Google (GOOG) recently announced a significant revision to its search engine algorithm called Knowledge Graph. This modification uses word associations (in a manner similar to the human brain) to enable it to deliver more relevant search results, thereby enhancing its users' search experience.
The change came amidst reports that Google has been losing search market share in the U.S. market - which has long been the bulwark of its profitability - to Microsoft's (MSFT) Bing search engine. Tallies for April 2012 show that Bing now accounts for about 30% of the U.S.'s online web searches, up over 3 percentage points from a year earlier.
Meanwhile, by April of 2012, Google's share of U.S. online queries had fallen by almost 3 ½ percentage points, from close to 68% to around 64.4%. Even beleaguered Yahoo (YHOO) saw a moderate uptick of 1% on its search
This is more significant than it seems: Bing's predecessor, MSN, used to account for just around 9% of the U.S. search market, so it is clear that it has been taking market share away from both Google and (in past years) Yahoo, which used to account for over 20% of U.S. search traffic.
As Microsoft has seen its market share grow, it has gotten bolder. It recently introduced new tweaks to Bing that simplified search results while also integrating Social Network recommendations from Bing users' Facebook (FB) contacts. Ironically, the other change that Microsoft has implemented has been to streamline Bing's search results interface, making it more similar to Google's - perhaps in an attempt to attract loyal Google users.
Despite the inordinate amount of attention on Google's battle with Apple (AAPL) in the smartphone space, Search and Search Network revenues still accounted for 96% of Google's total revenues in the First Quarter of 2012. Indeed, Google CEO Larry Page has said that Android is not critical to Google's strategy, labeling it a delivery vehicle for Google Services - that means search.
While its revenues were 24% higher than a year earlier, it has to be a concern that Google is facing a serious challenge on its home turf. What happens, for example, if Google's share drops by another 6 to 10 percentage points?
Moreover, while Google still controls over 83% of Global search traffic, it could face a serious challenge in the coming years as companies like China's Baidu (BIDU) more forcefully leverage their strengths in their native markets. This cannot be overstated, particularly as the Chinese economy is expected to exceed the U.S. economy by 2016.
Interestingly, Google's lead in the smartphone space, where Android is on over 58% of devices, has been a bit of a poisoned chalice in that it actually earns more from Apple than it does from Android: About $40 per iOS device compared to only $10 per Android device. In fact, Google earned just $550 million from Android between 2008 and 2011.
If Google wants to reinforce its dominance in the search market and sustain its profitability amidst challenges from Microsoft and others, it needs to utilize its own "delivery vehicle" more effectively. It has already begun to do so: The latest edition of Android places a persistent Google search bar on the main user interface, emphasizing the centrality of search to the user experience.
The difficulty of monetizing Android, of course, rests in the fact that it is open source, meaning that Google only earns royalties from its own Android applications like Gmail and Search or the Google Play store, with its paid and advertising-supported apps. This may be why Google is said to have started tweaking its payments system.
With the subsequent outcry from app developers, Google has shifted gears. To wit, it has begun addressing two key concerns by developers who prefer developing for iOS: Android's less-attractive user interface and the seemingly-endless proliferation of Android devices.
Specifically, Google has issued design guidelines for the latest version of Android and has initiated moves to exert greater control over the device market by giving more handset makers early access to the latest editions of Android and sell their devices directly to customers.
I believe that these initiatives are valuable. A large part of the criticism leveled at Android has been that it's "ugly" and that has probably swayed potential Android customers who are intrigued by the larger screens on Android devices but prefer the more attractive and friendly user-interface of the iPhone.
Google is also looking to capitalize on the growth of Web Services in the form of Google Drive, which integrates closely with its popular Google Docs service. Unlike Android and Search, where its incomes are variable, Google has the ability to earn recurring fees from users in the form of premium storage fees on top of the initial free service.
The real potential for Google Drive, however, is in the Enterprise arena. The ubiquity of Google's services should make implementing Google Drive-based services across business segments attractive because of its low cost and the relatively low learning curve.
Even more intriguing is the fact that Google actually earns about $30 from each PC utilizing its search services. Despite the proliferation of smartphones, PC's have an installed base on 1.25Bn worldwide. This may be the reason that Google has gone ahead with its Chrome OS. To the extent that Google can transform PC's into delivery vehicles like smartphones, Google's profits will benefit. Moreover, Google can leverage the potential success of Google Drive and integrate it with Chrome OS, providing enterprises with a viable alternative to Microsoft's traditional dominance in that area.
Google currently trades at a Price-Earnings (P/E) Ratio of 18, compared with 21 for the S&P 500. That suggests that Google is close to being fairly valued. In fact, in comparison to the Tech Sector P/E of 17, it enjoys a bit of a premium.
Google is in the midst of fine-tuning its strategy, tweaking popular products such as Android and incipient services like Drive and Chrome to better complement its search services, which dominate its profits. Google needs to execute with great facility if it hopes to fend off challenges from Microsoft and retain its hegemony in the search hemisphere.
All this considered, I believe Google is fairly valued at current levels and will rise at the same level as the market - meaning that Google may have upside to $680 per share by the end of the year. Anything beyond that should be considered a bonus.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.