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

[bobbyjoe]

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.

[AndrewMelcher]

Why Google really has a network

Anybody can build a search engine. And anybody can take a pen and draw a crude map of the world in a few minutes. But guess what? The most precise free map/ search engine of the Internet gets most of the queries. And the search company with the highest viewership makes more profits and can afford a higher level of search engine improvement. Google has the leading search map now, and can profitably spend the most money on map improvement.

But this virtuous cycle of search engine development and financing only points to a high barrier to entry for the paid search business -- It does not explain why Google’s search network is probably invincible. Google’s invincibility stems from its market share of humans doing searches.

In other words, the biggest network of roving software robots only finds the biggest set of possibly valid websites for your search. And improved indexing algorithms only give a preliminary machine-based preference for these search returns. It is ultimately the gleaned preferences of the humans that have gone before you that give human meaning to the robot searches. Without the human network, the robot index is still only as smart as a bunch of dumb computers. That is to say, it is easily tricked by cleaver humans.

The human user network lets Google understand among other things, which search results are the last ones that people click on (ie. The human found what it was looking for). The search network with the most humans searching gets the most accurate search returns in human terms -- And the search engine with the most humanly accurate search returns maintains its dominance.

Some people argue that a breakthrough method of obtaining greater statistical accuracy with half of the sample size would unseat Google. They argue that Yahoo may find some way to obtain as much search accuracy from a particular search by 50,000 customers as Google generates from 100,000.

With large sample sizes, the idea is at least theoretically possible. If we compare this situation to a public opinion survey, the difference in survey methodology could easily matter far more than increasing the sample size from 50,000 to 100,000. However, this idea falls apart when only say 2 people undertake highly specific searches in that particular day. With small samples, the methodology (within reason) is less critical than the sample size. And perhaps half of all searches could be considered small sample size searches.

If Google has seen 2 people searching for something, Yahoo with its 2nd place market share might not have had any customers at all doing that search. And Yahoo might not be able to draw any up to the minute customer inference, no matter how many thousands of pages of websites Yahoo’s robots turn up.

In order to make any serious headway in search, Yahoo and MSN must stop losing human market share and start gaining it. And in order to do that, Yahoo and MSN must prove to the public that they are not merely equal to Google, but superior. And they must now do so while overcoming the handicap of a smaller human user network to sample and base their search returns on. Absent that miracle, Google will simply continue to return more accurate search returns, and its reputation will continue to spread. Eventually, even the folks who barely know the difference between an email address and URL will know of Google’s superiority. That point will be the end of the other search engines. There is only room for one dominant search engine... a machine that measures human intentions just like there can only be one consciousness in a person and one common language to among people.

[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.

[Stan Ross]

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

[DavidJackson]

<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.

[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.

[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.

[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