Google, the Wall Street Journal, and dmg

March 2, 2006 2:35 a.m. EST; page A1

URL for this article: http://online.wsj.com/article/SB114122017184586430.html

Engine Knocks
As Google Matures, Investors Take Closer Look at Its Risks
Mixed Signals on Growth Create Tug of War on Stock Among Skeptics, Believers
A Tale of Two Shareholders
By KEVIN J. DELANEY and GREGORY ZUCKERMAN

There is one thing about Google Inc. that investors seem to agree on: Its stock has entered a new era, in which shareholders are looking beyond the Web-search giant's stunning growth and raising questions about its business risks and tight-lipped approach to strategy and earnings.

But that is where the agreement ends, as the divergent bets placed by investors like Chad Brand and David M Gordon show. Mr. Brand and Mr. Gordon each bought Google shares in the months after the company went public in 2004. They both saw wild increases in the value of their stock. But after Google reported on Jan. 31 that fourth-quarter earnings were short of expectations, the two investors came to sharply different conclusions about the prospects for the 21st century's hottest stock.

Mr. Brand, who manages money in St. Louis at his one-man Peridot Capital Management LLC, sold all of his clients' remaining Google holdings early last month for about $400,000, or $400 a share, after the company reported the disappointing earnings. After analyzing the earnings, he decided that "it's a dicey situation in the short term," says the 26-year-old manager.



Mr. Gordon, creator of and writer for, the blog site, The Deipnosophist, placed the opposite bet after examining Google's numbers. Two weeks after Mr. Brand bailed, Mr. Gordon bought 1,000 shares at around $339 a share, adding nearly $340,000 to the few-million dollars of Google stock he already held. "The stock will give Wall Street fits," says the 50-year-old Mr. Gordon, a Las Vegas-based former stock broker who now invests his own money full time. But, he says, "months from now, it will be at $600 to $800 a share and people will say, 'My God, why didn't I buy it back then?' "

The competing forces of investors like these have helped whipsaw Google -- a stock that evokes the wild hopes of the dot-com boom. Even amid Google's current hiccups, few are predicting a dot-com-style bust. Unlike many of the Web upstarts that flamed out starting in 2000, Google has built a real business that generates significant profits.

Still, skeptics are concerned that as the company gets bigger, it can't keep up its torrid growth since going public less than two years ago. The true believers, while acknowledging that growth may slow, think Google has yet to fully realize its potential and have acted as a safety net, swooping in when the price falls and keeping the stock afloat.

As the two camps place their bets, the stock gyrates. It fell sharply early last month after disappointing earnings, and then crept back up. Tuesday brought another selloff, when Chief Financial Officer George Reyes said Google's growth is slowing due to the "law of large numbers" and it will need to find new ways to boost revenue. He added, "I think we have a lot of growth ahead of us. The question is at what rate." Google's stock fell about 13%, then quickly rose, finishing the day down 7%.

Yesterday, the stock edged up $2.18 to $364.80 in composite trading on the Nasdaq Stock Market. A big meeting with analysts today could generate more volatility.

The company declines to comment on the stock moves. "Our primary focus is on making Google more beneficial for users and customers, and on building a world-class company," said a Google spokeswoman. "As a policy, we have no comment on Google's stock performance."

The divide between buyers and sellers is particularly pronounced with Google because the Mountain View, Calif., company has been growing so quickly -- and because its business model and the risks to it remain largely uncharted.

Also adding to investor uncertainty is the company's reluctance to give guidance to analysts seeking to hone revenue and profit forecasts. Google executives say their goal is to manage for the long term and not to attempt to smooth out any quarter-to-quarter bumps in financial results.

Investors largely took that approach in stride until recently. The stock rose from its August 2004 initial public offering price of $85 to above $471 by January. With revenue increasing about 100% each quarter from the year-earlier period, many investors were willing to look past concerns and keep the faith in the stock. Fueling their excitement was the company's clever model for selling ads alongside Web-search results and other online content, which alone generated about $6 billion in revenue for Google last year. Profits also were stellar, with net income of $1.5 billion representing 24% of revenue in 2005.

Messrs. Brand and Gordon, like many investors, hadn't started out with that faith: Each had decided against buying stock in Google's IPO. Mr. Brand, the money manager, was wary about the projected price, which he believed was too high. Mr. Gordon, the individual investor, sat out the IPO because of its unusual online-auction-style format, a factor that also deterred many other investors.

Mr. Gordon jumped in first. He bought shares within a few weeks of the stock's launch, on the belief that Google was a "generational, singular opportunity," he says, to benefit from a "convergence of many once-divergent political, social, cultural and financial trends." Those trends include the rapid digitalization of vast tracts of human knowledge, including detailed information about the human body. Google was trading between $100 and $110 at the time of his purchases. About a month later, Google announced third-quarter 2004 earnings and revenue that far exceeded analysts' consensus forecasts, and investors pushed its price sharply higher, to above $190 by the end of October 2004.

Temporary Swoon

Mr. Brand bought Google shares for his clients in January 2005, when he saw what he viewed as a temporary price swoon. Google's stock had dipped below $180 on fears that selling by employees would damp its rise. Mr. Brand, who started investing his family's money as a teenager and now manages about $10 million from roughly 30 clients through Peridot, believed investors had lost sight of Google's strong growth prospects. The stock looked cheap compared with other Internet companies, he decided, on the basis of price-to-earnings ratios and other valuation measurements.

It proved a good time to buy. The company's fourth-quarter 2004 earnings were another blowout, with profit rising almost eightfold as more advertisers bought Google ads. Big institutions were snapping up the stock, spurring interest by other investors. One key buyer: Lone Pine Capital, an influential hedge fund run by Steve Mandel, which began buying on a large scale in early 2005 and became one of Google's biggest holders. Mr. Mandel's enthusiasm was a green light for other hedge funds to buy Google shares, helping to send them past $200 in early 2005.

Mutual fund giants Fidelity Investments and Capital Research & Management Co. added huge helpings of Google shares to their portfolios in the first half of 2005, helping lift the stock to $300.

By the second half of 2005, a new group of investors joined the party: "momentum" investors, including hedge funds and individual investors, who hoped to catch the wave. Momentum investors try to ride updrafts in stock movements -- sometimes betting less on the fundamentals of a company and more on an extrapolation of possible price increases. Ever sensitive to changes in direction, these investors can exaggerate a stock's volatility.

A buying frenzy developed from September to mid-November, as Google's stock jumped above $400. In January, some of the last skeptics threw in the towel, and the stock hit a peak of $475.11. On Jan. 4, Bear Stearns Cos. analyst Robert Peck increased his rating for Google to "Outperform" from a less enthusiastic "Peer Perform" and raised his 2006 price target for its shares to $550 from $360. "We believe that we have been too conservative in our original models," he and colleagues wrote in a report.

Around this time, Mr. Brand, who had accumulated about $600,000 in Google holdings, began to worry about Google's price. At $467, Google traded at 21 times 2006 sales estimates, Mr. Brand says, which he saw as unsustainable. He sold roughly a quarter of Peridot's holdings in early January at above $460. Mr. Brand wanted to lock in some of his gains, but believed Google still could move higher in the short-term.

Even with the shares touching $475, Mr. Gordon remained a believer. He was convinced most investors didn't understand Google's potential. He compared the search company to a black hole, sucking in the best employee talent and the most advertising dollars, while maintaining lower costs than those of competitors.

Then Google dropped a bombshell. On Jan. 31, it reported fourth-quarter 2005 per-share earnings of $1.54, far short of analysts' consensus estimate of $1.76 when factors such as stock-based compensation are excluded. Google blamed complicated tax-related reasons. "We are very pleased with these results," Chief Executive Eric Schmidt told analysts during a conference call, reminding them that "we take a long-term view of business."

Many investors didn't buy it. Clearly, Google's stock wasn't the sure-fire momentum play it had appeared. Some investors were counting on 30% or more revenue growth from the third quarter, when certain marketing expenses are factored out; Google reported growth of 23% on that basis.

Google's shares plunged more than 16% in after-hours trading to around $360 from $432.66 following the earnings announcement. Suddenly, the company's business prospects -- not the momentum of its stock -- were on investors' minds. International growth was weaker than many anticipated, led by disappointing sales in the United Kingdom. Google had misjudged its annual tax burden, raising doubts about its internal financial forecasting.

Perhaps most importantly, the company had failed to beat analysts' consensus forecast, as it had done each quarter since its IPO. One factor was an increase in sales and marketing expenses, which rose 47% in the fourth quarter of 2005, compared with the third quarter. Some analysts pointed out that interest income on Google's $8 billion cash pile contributed to profits, prompting questions about growth in its core business.

Nothing New

Such concerns hadn't mattered much before. In fact, none were really new. But investors, both skeptics and believers, suddenly began looking at everything. "The old 'In Google We Trust' mentality has dissipated," says Bear Stearns's Mr. Peck. "People are taking a closer look at numbers."

Sitting in Peridot's headquarters, Mr. Brand's home office, the fund manager listened to Google's management discuss earnings. As Google executives talked, he became concerned that short-term profits would be damped by Google investments in new staff and international expansion. His heightened awareness of those concerns led Mr. Brand to cash out of Google entirely. "It just seems there's a lot more risk to banking on all of these other things they're doing," he says.

More investors began to worry about the increasing number of restricted shares and options that Google is handing out to employees. A bearish Feb. 13 article in Barron's added to the dark cloud over the company, asserting that factors such as online fraud and competition would weigh on Google. Barron's and The Wall Street Journal are both published by Dow Jones & Co.

Some began drawing parallels to what happened with other growth stocks, such as Microsoft Corp. and eBay Inc. Those companies also had gone through periods of phenomenal profit growth and could do no wrong in many investors' eyes, before scrutiny grew. Meanwhile, Google and other Internet companies have come under fire in Washington for complying with government censorship in China. And telecommunications carriers are pushing regulators to allow them to charge Internet companies to carry data traffic to consumers.

By Feb. 15, Google shares had fallen to $342.38, 27% off their high. Then, suddenly, the plunge stopped. On Feb. 16, the stock jumped 7% to $366.46. It jumped another 3% to $390.50 on Feb. 27.

While acknowledging new concerns about expenses and other business risks, Google bulls like Mr. Gordon saw reasons to buy more. At their recent low on Feb. 15, he snapped up the additional 1,000 shares. Worries about such factors as competition and growing expenses that others have raised about Google "are all valid risks," Mr. Gordon says. He says he is particularly baffled by Google's misjudging of its 2005 tax rate. "How could they not know that?" asks Mr. Gordon.

Still, after analyzing those concerns, he has concluded that Google shares will continue going up, whatever the short-term fluctuations. Mr. Gordon says he learned to focus on a company's long-term prospects after missing out on big rises in other growth stocks such as Microsoft and Cisco. He believes Google will be a principal beneficiary of shifts in advertising spending and will likely generate other major revenue sources along the way.

The plunge in Google's stock price this week didn't change Mr. Gordon's analysis. Mr. Gordon called the sharp intraday drop in Google shares to $338.51 from $397.54 "incredibly horrifying." But reiterating his long-term view, he says, "I haven't lost my bullishness -- this is Wall Street doing its typical dance."

Like Mr. Gordon, other investors have decided to hold on or buy more. Bill Miller, who runs the big Legg Mason Value Trust mutual fund, bought more than four million Google shares in the IPO, becoming one of the largest shareholders in the company. Yesterday, Mr. Miller said he remained positive on Google's future, saying the company "will grow substantially for many years to come." People close to the matter say Lone Pine remains a big holder.

When Google shares hit $450, some hedge-fund managers, such as Thomas Vincent of New York-based Acero Capital Management LLC, started selling. Mr. Vincent says he sold most of his Google holdings in January. In recent days, he was among those inching back into Google shares.

Mr. Vincent says the market overreacted to the financial chief's comments on Tuesday and that his firm is looking to buy even more shares. All the same, "it's clearly a different environment for the stock," he says. "Ever since the negative reaction to their earnings, anything that comes out of the company will be scrutinized more than ever."