The Kelly Letter bought shares of Google (NASDAQ:GOOG) in the midst of the subprime financial crisis at an average cost basis of $407. They rose to a high this year of $630 on January 4, fell to a low of $434 on July 6, and closed Friday at $500. I listed GOOG as one of the letter’s best buys from May 23 until now, a period that included share prices between the $434 low and Thursday’s $509 high. Now that GOOG is back over $500, I’ve removed it from the short list of best buys.
That’s due to valuation, however, not a lack of faith in Google’s future. I want to revisit the case for Google, having read and heard a great deal of skepticism about the company’s prospects as it competes with Apple (NASDAQ:AAPL) and Microsoft (NASDAQ:MSFT) in the hunt for online profits.
The bearish case against Google is well presented in the August 16 edition of Fortune magazine, which sports the unsubtle cover title, “Is Google Over?” with a picture of the letters in Google’s name melting into a puddle of their individual colors. The article by Michael V. Copeland and Seth Weintraub begins with the teaser:
Yes, the company is still growing at rates that would be the envy of the rest of the Fortune 500. But its core business is slowing, its stock is down, its Android mobil platform generates scant revenue, and competition (hello, Facebook) is fierce. Can Google find its footing in this brave new world?
The article contends that a classic innovator’s dilemma confronts Google, and “the company seems unsure about how to move beyond the core search business that has brought it such massive success.” That success is to the tune of $23 billion per year in revenue, 91% of which comes from the AdWords and AdSense business model built around Google’s PageRank algorithm. “Even more telling,” the authors point out, “an estimated 99% of its profit does too.”
With 99% of its profit coming from search, Google looks vulnerable to an evolving internet that might not value search as much as it does other activities. The authors offer this example:
Say you want to buy running shoes to train for a marathon. Five years ago you would have simply Googled it, looked at the list of results, weighed your options, and made the purchase, perhaps by clicking on one of the sponsored links that accompanied your search. Today you might still do that, but increasingly you might pose the question “What running shoes should I buy?” to your friends on Facebook, or maybe write “Who knows about training for marathons?” on Twitter. By the time shopping service Groupon sends you (and 25 of your friends) an offer for the perfect shoes and registration for a race, you’ll probably just pounce on it.
They also tell the story of one James Buck, an American graduate student who was arrested in Egypt for taking photos of a protest near Cairo. He typed only the word “arrested” into his Twitter account via cell phone, and his network of people contacted officials at the University of California at Berkeley, who involved the US State Department and a local lawyer to get Buck out of jail within 24 hours. “Try that with a keyword search,” the authors quip, and contend, “This is the phenomenon Google is up against.”
Those two examples form the crux of the article’s argument that search isn’t what it used to be and, therefore, Google will need new business lines to grow. The growth of the internet itself is not enough to grow Google’s search business because search isn’t a core part of the new internet.
I disagree. The examples offered are fundamentally flawed.
In the first, we see a different way to gather information but not one that displaces initial search. While we may turn to our various online networks for personal advice on which shoes or other products to buy, where will the friends offering advice get their information? Somebody had to do initial research to whittle down the list of offerings in each category. They could always go to the source directly, such as a consumer website that specializes in product reviews, but a Google search remains the best way to get a list of such sources. Some people will have walked into physical stores to perform comparisons, but that option existed since long before Google took over the internet search industry.
So, research still needs to happen even when many people get their information via word-of-mouth, or word-of-fingertip (typing) as the case may be these days. When you merely utter the word “research” anymore, it’s tantamount to planning to Google something, be it shoes, or restaurants, or the history of space exploration. Moreover, somebody fishing for tips from friends rather than Googling their own information is assuming that those friends have already done worthwhile research which, as I just pointed out, probably included Googling as part of an in-depth effort.
In the second example involving the arrest of James Buck, we find a straw man. At no point in history was a Google keyword search the preferred way to get out of jail. Had Buck not found access to his Twitter account, he could just as easily have emailed a friend in California or called them. The State Department responds to phone calls as well and, by the way, automatically sends a consular to visit any American arrested abroad. They even provide a manual in English on how best to proceed in the arresting country’s legal system, and basic legal advice. I know this after an incident left me wiser and leaner at the end of an 11-day stay in a foreign hoosegow, and more familiar with a jail system than I thought I’d ever be.
For anybody who has not been through such a firsthand experience abroad, details await at the end of a Google search on “assistance to US citizens arrested abroad” and a click to the travel.state.gov page that comes up as the first result. Maybe James Buck could have saved his network of friends the trouble of “rescuing” him by running that lowly keyword search from his cell phone. He may have quickly noticed that Article 36(b) of the Vienna Convention on Consular Relations “provides that the foreign authorities shall inform the consular officer of the arrest of a national ‘without delay’ if the national requests such notification.” Most local authorities will ask the arrested subject if he or she would like them to submit such notification, which is why doing nothing would likely have produced the same result as James Buck’s now famous one-word tweet.
Thus, I reject entirely the argument that search is no longer a key part of the online experience. Social networking is great, but it did not supplant the need for somebody to research which running shoes are best for a marathon nor did it get James Buck out of an Egyptian prison. Google still plays a role in finding the right shoes, and the State Department needed neither Google nor Twitter to receive word that James Buck had been arrested and required a consular visit.
If the argument that search no longer matters falls flat, then the case against Google becomes unconvincing. It owns search, as the Fortune article points out: “Google sites lead the US market with 64% of all searches conducted.” If that can grow or even stay constant, then the growth of the internet should produce more search activity that turns into more revenue for Google.
As for it being a vulnerable one-trick pony, most great companies are exactly that. It’s di-worsification that usually causes problems. For instance, it doesn’t seem to bother anybody that Coca-Cola (NYSE:KO) makes 100% of its profit selling drinks, that Exxon Mobil (NYSE:XOM) makes 100% of its profit selling oil and gas, or that McDonald’s (NYSE:MCD) makes 100% of its profit selling food. That’s what they do, and they do it better than most. Online search is what Google does, and it does it better than most.
All of Google’s other efforts are aimed at growing its search business, and that’s fine. The Fortune article mentions Google’s budding sub-businesses such as Android, DoubleClick for multimedia ads, Google Apps for Enterprise, Google Me (a planned social service to compete with Facebook), and YouTube. To downplay the impact that these and other non-core initiatives will have on Google’s bottom line, the article quotes Caris & Co. internet and software analyst Sandeep Aggarwal as predicting that they’ll total just $5 to $8 billion in 2013, which is peanuts compared to the $40 billion that Aggarwal estimates search will produce in three years.
While the Fortune writers see in that statement small numbers from the non-core businesses, I can’t help but notice the projected 74% growth in core search revenue on top of the new $5 to $8 billion from non-core business lines. Let’s take the middle of the non-core projected revenue range, $6.5 billion, and add it to the $40 billion in core search revenue to get total revenue in 2013 of $46.5 billion. Going from $23 billion now to $46.5 billion in three years doesn’t look like cause for concern, does it? I wish I could double my business revenue every three years.
Other sources show Google’s current revenue being $26 billion rather than the $23 billion used in the Fortune article, but the growth rate to $46.5 billion remains impressive from anywhere below $30 billion.
Finally, the article implies that Facebook advertising is going to prove more valuable to some advertisers than Google’s various forms of advertising. Real world results, however, give the nod to Google. As long as three years ago, advertising analysts found that Facebook’s way of advertising by targeting user interests was not as effective as Google’s way of targeting user behavior. The former relies on what people say while the latter relies on what people do. We should all know by now that actions speak louder than words.
The following is from a test run in October 2007 by AU Interactive writer Markus Urban:
Comparing every single metric, Google AdWords visitors were far more engaged, far more valuable, and far better targeted. The traffic was cheaper and more consistent. The volume was far higher.
It’s not even close. Facebook ads just don’t work.
And for all the hype that it’s gotten, it’s not even in the same ballpark as Google’s AdWords. Not even the same league. While targeting users by their listed interests may sound promising, it’s just not very effective.
More recent comparisons I’ve seen (by Googling the topic, incidentally) have shown Facebook narrowing the gap, but not closing it. It seems that knowing a person’s identity is less important than knowing what they’re looking for right now. For example, will my sister have better luck getting customers to Red Frog Coffee by targeting 30-year-old women within a 50-mile radius of the shop who identify “coffee shops” as an interest of theirs, or by targeting anybody searching on the phrase “coffee shop” within that same 50-mile radius? Probably the latter, because it allows flexibility for any demographic, for people who are traveling through the geographic zone instead of just those living there, and specifically people who are looking for coffee shops in the area. Advantage: Google.
I’m sure results from both advertising platforms vary based on a number of factors, so there’s no doubt that an increasingly popular Facebook and its ever-improving advertising platform are a challenge for Google, but they’re almost assuredly not a game ending development for the search giant.
Google has a history of surprising entrenched competitors with innovation. The search market itself was well established when Google came on the scene with its minimalist search box. I remember those days. I was one of the early users, and loved showing people stuck on Yahoo (NASDAQ:YHOO) a new way to search. Since then, Google has managed to outflank installed software companies, such as Microsoft, with its excellent Google Docs system, and even browser makers with its unsurpassed Google Chrome browser that is both faster and more elegant than any other offering.
Should that innovation turn itself to social networking online, Google could open up a very profitable new business line. The Fortune article concedes that, too. In the concluding paragraph, we read that if Google added a “social layer to its core search business and to Android, and blew it out on YouTube, giving people a reason to hang out on Google sites for long periods,” advertisers “would come flocking” and Google would become “unstoppable.”
To that, I’d like to add that Google is up to something more with its Chromium project than just pumping out the world’s best internet browser. I’ve contended for some time now that all of Google’s endeavors seem to be heading toward a grand unified offering that could finally present a real challenge to the operating system duopoly of Microsoft and Apple. Those parts are essentially in place now, and Google is in the final stages of pulling them together when it rolls out the Chromium OS this fall. There’s a nice three-minute video on the OS at YouTube that shows how most of what we do on a computer involves the internet anyway, so we should reorient the OS to emphasize the internet.
Once that rolls out, it could be a compelling alternative to existing operating systems. Computer makers could bundle it for free, greatly helping their margins. Computer buyers would be able to get online within seconds of powering up their machines and access all of their online services, which comprise the bulk of what they’re doing with computers now anyway. What would they use? Anything they wanted, but probably a lot of what Google offers: Gmail, GDocs, Google Apps, Google Earth, YouTube, Google Buzz, Google Maps, Google Me social networking, and so on. What does Google hope to get out of this free giveaway? More people online to generate more ad revenue.
All in all, I don’t see much of a problem in Google’s future. Even if it maintains its current hold on search, the mere growth of the internet will see its revenue advance smartly. If it does a few things right to grow search, its revenue will improve all the faster. If it proves clever with its many new lines of business, they should add a decent chunk to overall revenue as well. If all of this adds up to a doubling of sales in the coming three years, current shareholders will be happy.
That’s why we’ll hold.
Disclosure: Author long GOOG