Barrons 'Q&A' re Google
By ERIC J. SAVITZ
ONE OF GOOGLE'S MANY UNIQUE BUSINESS practices is its flat-out refusal to provide Wall Street with any help on how to model the company's future financial performance. Google (ticker: GOOG) offers no quarterly or annual earnings guidance and declines to give any details on the direction the business might take in the months and years ahead. As a result, making forecasts about the company's profits -- and stock price -- involve inherent peril.
Last year, for instance, we ran a chart that looked at the attempts of 19 Internet stock analysts to value the stock ("Value Quest," Nov. 29). As it turned out, all of the analysts willing to offer price targets were dramatically too conservative; some were off by 100%. To no small extent, the analysts totally underestimated the rate at which Google's revenues and profits would grow. As the adjacent chart shows, the Street in recent months has had to sharply ratchet up their expectations for the company, providing a springboard for the soaring stock.
Nonetheless, the recent surge in Google's stock price to nearly $300 a share, and a subsequent correction of nearly 8% to about 277, underlines the Street's continued inability to reach any kind of consensus on what Google might be worth -- or even how to go about trying to figure it out. If you're looking for a definitive answer, you're on your own. But before you put pencil to paper, or cursor to spreadsheet, I offer you a few facts, in the form of a question-and-answer session, conducted just 10 minutes away from Google's headquarters, in my cozy Palo Alto office, with myself.
Q: Let's start with some basics. What kind of company is Google, really?
A: Well, Google thinks of itself as a technology company. But from the standpoint of where it generates revenue, it's a media company. Purists argue Google can't be a media company, since it doesn't produce original content. But Google sells ads for a living. So it's a media company.
Q: OK, so how big is Google? And how fast is it growing?
A: In 2004 Google generated total revenue of $3.2 billion; but that includes something called "traffic acquisition costs" -- payments made for Google ads that run on other sites, which anyone who tracks the stock strips out. After TAC, revenues came to $1.96 billion, which was up from $939 million in 2003, $345 million in 2002 and $86 million in 2001. Oh, and by the way, they're hugely profitable: Pro forma profits before stock compensation, the way the Street tracks it, totaled $2.73 a share, up from $1.28 in 2003.
Q: Ancient history. What about 2005?
A: The Street consensus -- it's more an average than a consensus -- calls for revenues this year of about $3.6 billion, with profits of $5.21 a share. And since I know you're going to ask, the 2006 estimates call for revenue of $5 billion and earnings of $6.62 a share. But please keep in mind that the Street doesn't really know anything, since, as I said, Google won't help them with their models -- in Google's first few quarterly reports, estimates have been way too low.
Q: Because there's no guidance.
A: It's more than that, David Edwards, an analyst at American Technology Research, says. "Google is managed in an unconventional manner," he says, " so you can't assume they will do things other companies would do." Edwards notes, for instance, that Wall Street might like to see Google sell ads on its home page -- but it doesn't. "So you have to make double assumptions. You don't know what the company is doing, and you don't know the motivations of management."
Q: Nonetheless, this is a wondrous stock.
A: Indeed. The stock has more than tripled since it came public at 85 in August 2004; for the year to date, the stock is up about 43%, or more than 80.
Q: So what about valuation?
A: Based on 2004 numbers, Google trades for about 40 times revenues and roughly 100 times earnings. Of course, no one uses those numbers. Using 2005 estimates, you get 22 times revenues and 52 times earnings. Things look more reasonable if you use 2006 estimates, which translate to 16 times revenues and 41 times earnings. If there were 2010 estimates, the stock might actually look cheap.
Q: Yeah, right. Let's talk about the market cap.
A: At 277 a share, the stock is worth about $77 billion; when it peaked a little shy of 300 earlier this month, the market cap topped $80 billion, triggering all this hand-wringing about how the stock was now the world's biggest media company, ahead of Time Warner (TWX). (Time Warner last week had a stock-market cap of $78 billion, but it also has $20 billion in debt, so it never really was a fair comparison.)
Q: So what?
A: Google, which barely even existed during the Internet bubble, now ranks as one of the 50 largest U.S.-traded companies by market cap. Last week Google's $77 billion valuation made it almost the exact same size as Abbott Laboratories (ABT), which should do $24 billion in revenues this year, and nearly as big as United Parcel Service
(UPS), which this year should rake in $44 billion in revenue. Time Warner? Figure on $46 billion this year, about 13 times what Google will do.
Q: How about comparing Google with some other media companies?
A: It's a useful exercise, if only because it shows why Google holders might not want the stock viewed as a media company; those companies tend to trade at about twice annual revenues. Tribune (TRB), which should do $5.7 billion in revenue this year, has a market cap of $11.3 billion. Gannett (GCI) has a little higher valuation, $18.5 billion, compared with expected revenues of $7.6 billion. Clear Channel (CCU) gets a lower valuation, a market cap of $16 billion on expected revenues of $9.4 billion.
Q: But Google is growing a lot faster, and so is the market it serves.
A: Certainly true. According to Forrester Research, total U.S. online advertising and marketing spending in 2005 should hit $14.7 billion, up from $12 billion in 2004. (The Internet Advertising Bureau puts the 2004 number at a more conservative $9.6 billion.) By 2010, Forrester predicts, the total should reach $26 billion. So Google trades at about three times the entire domestic addressable market five years out.
Q: What about competition?
A: There's plenty of that. In search, there's Yahoo! (YHOO), of course, and Microsoft (MSFT) and AOL, which is shifting its focus to free sites on the Web, finally. Plus hordes of smaller players and some strong regional players, like Yahoo! Japan.
Q: But Google rules the roost at this point.
A: In search, it certainly does. In the March quarter, Google represented about 50% of total search queries globally, with about 36% of the domestic market and 60% or so internationally, according to comScore Media Metrix. By the way: JMP Securities figures Google already gets about 39% of its gross revenue from outside the U.S., and the figure seems likely to grow.
Q: Let's get down to the nitty-gritty. What's the stock worth?
A: Search me. Lately, the Street has been lifting its price targets to well north of 300; among the highest I spied was the 360 target from Citibank Smith Barney. But before you bet the ranch on the accuracy of that prediction, keep in mind that in November, the same firm was using a price target of 170.
Q: Could it get another $100 higher?
A: Sure. Google has had a habit of blowing away earnings estimates, and as long it keeps doing that, the stock could go a lot higher. But then what? When Henry Blodgett made his famous $400 call on Amazon, the stock got there in a hurry. Now it's 35.
Q: OK, they could beat estimates. But how do they keep up the rapid growth?
A: Google is trying to spread beyond search into display advertising, for one thing. And there's rampant speculation on what else they might do. Ask around, and you get a lot of theories. How about a browser? Or an instant messaging client? Or an electronic payment service to compete with eBay's (EBAY) PayPal? Or maybe they can provide search and targeted ad services for Comcast's (CMCSA) video-on-demand service. Google's not saying, so feel free to speculate. Keep in mind, though, that Google is not the only company that's noticed the opportunity in monetizing search. "If you look 25 years out, it's just endless," says Charlene Li, an analyst with Forrester Research. "But the same is true for MSN, AOL and Yahoo!. Google got off to a flying start in the absence of competition. They'll have to fight for every single incremental increase in
Q: So what could go wrong?
A: Well, the industry could slow down, as it did after the bubble burst. Marianne Wolk, an analyst at Susquehanna Financial, last week trimmed her second-quarter revenue estimate for the company to $832 million from $856 million, after "channel checks" found slower-than-expected growth in Europe, particularly in the travel and financial-services categories. David Edwards, an analyst at American Technology Research, pointed out in a research note earlier this month that the total number of search queries in April fell 7.6% from March. Fathom Online, which tracks prices for key words sold by search engines like Google and Yahoo!, reported that prices in May fell 15% from April, with declines in all major categories other than automotive. TNS Media Intelligence reported just a 4.4% increase in U.S. ad spending in the first quarter, slower growth than in any quarter in 2004. The question is whether any of those things are any more than anomalies. We'll see.
THE BOTTOM LINE
Google may be worth $30 or over $300 a share, but whatever numbers you believe, the stock has a lot more risk and a lot less upside at its current exalted level.
Q: What's the worst case?
A: John Hussman, proprietor of the $1.7 billion Hussman Strategic Growth fund, wrote a column on his Website last week that theorized Google would be more appropriately valued at $30 than $300. "I'm happy to concede that if Google's current revenues and profitability are only the beginning, and can grow at very high rates for very long periods of time, then the stock might be worth $300," he said.
"But my argument is that those assumptions are absurd. Even though the company's free product is very good, it's not defensible in any particularly strong way. In Economics 101, we teach that the only way a company can secure a profit is to have a product that is not only useful, but also kept scarce in the sense of not having constant new entries and competition. And one thing that's certain is that valuing this company at one-fifth the value of General Electric (GE) will draw a lot of very intelligent competition. It's going to be a lot of fun to see how many competitors enter this field in the next couple of years. Nothing draws innovation like this sort of market capitalization."
Q: Hussman sounds a bit radical.
A: He has a point. With a 50% gain, the stock would be about the same size as IBM or Intel. A triple would make it one of the five highest market-cap companies in the world, a tad under Microsoft, which has 10 times as much revenue as Google. The bottom line is, at $80 billion, the risk in Google shares has grown. And the upside ain't what it used to be.