How Google Slips To $100 a Share - And Stays There

Worried lest our last post on this topic (How Google Hits $1000 a Share) might become a Blodget-style self-fulfilling prophecy, here is the other side of the argument. Succinctly, Google (GOOG) is not Microsoft (MSFT).

Microsoft makes all of its money from its operating system and office tools (actually over 100% since its entertainment biz is not yet profitable). These both benefit from the celebrated network effect: for every product sold all existing customers benefit - the more Windows PCs there are, the more programs will be developed for it.

Google makes all of its money from search related advertising (actually over 100% since it gives away lots of software, including the hosting of many blogs, in the hope of revenues to come). But search is not a beneficiary of the network effect and neither are the advertising programs Google inserts. Your search is not easier because other people have searched before you. The amount advertisers pay per keyword is, if anything, higher because of Google's dominance. The service is used because Google built a better mousetrap. But another, better algorithm is just around the corner. Ask.com (IACI) could be to Google as Google was to Yahoo (YHOO), for example. And as Yahoo was to AOL (TWX). Google has not developed sticky applications or given up so much margin that it has economies of scale. The reverse is true. Google's margins are so high, it is easy to see how smaller rivals could come in to its markets. And we would all switch again. Why wouldn't we?

Current search market shares are roughly as follows:

Google........44%
Yahoo.........29%
Microsoft...13%
AOL .............6%
Ask...............5%

Were Google to switch places with Microsoft in these rankings its revenues would fall by at least two-thirds, to $3 billion and its earnings per share to, say, $3. Even with the market growth forecast in our last piece, the stock would find it hard to go north of $100 for some years to come.

GOOG 2-yr chart:

Disclaimer: We have a position in IACI.

Comments

[jbs:]

Over time, generally speaking, competition causes profit margins to contract and revert to the mean. This is why it is important to analyze the competitive advantages of a given company. If there is a sustainable competitive advantage (or economic moat) then a company's margins won't contract as quickly.

Where am I going with this? You said:

"Google's margins are so high, it is easy to see how smaller rivals could come in to its markets."

Google has a competitive advantage (the reason it has high margins), a significant one: technology that was developed by the world's best engineers over several years. Also, their brand provides a competitive advantage, simply because when you say online advertising, I think Google.

So although I agree they have high margins and they will decline over time. They won't decline because of small competitors, but the majors.

2006 Nov 24 04:36 PM

[Eric Bingham:]

What's lost on most analysts is that the vast majority of MSN's user base is generated via MSFT's control of the OS and the ability to make it the default setting on their OEM versions of Internet Explorer. Luckily for MSFT many people have no idea how to change their home page.

Contrast that with GOOG (and YHOO) whose users made conscious decisions to use their services. Who do you think has the more enduring relationship with their users? Whose services were chosen on their merits not because their users were captive?

Anyone who forecasts MSFT overtaking either GOOG or YHOO needs to start by addressing this issue. Just like Zune and its other offerings in competitive (non OS) environments, MSFT has shown clay feet.

GOOG and YHOO have to continue to earn it everyday, but they've shown the ability to compete and this race is theirs to lose, not MSFT's to win.

2006 Nov 24 05:25 PM

[Stan Ross:]

I am thesullster from Motley Fool CAPS and I disagree with you. Disclosure: I do not own GOOG.

2006 Nov 24 06:46 PM

[David Jackson:]

<em>Google's margins are so high, it is easy to see how smaller rivals could come in to its markets.</em> This is a common misnomer about Google that points to one of its remarkable strengths. Google gives away its search service for free, and charges for ads by the search results. But Google doesn't set ad prices. Rather, prices for Google AdWords are set by auction, so advertisers bid for AdWords based on their own ROI. So demand for ads sucks up all the available supply, and Google has most of the supply.

That's why other search engines which offer ads at lower cost (by pricing them inefficiently) haven't impacted Google's business, and why price competition isn't -- and won't be -- an issue for Google. You can't undercut free (for its users), and the advertisers will bid for the supply of ads based on the value to them.

Where Google is susceptible to price competition is in its AdSense business, where it doesn't disclose the share of ad revenue that it gives to small publishers. Another service could come in and give publishers a higher cut of the revenues, and displace Google. But Google's technology is so good, and its roster of advertisers so large, that so far that hasn't been a problem.

2006 Nov 25 12:06 PM

[Chris Kameir:]

I couldn't agree more - Google is moving on very thin ice there: no long term commitment and all revenue is attention driven. It's almost like a rock band: today they are hip and hit the sound the masses like and tomorrow they miss the beat. The one thing they have going for them right now is - definitely of move in the right direction.

2006 Nov 25 01:04 PM

[anton berger:]

About the free searches google provides: lately the answers smell like advertising and they are . Thats a big turnoff for some surfers and they start to look for answers elsewhere. When you want to find relevant answers you have to use googles image search because there the results are without adverts and not reaching the million level. But I must admit google has many bright people that come up with new ideas and new products so they might not loose that much in growth.

2006 Nov 26 08:47 PM

[sam mitter:]

What people dont seem to get is that online advertising is 6-7% of advertising budgets compared to television at 34%. The 20s generation are spending more time on-line at the expense of tv, and thus there is a secular shift to online advertising. The companies that control traffic are the big winners - Google, Yahoo and MSN if they can get their act together

2006 Nov 27 10:10 PM