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Introduction

Google (GOOG) is the world's second biggest technology company by value and has a dominant position in some key technology markets such as search, internet advertising and mobile operating system. The company is a colossus of the Internet world and can make or break many enterprises in the world today through its sheer power and reach. In fact most of the Internet revenue models are becoming increasingly dependent on Google's network. Most Internet companies and websites would give an arm and a leg for a top listing on Google search results for popular keywords. Unlike other big technology companies such as Microsoft (MSFT), Google has not stagnated but has continued to innovate and bring out great new products and services (Gmail, Android, Google Maps etc.). While there has been criticism about Google's excess dependence on search for revenues and profits, the market is giving a high valuation to Google because the company's new products have a lot of potential. While Google's stock is currently trading at a higher valuation compared to other mega cap tech companies such as Apple (AAPL), Intel (INTC), Cisco (CSCO), we remain convinced of Google's long term growth potential.

1. Competition

  • Microsoft - Google's biggest competitor in the technology industry is the Seattle behemoth Microsoft. The company fights with MSFT in a number of areas such as search, operating systems, email, office productivity software etc. Google has a stranglehold in the tablet and mobile operating system market with Android. To counter this, MSFT has made the latest Window 8 operating system more mobile and tablet friendly. Microsoft is also making a strong effort to retrieve its numero uno position in email by introducing features that gmail does not have, such as ability to send large file sizes. MSFT has spent billions of dollars to improve Bing's technology and acceptability, but the company has not managed to significantly slow down Google's strong double digit growth.
  • Apple - The company has become a bitter rival from a partner in the last few years. Google's Android operating system directly threatens Apple's iPhone smartphone ecosystem by giving a well supported decent operating system for free to hardware vendors. The erstwhile CEO Steve Jobs spoke of a "thermonuclear war" against Google. Apple recently introduced its own maps application replacing the popular Google Maps. Apple is also trying to reduce Google's search dominance through the Siri application.
  • Nokia - Nokia has become another strong competitor to Google after the company joined the MSFT camp ditching its own Symbian operating system. The biggest risk that Nokia faces in regaining its lost market share is from Android mobile phone makers.
  • Samsung - While Samsung is a partner to Google currently, we think that Samsung will become a strong competitor soon. The reason is Google's acquisition of mobile hardware vendor Motorola. Google has already become both a partner and a competitor. Samsung being the No.1 mobile phone supplier will have to reduce its Android dependence either by selling more Windows handsets or by making its own O/S (Tizen).
  • Facebook - Facebook is Google's biggest threat in the Internet advertising space. Facebook gets a huge amount of Internet traffic and is desperately trying to monetize this traffic through various means. The company recently introduced an internet search product which competes with Google Search.
  • Yahoo - Yahoo is no longer one of Google's major competitors given its reduced size and ability. Yahoo search and internet properties are not much of a threat to Google. In fact Yahoo recently signed a display advertising agreement with Google to better monetize its existing display properties.
  • Blackberry - The iconic Canadian smartphone company has been massacred by Android and Apple in its core smartphone market. The company is trying to make a comeback with a revamped operating system BB 10. We are not sure how much BB 10 and the new smartphones will succeed. We think it will be difficult for BBRY to regain its lost market share without the help of a stronger company. BBRY can pose a big threat to Google if it is bought and leveraged by one of the big technology companies such as Samsung.

Google also has many more competitors such as Baidu (BIDU) etc. In summary, Google faces formidable competitors in almost all areas. However, Google has a history of fighting strong competition against all odds.

2. Regulatory Pressures - As Google becomes a bigger information power, it is colliding with global governments on how information is collected and disseminated. The company was recently forced to succumb to French government pressure on posting of links of French newspaper articles on its Google News. The company was also driven from China, as the government there likes to be in total control over information flow. The company has been subject of an FTC investigation over unduly favoring its own products when displaying Google search results. Microsoft used to be the target of strong government regulation in the past because of the power of its Windows operating system. Google is now facing the same situation due to the dominance of its search product.

3. Don't be Evil - Google has always advocated that it won't become a large big "evil" corporation however in recent days the company is not exactly living up to its stated principles. The company has come under attack for revealing information to the government agencies. The company has also attracted heavy fines for breaking into Wi-fi networks during collection of data for Street View. The company has become too strong in the Internet advertising market and its difficult to find decent alternatives to Google's adsense network. Google recently stopped sharing private search referral data with external websites, though the company's own Adword network has access to this private search data. The company has the power of death over small businesses and websites. Google's new algorithm changes (Panda and Penguin) have led to a huge traffic loss for many websites which used to follow SEO techniques. While these initiatives are not wrong as they have helped in reducing SEO spam, this shows the power that Google has over others. Google is also promoting its own social network Google Plus by giving higher rankings to search results which are linked to Google Plus authors. Small players in the Internet world have no redressal mechanism against undue display of Google power.

4. Privacy Issues - Facebook has faced huge attacks from users whenever it has introduced monetization measures based on the private user data. I have found that a number of Google users have also started getting irritated by targeted ads based on personal data. The aggressive promotion of Google Plus and other Google products is also not very customer friendly in my view.

5. Motorola - Google bought Motorola for more than $12 billion in order to protect its Android operating system from patent lawsuits by other telecom companies. Despite restructuring, Motorola is still showing operating losses. Also Motorola will make other Android users such as LG and Samsung doubt Google's impartiality.

Valuation

Google's valuation is not expensive if you use traditional metrics with a forward P/E of ~16x. The P/S of 5.1x and P/B of 3.6x is also not exorbitant. However if you compare Google's valuation with that of mega cap technology plays then it is quite expensive. You can buy most of the other technology companies at a P/E of ~10x. The reason for the higher valuation is that the market is factoring in Google's higher future growth rate.

Summary

Google has a great portfolio of new products and services which has led to the stock touching all time new highs. The market has started to recognize the strong earnings potential of Youtube, Android etc. Also despite numerous attempts by competitors to break Google's stranglehold on Internet search, the company has managed to grow earnings and revenue in the high double digits. The competition for Google remains high across all product segments and the company faces increased challenges due to its greater size. However, Google has managed to overcome competition quite effectively in the past and we believe it will do in the future as well. As the stock has run up quite a bit in recent days, we would look to buy on dips.

Source: Google: Analyzing The Downside Risks