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The Battle for Business Ethics
Is Google a Good Investment?

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By TParadiso
May 11, 2004

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Google Goes Public: To Invest or Not to Invest

I don't normally do this type of analysis and investment recommendations are not my focus. However, given I spent almost three decades in the technology industry, perhaps I can offer a reasonable opinion.

The Financials

Google's financials are outstanding. They've been profitable since 2001. Last year's revenues were $962 million, almost triple the previous year. Considering the lackluster economy during the period the company's growth is impressive.

As are their margins, which increased in the first quarter of this year to 39.9% from 35.6% in 2003. That's the type of margins technology companies routinely enjoyed 20 years ago but don't often see today.

Net income for last year was $106 million and would have been substantially higher if not for an unusually hefty tax bill. The higher taxes were the result of the accounting treatment for a large chuck of stock options. Analysts believe the cost of the stock options will dramatically decline in future years. If you segment out that cost for 2003, on a cash basis Google had an operating profit of $570 million and an operating margin of 62%. Not too shabby.

If the company is able to sustain that pace through this year they'll do $1.6 billion in sales with a staggering $620 million in operating profits. Based on the Q1 numbers they're right on track. Revenues in Q1 were $390 million and operating profits totaled $155 million.

On the down side, revenue growth was slightly lower from the previous year: 118% versus 177%. Bummer. Who would want to invest in a company only growing at 118%?

The slower percentage growth is of little concern. It's a natural progression of a company the size of Google. Percentage revenue growth invariably declines the larger a company gets. For a billion-dollar company to be able to double its revenues sets Google apart from most companies.

There is one concern however. For the moment expenses are rising rapidly, increasing 149% in the first quarter. That's faster than revenue and if not addressed margins could quickly erode.

As previously stated, impressive numbers. Now you know why the Google IPO has Wall Street salivating. The six-year old company could be valued in the $30 billion range making it on paper more valuable than Sears.

The Competition and Market Dynamics

Google's main rival is Yahoo. At present they don't have as many users as Yahoo. According to Nielsen/NetRatings in March, Google attracted 65 million unique searchers compared to Yahoo's 96 million. But Google is growing twice as fast and they can sustain that growth Yahoo's lead won't last long.

In terms of dollars and cents Yahoo registered $758 million in sales and operating profit of $132 million, or 17% in Q1 of this year. For the year, Bear Sterns expects Yahoo's revenues to jump 71% to $2.51 billion. Though Yahoo's profit margins aren't quite up to Google's, they ain't chop liver either.

Last year Yahoo had sales of $1.6 billion with operating cash flow of $428 million. Yahoo's valuation is also in the stratosphere at $36 billion.

Here's an eye-opener. When Yahoo first went public it was valued at $1 billion, a fraction of Google's expected valuation. And other Internet titans like Amazon and eBay were valued below Yahoo. That's something to consider if you're thinking of bidding on the IPO.

Those are some of the numbers. The problem is the numbers don't tell the entire story, something Wall Street habitually ignores.

Google's "bread and butter" is its search technology. It has parlayed its superior technology and architecture to such an extent that Google is assuming a place next to Xerox as a verb in the lexicon. To "Google" someone is becoming synonymous with a search for information. Rarified air for any company.

That's the good news. The bad news is they don't profit directly from the search technology. It is a "means to an end" in that it draws users to its site thereby facilitating the sale of advertising. According to the Interactive Advertising Bureau 35% of Internet ad revenue was related to search engines. That's up from 15% in 2002 and sweet music to Google.

Google is almost completely dependent on ad revenues which accounted for 96% of its Q1 revenues. That makes Google more a media company than a technology company.

And consider this: although Google touts more than 150,000 individual advertisers, a major portion of its revenue comes from other large online companies including eBay and Amazon. No single company accounts for a high enough percentage of Google's revenue to require specific disclosure so exact amounts are unknown. However, Piper Jaffrey & Co. estimates eBay spends $100 to $150 million with Google.

Today these relationships are symbiotic. Tomorrow, the likelihood is these online giants will become competitors as each expands services. This will put Google's major accounts revenue stream at risk.

The convergence of services has already begun. Google is diversifying into news and the e-mail business with a product called Gmail. They also plan to enter the online shopping business with Froogle, a service that allows users to compare prices and purchase products from different vendors. This pits them squarely against Amazon and eBay.

Normally companies try to avoid competing with partners. Unfortunately Google has no option but to migrate into the areas currently occupied by some of its customers. The necessity to do this will make sustaining revenue growth a bit more difficult as it stands to lose some existing revenue in the process.

Nonetheless, the real question is how Google will fair in penetrating markets where others have more experience, infrastructure, and perhaps better technology. As of yet, the company hasn't faced this sort of challenge and that means its management team is largely untested.

That will change soon. In addition to needing to wade into uncharted territory, Google's management troika must also prove they know how to navigate the landscape of the media business. Media is not the core competency of the founders or chief executive.

And the media business is tricky. Ask AOL. Advertising revenue can be quite fickle. They are subject to economic fluctuations and ad rates are totally contingent on circulation. In Google's case the "circulation" equates to the number of users visiting its site. To date, that's a base they've been able to rapidly increase.

This is in part due to the company's "purist" approach to online searches. Unlike its competitors, Google's search results are not predicated on whether a company has bought a preferred position. With Google, search results are solely a byproduct of the search methodology not the deep pockets of advertisers. This is great for users but hampers revenues.

Then there's the industry's 800-pound gorilla ? Microsoft, who may be more than a little jealous of Google's growth. What to do? What Microsoft always does - imbed a search engine within the operating system.

Surprise surprise. That's precisely what Microsoft is doing in its next major release of Windows due out in 2005. Note that Microsoft did the exact same thing with its Internet browser. Although the action resulted in the company's antitrust troubles, it virtually strangled the then market leader Netscape.

Microsoft's technology doesn't have to be as good as Google's. It just has to be good enough. The inherent advantage they enjoy from integrating it within the operating system coupled with their ubiquitous presence in the market will garner them millions of users regardless of Google's superiority.

Google's current technical superiority is immaterial anyway. Regardless of how smart its engineering team may, technology leads don't last forever. Both Microsoft and Yahoo have some smart cookies working for them as well. Over time the lead Google enjoys will continually diminish. That is the nature of high tech.

Moreover, keep in mind that the patent on Google's core search technology is due to expire in 2011. So under any circumstances everyone will be on even ground within the next five to seven years.

Management and Corporate Culture

Thus far Google has experienced the easy part of growing a company. It gets much tougher from here on out. Whether its two 30-something academically minded and technically driven founders are up to the challenge is more than questionable.

Investors would be wise to be concerned about the management team. The founders Sergey Brin and Larry Page are idealists who possess no business experience outside of Google. CEO Eric Schmidt has broad industry experience. The problem is his claim to fame is more being in the right place at the right time rather than making meaningfully contributions. All three are PhDs with a technical bent. Not a good thing. Can you say minicomputer industry?

The founders will control roughly 30% of the company. Despite their minority ownership they will maintain control of the company. That's because they plan to issue two classes of stock. The Class "B" stock which they will hold has 10 votes per share. The Class "A" shares that will be issued at the IPO have one vote per share. The saying "I want my cake and eat it too" comes to mind.

Not that the founders are devoid of good ideas. They are thinking and talking long-term. That's refreshingly positive. However, they have publicly stated they won't hesitate to take a flyer on risky bets and some of the company's unique cultural characteristics may become liabilities in the long run.

For example, they allow every employee to spend 20% of their time working on whatever they think will benefit the company. This is a kind of built-in brainstorming capable of generating many viable ideas. Nonetheless, as time goes on, the concept is more likely to cause a decline in productivity than become a source of revenue.

Additionally, the founders along with the CEO plan to make decisions as a committee. I've experienced first hand the perils of that approach. It works great when times are good because few disagreements arise. But when things get rough, it can be a source of paralysis and infighting at the top.

Lastly, going public flat out changes things including a company's culture. The founders naively believe they will be different. They won't be. The newfound millionaire employees who will strolling the hallways will have altered motivations and attitudes. More often than not, this change is not for the better, particularly in a company where an innovative culture has been a large part of its success.

Case in point: I suspect many now wealthy employees may be reluctant to continue to "brainstorm" for Google when the potential of starting their own enterprises becomes more viable.

I hope they succeed in maintaining their cultural differentiation. To do so they must recognize things will change no matter how much they believe they won't. Thus, they must be prepared to adapt the existing culture to accommodate the inevitable changes.

The Bottom Line

Is Google a good investment? Let me preface my answer by saying invest at your own risk. This is my opinion and you alone are totally responsible for your actions. I think I've covered myself legally. With that said I'd say Google may be a decent near-term investment.

I wouldn't touch the IPO with a 10-foot pole. The risk the auction process will bid the stock price beyond its true worth is too high. I'd wait until shortly after the IPO. Odds are there will be a correction. Beyond the initial IPO stage, I'd say the stock will perform well over the next two to three years. After that I don't give them a snowball's chance in hell of maintaining their lofty perch.


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