Summary: Google's contextual advertising business has far better growth prospects than its search business.
Here's Wall Street's view of Google in one sentence: the search business is great, but Google's move into the lower-margin contextual advertising business is worrying and justifies the stock's lower valuation compared to Yahoo.
But this consensus is wrong. In Will Google be forced to re-ignite the browser wars?, we saw that Google's search business could collapse overnight. So Google's search business is far from great. What about Google's contextual advertising business and declining margins? Are they as worrying as the Street suppposes?
First, a one-paragraph primer on Google's contextual advertising business. Google offers a program, called AdSense, to owners of web sites like this one. It takes five minutes to sign up, and ten minutes to insert Google's code into your web pages. Once you've done that, Google places contextually relevant ads on your site. Advertisers bid for key words, and then pay Google per click (not per view). Google pays the web site owner about 80% of the per-click fee from the advertiser, keeping about 20% for itself. The price per click varies depending on the content. The Google ads by The Radical Guide to Credit Cards, for example, can generate up $1-$2.50 per click, while other ads can generate as little as a few pennies. Google has no contractual commitment to pay out a specified percentage of ad revenue to the web site owner, and has in fact generated controversy in the web master community by refusing to disclose the payout rate to site owners.
Google keeps 100% of the advertising revenue on its own search site, but because it pays out about 80% of the AdSense advertising revenue to third party web site owners, AdSense lowers Google's margins. The Street is concerned about Google's margin declines, and skeptical that Google can grow AdSense as fast as its search business. American Technology Research analyst Mark Mahaney, for example, wrote that "the bear points for GOOG include: decelerating revenue growth and margin declines going forward". He predicts that Google's contextual advertising business will grow slower than Google's search business, falling from 16% of Google's total revenue in 2004 to 13% in 2006.
But Google's contextual advertising business has four drivers that will propel it to phenomenal growth:
First, the contextual advertising market is largely untapped. Traditional banner ads have low click-through rates and revenue generation. They're also annoying, intrusive, and are psychologically blocked out by web users. In contrast, Google's contextual ads have higher click-through rates, are less intrusive, and in many cases are actually useful to the reader (because they're related to the content the user has chosen to read). Yet milions of web sites have no advertising on them, so the potential market is vast and is growing as rapidly as the Web itself. The search market is also growing. But every search is already accompanied by "sponsored links", or in Yahoo!'s case is already polluted by undisclosed paid-placement in the top 10 results. Google's contextual advertising business could therefore grow far faster than its search business.
Second, AdSense is viral. Look carefully at the Google ads on this page; the column of ads includes a link at the top titled "Ads by Google". A web site owner who sees that a growing number of other sites are carrying Google ads can click on that link and sign up for and implement AdSense on her own site in less than half an hour.
Third, there's significant room for technology improvements to drive Google's AdSense business. Wall Street seems not to have noticed that in the last couple of months Google implemented graphical ads in its AdSense program, and increased the number of blocks of ads a web master can place on a single web page from one to three. Both of those will likely increase click-through rates and revenues. More important, in the longer run Google should be able to further optimize ads for individual sites and web users. Here's an example. The return on investment for advertisers is determined by sales generated as a percentage of the advertising cost. Google currently pays (and charges) the same advertising rate for advertisers to place ads on web sites irrespective of the "conversion rate" per click of the site in question. Yet some sites have high-quality audiences with high conversion rates, while others have lower-quality audiences with low conversion rates. Allowing advertisers to bid varying amounts for the same key words depending on the site's historical conversion rate would increase advertisers' ROI and thus the success of Google's business.
Finally, the competitive position of Google's AdSense business is far stronger than its search business. True, Overture (owned by Yahoo!) has failed to automate and optimize its contextual advertising business for small web site owners. And no doubt when it does so Google will finally face a major competitor in the contextual advertising arena. But Google's lead is immense, and it's now entrenched in the contextual advertising business. In contrast, we've already seen how Google's search business is fundamentally threatened by Microsoft.
In sum, Google's contextual advertising business should be far more interesting to long term investors than its search business.
The lower margins are also a non-issue. Google's payout to third party web site owners does not detract from the fact that this is a phenomenally high-margin business. Take Google's net revenue (the revenue it gets after paying the site owner), deduct software, hardware and marketing expenses, and you'll see that the margins are enviable. Complaining that Google's margins are lower as a proportion of gross revenue (which includes the payout to site owners) is like complaining that eBays' margins on car sales are lower than its margins on collectibles. All that matters is the growth rate of net revenue and the gross margins on that net revenue number.
Where does this leave the stock? In the short run, Google's search business will shine. Ad inventory is in short supply, and the price of key words is rising. But in the longer term, Google's stock is a mixed bag. AdSense has terrific long term prospects, though it currently accounts for a minority of Google's revenues, while Google's search business will one day fall off a cliff. For that reason, I don't own the stock.
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