Is Google due for another plunge?
Google shares could sink 50% if the company falls substantially short of 2006 revenue expectations because of increased competition or fraud by users, Barron's said.
Assuming a 20% drop in this year's projected revenue of one bullish analyst and a 5% drop in expenses, earnings for 2006 would fall 30% short of expectations, the magazine said. Add to that a lower price-to-earnings multiple of around 30, due to slower growth, and shares would be worth $188.
The stock closed at more than $362 on Friday, but dropped 4.4% in midday trading today
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</TD></TR></TBODY></TABLE><TABLE cellSpacing=0 cellPadding=0 width="100%" border=0><TBODY><TR><TD class=greyEleven vAlign=bottom align=left height=20>BARRON'S COVER</TD><TD class=grayverdana10b style="WHITE-SPACE: nowrap" vAlign=bottom align=right>Week of February 13</TD></TR><TR><TD width="100%" colSpan=2>
Google Gets the Gong by Jacqueline Doherty</TD></TR><TR><TD width="100%" colSpan=2 height=8></TD></TR><TR><TD colSpan=2>
Google faces a gaggle of challenges. If it trips on even a few, its stock price could gag still
In the Drink<DATEANDTIMESTAMPWITHBR />
By
JACQUELINE DOHERTY<DATEANDTIMESTAMPWITHBR />
INVESTORS HAVE BEEN FIXATED on
Google the past few weeks, as its shares have tumbled nearly 25% from a peak of $475 -- and the fact is, there could be a lot more tumbling ahead. The share price could well be cut in half over the next year as the Internet giant grapples with growing competition from
Microsoft and
Yahoo!, increased pricing pressures in its online ad sales and mounting concern about what's known as click fraud.
Suffice it to say, there are those who disagree: Fans insist that Google (ticker: GOOG) is headed to $500, maybe even $2,000. But the list of challenges the company faces is nothing short of mind-googling. As if Microsoft weren't enough, the search concern is headed for brawls with content providers like newspaper and book publishers. Phone and cable firms may also join the fray. Google's cost structure, meanwhile, is ballooning, with the company hiring thousands of new workers and mulling projects as far afield as space travel. If Google trips on even a few of the challenges, its earnings could easily disappoint.
To get a sense of what might happen to the stock, we gave one über-bull's 2006 revenue estimate for Google a 20% haircut, trimmed his projected expenses by 5% (but no further, because bulls greatly underestimate Google's costs), deducted stock-based compensation and, generously, gave the company credit for the considerable interest income on its cash. The result: Earnings would be 30% lower than the bull's projection, at $6.28 a share. If the stock were to maintain its current multiple of 41 on those lowered earnings, it would be worth $257. It's more likely the multiple would shrink to as low as 30, in line with the slower growth. That would make the stock worth $188, versus its recent $360.
Though this exercise is less than scientific, it clearly demonstrates two things. First, Google's business has tremendous leverage -- changes in revenue, in either direction, have outsized impacts on the bottom line. That's the result of high profit margins: 88% of net revenue and 58% of gross revenue. Second, the exercise provides a glimpse of the risk posed by a lofty stock multiple.
"Google reminds me very much of what went on in 1999 and 2000," says Fred Hickey, editor of the well-regarded High-Tech Strategist newsletter and a member of the
Barron's Roundtable. "The valuation is insane, relative to what they do."
GOOGLE, BASED IN MOUNTAINVIEW, Calif., has been the hot company of the decade. Anyone with a personal computer knows the virtues of Google's cheery-looking search engine. The company's stock -- which came public in 2004 and then marched above $200, $300 and $400 -- is the stuff of cocktail chatter around the world. Co-founders Sergey Brin and Larry Page, who dreamed up Google seven years ago as computer-science students at Stanford, are now cultural icons with estimated net worths of $11 billion each.
Over the past two years, the company has shot ahead of
Amazon.com (AMZN), Yahoo! (YHOO) and
eBay (EBAY) in terms of sheer growth. Net revenues have increased more than 300% and operating earnings have soared 750%.
Though the company rightfully describes itself as a global technology leader, it makes its money from hawking ads. A full 99% of 2005's $6.14 million of gross revenue was derived from advertising; the other 1% came from licensing its search technology.
Google, which declined to make executives available for this article, profits from advertising in two ways. About 55% of gross revenue is generated when you click on an advertisement on Google's search-result page. Another 44% of gross revenue comes from clicks on ads that appear on Websites that are part of Google's network, hundreds of companies that gain advertisers for their own Websites through Google. Last year, Google kept 21% of the ad revenue from this channel, with the remaining $2.1 billion going to its partners. Google's $4 billion of net revenue excludes payments to Websites in the network.
Without question, the geeky Google guys have built one awesome money machine. The problem is, all the awesomeness is more than reflected in the stock price Barron's Online correctly made that observation when the stock was at $400 three months ago. The observation is still true at $360.
Google now sports a market capitalization of $110 billion, the 18th largest in the U.S. stock market. It is bigger than the likes of Wells Fargo and Coca-Cola. Google's market cap is 27 times its 2005 net revenue of $4 billion and 17 times its $6.53 billion of net revenue estimated for this year. That's almost double the ratio of some of its peers.
The shares also trade at a lofty valuation, relative to earnings. Google earned $5.70 a share in 2005, and that should grow to $8.85 this year and $12.06 in 2007, according to analysts polled by Thomson Financial. While those are heady numbers, they exclude stock-based compensation expenses and include substantial interest income from the company's $8 billion cash hoard. If expected stock-based compensation of $320 million and interest income of $320 million are tax-adjusted and deducted, 2006 estimates shrink to $7.47. Based on the current share price, minus cash of $26 a share, the price-earnings multiple rises to 45.
That's a multiple that the very greatest of technology companies haven't been able to maintain for long. According to FactSet, Microsoft (MSFT) back in 1999 traded with a peak P/E of 68 and a stock price of 58; the multiple is now 23 and the shares are half of what they were back then. Likewise, computer maven
Dell (DELL) sported an 87 multiple in 1999 when its stock traded at 50. Now its multiple is 22 and its stock is 32. These are not companies that disappeared with the dot-com bust. They had strong businesses, but investors' expectations ran far ahead of reality, and growth slowed on an ever-larger base of business.
"Some of those who are euphoric about Google are focused on where the stock is going and not what the company is worth," says Scott Devitt, an analyst at broker Stifel Nicolaus, who rates the shares Hold. He thinks the stock is worth $400 in 12 months and would be an aggressive buyer if it fell to 314.
Google has been operating right in the sweet spot of the advertising world: ads placed on Internet searches. U.S. advertising in old-line media -- TV, radio and publications -- grew by just 4% last year to $265 billion, but Internet advertising surged by 34%, to about $13 billion, according to estimates by research firm eMarketer. And within Internet advertising, search advertising has been the fastest growing niche. It increased 42% in '05, and it's expected to grow by about 43% annually for the next four years, says eMarketer.
Advertisers like the targeted nature of search ads, which appear on Google's search-results pages with the label "sponsored links." They also like the ability to measure the results of the ads, seeing just how many people clicked them. Google has boosted its share of the segment to 40%, versus Yahoo's 30%, according to consulting firm comScore Networks.
The massive shift of dollars into search advertising helps explain why analysts expect Google to post high net revenue growth -- 63% this year and 40% in 2007, according to Thomson Financial. But those estimates may be ignoring a number of potential developments in the industry that could clip growth rates.
COMPETITION IS GETTING FIERCE. Over the next year, both Yahoo! and Microsoft's MSN portal are expected to improve their search offerings. In the second half of this year, Yahoo! hopes to improve its systems so that search-engine ads are more relevant to search results and therefore more likely to be clicked.
Microsoft, for its part, plans to introduce Windows Live Search, which will allow users to search across the Web, their desktops and their mobile devices, getting "fast access to real answers rather than hundreds of pages with thousands of links," according to Microsoft. It also is launching adCenter, allowing advertisers to come directly to Microsoft to place their ads on MSN and its searches instead of having to go through Yahoo!.
Last week, news came out that Amazon.com has jumped into the game through its network of "associates" -- Websites that have links to Amazon and receive fees when readers click the links and buy products. Amazon is offering to place ads from a third party on affiliates' sites; Amazon and the affiliates would then split the revenue generated by clicks on the third-party ads.
"Google is focused on one area. They're great at it, but the competition is mounting," warns Scott Kessler, an equity analyst at Standard & Poor's. He has a Sell recommendation on the stock and a 390 target.
There's also the threat someone will come along and change the rules of the game. Microsoft Chairman Bill Gates in a presentation in India reportedly discussed the idea of sharing the ad revenue generated by searches on MSN with the people conducting the searches. It's something Amazon.com already has started, by offering regular users of its search site, A9.com, 1.57% off of "virtually" all purchases at Amazon.com.
Certainly, prices paid for search advertising could take a fall. The market, in fact, has many of the earmarks of a bubble waiting to be popped.
To get an ad placed on Google or on its network, advertisers continually bid in an auction of key words or phrases used in searches. Google chooses to use the ad that has the best combination of high bid and relevance to searchers. The winner gets to show its ad prominently on the search-results page that pops up when someone types the key word into the search engine. The ad could also pop up on a Google partner Website, and the advertiser pays every time it gets clicked. The prices paid for advertising literally change every second and are entirely at the whim of the market.
"You have a frenzy for ad words that could disappear," warns Hickey. And that makes him unwilling even to take a stab at what Google's revenues will be or what the stock is worth.
A key phrase like "charity car donation" cost advertisers $35 per click in November, according to the word-tracker AdsenseHeaven.com. The phrase "home equity loan online" went for $27.89 and "mesothelioma attorneys" -- essential for an asbestos lawsuit -- went for $16.46.
Those popular phrases are much more expensive than the average word. A key-word price index calculated by marketing firm Fathom Online came in at $1.43 in December, up 4% from when the index was started in October 2004 but down from a peak of $1.93 in April. Some other market trackers, however, say they haven't seen a decline.
Key-word prices are coming under some pressure as consumers have become more sophisticated searchers and use more varied or specific words to search. That has increased the inventory of words to bid on just as the number of places for ads to appear has increased. Despite those pressures, the search industry's revenues have continued to climb because the number of searches conducted on the Internet has risen rapidly -- up 55% last year alone, according to Nielsen/NetRatings.
THE LOFTY PRICES FOR COVETED WORDS already have prompted some large advertisers to scale back. Flower giant
FTD Group (FTD) recently complained about the high price of search advertising. "During the Christmas season, certain online search engine costs increased significantly over the prior year, and as such we made the decision not to pursue the resulting high-cost order volume," said Michael Soenen, chief executive officer.
FTD's move was spotted by none other than Henry Blodget, the scorned Wall Street analyst who famously predicted Amazon.com would more than double to $400 while the tech bubble was still inflating. He reported the move on his Internetoutsider.com while laying out a bear scenario for Google. If it plays out, he wrote, the stock could crumble to $100.
A number of other companies, including eBay,
Priceline (PCLN) and Travelocity, owned by
Sabre Holdings (TSG), have mentioned "an unsustainable level of spending" on search advertising, says Devitt of Stifel Nicolaus, citing transcripts of company presentations.
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