but Rick does make a persuasive case for the company to be worth every penny.
Thankfully, Rick agrees with me that Google doesn't scream cheap, even at 29 times 2007 earnings. But compared to Internet bellwethers like Amazon (Nasdaq: AMZN ) , and Yahoo! (Nasdaq: YHOO ) , which trade at roughly 39 and 41 times 2007 estimates, it is cheaper.
I am not particularly fond of using forward P/E ratios for valuing high technology companies -- and Google in particular -- for several reasons:
1. Wall Street analysts have this funny tendency to be over-optimistic when predicting the future, and in general they're not good indicators of where earnings might be in a year. Since Google makes a habit of not giving forward guidance (except when accidentally posting internal PowerPoints online), what is there to give investors any confidence that analysts will get it right on the upside or the downside? Google's recent earnings blow-out was another example of analysts missing the boat.
2. Plus, technology markets can change so quickly in the space of a few months (think what damage Zillow.com has done to HouseValues.com in the past few months) that relying on estimates a year out can be dangerous for investors' health.
The perils of click fraud
Rick argues that click fraud can be an integrity killer, but at the end of the day, advertisers don't mind paying a few pennies more for a good lead. I would agree, but advertisers are not always that rational, and if the perception is that click fraud is a problem then this would have the logical effect of pushing advertisers away and driving down revenue. If Rick's excellent research from Click Forensics is correct, and click fraud runs about 12%-13% of clicks at Tier 1 providers like Google, it would also be logical to expect intelligent advertisers to take that into account and lower their bid prices accordingly.
You'd think Yahoo!, who -- via acquiring Overture (the original pay-per-click pioneer) -- actually has more experience than Google with policing click fraud, would do better at the problem, but alas, no luck. Why else do we have a rather substantial mini-industry devoted to stopping click fraud? Google alone can't cut the mustard.
Canaries in a coal mine?
It's true that Blue Nile may be whining a bit, but Blue Nile (Nasdaq: NILE ) does happen to be able to monetize the online jewelry shopper better than just about anyone else on the Web. If Blue Nile is stating that pay-per-click is unprofitable, then who is making money off pay-per-click advertising in online jewelry?
Newer advertisers may see the pay-per-click model as cheaper than offline alternatives, but presumably they are still driving consumers to online properties that compete with these e-commerce vets. If these newer advertisers are attempting to build brand awareness, and are willing to deficit spend their way into the consumer mindset, then yeah (as Rick stated in his original response), "Nobody goes there; it's too crowded." Essentially, we'd be back in the craziness of the early 2000s and the Internet Bubble.
The costs of content
Growth in organic revenue is not going to save Google's margins if Google has to pay for more and more content as they expand. As more advertisers enter the online market, content providers will be able to push back for better revenue sharing, and ad placements, thusly pushing Google's ad margins lower.
For example, one hypothetical situation would be if a user wanted to read a story on Enron and typed in "Enron, Kenneth Lay." The New York Times may want to charge $0.05 or $0.10 a click to Google so that Google can provide the link to the Times' original content on the right hand side of the page. The Times may pay $0.50 a click, and thusly Google's margin has been reduced from $0.50 to $0.40 a click. Alternatively, the Times may demand a higher cut of the revenues generated from placing Google ads on their site. If Google wants to continue to grow as they have been, maintaining a good relationship with the Times, and other content providers, is crucial to the engine's continued success.
Google simply does not have the 80% plus market share needed to be able to push back on marketers and content providers and demand their way or the highway -- especially since Yahoo! and Microsoft provide credible alternatives.
Don't be evil (most of the time)
I think that entering China may be a substantial long-term positive for Google, but I disagree with how they did it. The issue at heart is not pride, but the mismatch between cultural values and business execution. When a company grows their employee base as fast as Google is doing, it will become an issue.
Google does have a compelling point, though: do we filter our search results or do we not offer Google search in China at all, thus disregarding a fifth of the world's population? It is a difficult decision and I am not surprised that Google executives struggled for several years to orient their moral compass with the decision to enter China. While quantifying the impact of this on the bottom line is difficult, it opens a door to a slippery ethical slope for management.
Expand first, make money later
Rick argues that the expand first, make money later strategy worked out well for companies like Netflix (Nasdaq: NFLX ) and Amazon. I agree, but their business models were a lot more compact (rent DVDs via mail, sell goods online) than Google's. Expansion was a matter of the logistics of locating warehouses, adding tabs on websites, and moving product from manufacturers to end users. Plus, both companies were legitimate first movers in their respective spaces, and expanding as rapidly as possible to capture as much of the developing market as possible is simply smart business strategy. In contrast, Google is expanding into markets with entrenched competition and some of the savviest competitors on the planet.
Google may be the online leader in advertising, but it has a long way to go to catch up to Microsoft's Hotmail or Yahoo! Finance in terms of numbers of users. For example, Amazon was one of the first, if not the first to use "One-Click Shopping" and offer tabbed store formats to make it easier for users to search and buy items. Netflix had their DVD queue, which was crucial to attracting and keeping subscribers. These companies were the real trailblazers in their spaces, and thus they managed to retain much of the competitive advantages derived from them.
Google may do very well, their new ventures may be incredibly successful, and all of the issues I have raised may be moot points. However, if the company is indeed priced to perfection as I believe, any meaningful appearance of the aforementioned issues might weigh heavily on the company. So I guess the final question would be this: Can Google deliver market-beating returns going forward with a hefty enterprise valuation of $105 billion dragging it down? I don't think so.
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