An Upside and Downside Scenario for Google

Nov.19.10 | About: Alphabet Inc. (GOOG)

Google (NASDAQ:GOOG) competes with Yahoo (NASDAQ:YHOO), Microsoft (NASDAQ:MSFT) and AOL (NYSE:AOL) in search and has gobbled up market share in recent years, from 61% in 2007 to 68% in 2010, mainly at Yahoo’s expense. Yahoo’s share fell from 14% to 6.4% in the same time period.

We estimate that Google’s Search business accounts for 71% of the $632 Trefis price estimate for Google’s stock, which is about 7% above the current market price.

Below we look at potential upside and downside scenarios for Google that focus on two of the most sensitive drivers to its share price – market share and traffic acquisition costs.

-10% Downside – Market Share Loss

Microsoft has started to aggressively tap into the search market, and Bing gained share from 2.9% in 2008 to an expected 3.3% in 2010.[1] In the US, Bing has an expected share of around 13% for 2010.

Microsoft has partnered with Yahoo and Facebook in efforts to provide better search capabilities. Its deal with Yahoo is a 10-year contract that gives Microsoft access to all Yahoo searches. This enables Bing to yield better search results and offer a more robust alternative to Google

Facebook makes searches more personalized. For example, when a user is searching for a movie on Bing, he sees results that include how many Facebook friends “liked” the movie. Such results can extend to news articles, books, restaurants, music and a variety of other products.

This partnership can provide Bing with an advantage over Google if the feature is well received by users and leads to greater use of Bing at the expense of Google.

There could be a downside of 10% to the Trefis price estimate if Google’s market share declines to 2007 levels of 61%.

+5% Upside – Profit Margins Higher on Lower TAC

We currently forecast Google Search EBITDA margin (a profit margin measure) to increase from about 49% in 2010 to nearly 53% by the end of the Trefis forecast period.

Google’s main operating cost component is the traffic acquisition cost (TAC). The TAC as a % of revenues has gone down for the past few years (from 30% in 2007 to 27% in 2009).[2] This most likely comes from Google having more negotiating leverage with network sites that it pays for search results and scale gains from that allow it reach smaller sites. As its scale grows, its more difficult for Yahoo or Bing to bid against or reach the same audience.

If Google can further control this cost component, its margins can go up at a fast pace. There could be an upside of 5% to our price estimate if its margins go up to 57% by the end of Trefis forecast period.

Notes:

  1. Comscore report: July 2009. Comscore report: Dec 2009
  2. Data provided in SEC filings

Disclosure: No position