Buying Google, All the Way Down

On Monday, I bought some more Google (and some more Apple). I explained my rationale for both trades in this twitter post. I went into even more detail on the Google purchase in this Covestor post.

I was busy yesterday and not paying attention to Techmeme, the stock market, or my portfolio (always a bad idea), and saw this twitter post by Christopher Finke:

Being glad that I didn't buy GOOG like @fredwilson did. Down 36 points so far today.

Down 36 day one, ugh. Typical trade for me. The way to make money in the stock market is to sell to me or buy from me. I am not kidding.

So last night, while watching the debate, I spent some time on Techmeme making sense of the Google news. Turns out comScore, a company I am on the board of, released some numbers on Google's paid click growth, or lack thereof. Comscore data shows that the number of paid clicks on Google's network was flat December to January. For a company that has been growing like a weed for years, a flat month is never good news.

So am I concerned? Did I just buy a stock that is going to be cut in half in the coming months?

Who knows? The market is going to do what it's going to do. But I stick by my Covestor post. I like to think of stocks as proxies for buying companies. If someone was willing to hand you all of Google in return for paying them the next 10 years of its cash flow, would you do that? I would, for sure. (That's a theoretical exercise of course, as not many people can just show up with $150bn.)

I did a back of the envelope calculation that says if Google grows its operating cash flow at 15% per year for the next 10 years, then at today's price, you can own the company for the next 10 years of cash flow.

Well, what if paid search doesn't grow any more? First, I don't think paid search has suddenly stopped growing. It's growth is slowing for sure, driven by multiple factors. I don't think a slowing economy is one of them because in a tough economy, marketers move marketing dollars to high ROI channels like paid search. I do think many keywords have been bid up to a price that it's hard to get an ROI on them. And I do think Google is cracking down on click fraud, which is showing up in the total number of paid clicks. And that's a very good thing in the long run.

But the bigger story on Google is that it has been a one trick pony for years. Everything that Google does is paid for by its paid search business. In the fourth quarter, Google generated $2.9bn of gross profit (gross margin) and $1.7bn of operating cash flow. That means it spent $1.2bn on operating expenses. I bet that only $200-300mm of those operating expenses had anything to do with paid search. So if that's true (and it's a wild eyed guess), then Google is spending close to a billion dollars a quarter on stuff that is not producing revenue right now.

Do you think that stuff will never produce revenue for Google? Maps and other local services are going to be a huge revenue stream at some point for Google. Same with Google Apps, which is slowly but surely becoming a better alternative to Microsoft Office, a franchise that spits out billions of dollars of cash flow to Microsoft right now. I could name a few more lines of business at Google that today are total cost centers, but will not always be.

It's hard to figure out how to value these opportunities - so Wall Street doesn't. But that doesn't mean we shouldn't. If Google drops in half from today's prices, I'll be buying it all the way down.

Disclosure: Long GOOG

Comments

[Tom B:]

No one wants to "catch a falling knife", but sometimes investing requires courage. Advertising will rebound, probably this year, and GOOG owns advertising-- no competition. MSFT and others' efforts have been laughable and will remain so barring new, undisclosed strategies. I'm buying more GOOG.

2008 Feb 27 09:20 AM

[Vikram Saxena:]

Nice post especially about the port of advertiser behavior during a slowdown. In a slowdown revenues are more important than margins and the ad spending will focus on channels which result in short term revenues. And there is nothing like a paid search click when it comes to converting ad dollars to revenue. There is a reason why the keywords are being bid up. advertisers are not that stupid.

2008 Feb 27 09:23 AM

[win:]

Fred,
Thanks for your perspective. Google Apps are going against a well-entrenched competitor, so it will be difficult. As yet, in my circle, people haven't substituted Google docs for the MS Office package. My admin (young person) tried to get us on Google docs, but there was resistance from the company techie. Do you see the beginning of a trend? I'm curious - other people?
-Nitin

2008 Feb 27 09:24 AM

[Psycho:]

Buy at the sound of tunders. Sell at the sound of violins.
Thats the rule.

2008 Feb 27 09:53 AM

[Tom B:]

"My admin (young person) tried to get us on Google docs, but there was resistance from the company techie. "

IT: the "Department of "NO".

2008 Feb 27 09:59 AM

[tessant:]

if your time horizon is over 6-12 months, buying here is fine.

scott
growthportfolio

2008 Feb 27 10:01 AM

[Vladimir Se...:]

I don't think it's fair to say that "wall street doesn't [value those opportunities]". When Google IPOed i and many other skeptics didn't think it was even worth $100, because at that point many of those things didn't exist and it looked like Google was just going to be another online ad company.
I couldn't have known back then or perhaps could but in any case didn't that Google will become another Microsoft, just as strong and almost as scary. So today knowing that I have to admit that Google is worth much more than $100. So here you go, I value those opportunities. But like you said, it's difficult to put an exact dollar amount on many of these. Particularly because most of that stuff is free to be consumed at the moment. I use many Google services myself because they are the best in many areas, but if Google started to charge for them I'd settle for 2nd best if that was freely available. Will Google never start charging for that stuff? I hope so. Why? Giving out free stuff is a great way to create what exactly? GREAT AD REVENUE STREAM! So you can't exactly say that "all that stuff has nothing to do with advertising".

2008 Feb 27 10:01 AM

[just.a.guy:]

I remember last time there was a recession (2001-2002) and online ad spending quickly dumped 20%. This was in the face of a long-term macro trend of runaway growth in online ad spending. Yahoo! was sliced and diced valuation-wise in the process.

There is some chance things are different here. Maybe because of CPC and advertising accountability, or maybe because of today's 80% penetration of broadband in the US (market size catching market hype). But I don't think so.

I also don't buy into the diversification of their business model. That was the same story with Yahoo! It was the same story with Microsoft and msn (which took what, a decade plus to become profitable?)

The fact is that nothing that they do short of counterfeiting currency will come close to matching the income generating power of their pony's one trick.

And if the 20% ad spending decline scenario repeats, there will be a vicious cycle here. Ad spending down. Google growth 0 or lower. Google P/E contraction. Google stock down. A big slug of Google options worthless. A big slug of Google employees leaves, maybe a round of layoffs(?) Morale down. Productivity down. Growth slows. Lather, rinse, repeat.

We've seen a similar story before and it was called Yahoo!

Disclosure: I have owned puts on Google for several months.

2008 Feb 27 11:27 AM

[TA:]

Let's look at it from an IT perspective

If I were to convert to Google Apps, it would cost us an extra $1500 a month min($2000 is more reasonable but lets pretend it's cheap) in Internet bandwidth. Since we expect to keep an Office copy for 4 years average(5 for our last copy), that's $1500 x 48 months = $72000

This assumes that Google Apps is close to being as good as Office(it isn't) and Google Apps pro is free(it isn't). Did I spend $72000 on Office for the last 4 years? Yes I did - a little less but it's minor.

So now I have to deal with the fact that the Internet is now critical to our business(only email is currently and that can go through a cheap cable backup we have) and possible extra security issues.

That's just one small Enterprise, numbers vary - if you were IT, would you spend more on an inferior product and take on extra risks?

Here's a far better solution, keep your Office 2003/XP for an extra 3 or 4 years if you already own it or if you don't go with StarOffice.

Software is a cheap cost to running an Enterprise, people and downtime are not.

An office with 10 users sure go with Google Apps, anything more forget it.

2008 Feb 27 11:38 AM

[User 157690:]

I have to agree. The Google model depends on getting you "Google-Centric" and to do this they are making themselves indispensible, with a broad range of Apps central to our everyday life- all for free so you dont have to think about it. If they try to charge for these services there will be a shift. It may work in the long run but not before there is some pain for Google. In the mean time -
1. They need to support their valuation with OTP growth
2. You need to recognise that if they do introduce fees , that the price is heading lower before it goes higher.

Both points suggests that a period of price consolidation is in order.

Did I forget to mention- however YHOO partners with will make YHOO a better competitor.

2008 Feb 27 11:54 AM

[sixpackistan:]

First, I believe that you have a 60% chance of being right. Having said that, I think the stock is still priced to perfection and I'd have to buy it at around 300 to feel comfortable. I don't know that I have the courage to own this stock at anything less than a true bargain.
Secondly (a little off the point) no company in it's right mind will allow another company to house all of it's internal documents. Until google documents becomes a true enterprise solution (which it probably can not as long as it stores all the data on google servers) it will be stuck with the consumer market which already has free solutions such as openoffice.org- which is not only just as good as office but already far superior to google documents. Just my two cents.
Thanks for the great article.

2008 Feb 27 01:01 PM

[User 158044:]

I see adsense revenue slowing b/c there are only so many places to put ads. I don't remember the website but it had video with text overlay for ads from google. I don't think people will like watching youtube and user generated video if they have to put up with watching ads. I haven't used google docs, do they scan content and out ads on there like gmail? I would also be weary of why they want my medical records, just another place to put ads. What about gphone, will they try to put ads there as well.

2008 Feb 27 09:22 PM

[ironer05:]

just.a.guy, "Google stock down. A big slug of Google options worthless" doesn't apply if you're thinking of options owned by employees as the context suggests, given googleblog.blogspot.co... :
current employees of google (except a few senior VPs) can sell their vested post-IPO options, in daily auctions in which several financial institutions bid, for what turns out to be essentially the Black-Scholes value (and remember these options can be exercised at any time in the next TEN YEARS, so their time value is awesome!), so even options that are out of the money are worth cash (and the owners of those options would lose the opportunity of selling them if they left the company, as that opportunity only applies to current employees -- brilliantly designed "golden handcuffs"). For example, such options who are currently over $100 out of the money can still be sold (by current google employees, only) for over $50 -- and as GOOG's volatility increases, so does the premium the financial institutions bidding for those options are willing to pay over their (possibly negative) intrinsic value (as Black-Scholes predict). So I think you'd better redesign your hypothetical "Google crash scenario" to hide this "little" detail;-).

2008 Feb 27 09:51 PM

[thecarguru:]

I agree 100%. I've switched to Google docs and so have most of my friends. When Google comes out with a smart phone....I'll toss my laptop and Microsoft and maybe AT&T along with it. I purchased a ton of Google yesterday. My bank stocks cause anxiety(I sold NCC and C to buy more Google).....Google is without a doubt.....my most secure long term investment.

2008 Feb 28 09:03 AM

[Dira:]

Alternative theory: Google is a similar company, at a similar point in its life cycle as Yahoo was 8 years ago.

Why should it end any differently? Remember Yahoo's "game ending" buy of Inktomi? AOL Netscape? How quickly we forget...

2008 Feb 28 04:58 PM