Citigroup analyst Mark Mahaney re-initiated coverage report of Google on June 8th. Here's the section of his report titled "GOOG Investment Positives":
1. Exposure to the strong secular growth of online advertising -- After double digit declines in 2001 and 2002, U.S. Internet advertising revenue grew 21% in 2003 and 33% in 2004. Just as impressive as the overall growth rate is the accelerating growth U.S. Internet advertising posted in 2004. And it’s not just easy comps that drove these growth rates – results from several leading online advertisers consistently indicate renewed interest in online advertising among Fortune 500 companies and small enterprises.
Two factors in particular give us confidence in the sustainability of U.S. Internet advertising’s growth rates and drive our estimate of 20%+ growth through 2007. First, some of the largest Internet advertising segments – e.g. search, 40% of total, and rich media, 10% of total – are still developing significantly, with continued innovations in targeting and tracking likely. Second, there still remains a wide gap between the percent of ad spending by media type vs. the percent of total media time households spend with each media type. Per Forrester, over 30% of U.S. media consumption (both at home and in the workplace) is done online, while we calculate that less than 4% of total U.S. media spend is currently on the Internet. As a rough contrast, less than 10% of media consumption is via newspapers, yet newspapers account for approximately 30% of total media spend. This gap is bullish for Internet advertising and for companies with broad exposure to the sector.
A side implication of the gap is that online advertising may still have considerable upward pricing potential. As an example, we believe the rough industry average of $0.50 cost per click in search advertising can rise over time to meet or exceed the roughly $1.10 that Yellow Pages advertising currently draws.
International Internet advertising revenue data is much harder to come by. Our assumption is that international markets are still materially (two years’ish) behind U.S. markets in terms of Internet advertising development, but we anticipate similar strong growth trends over time. So on a global basis, we would look for 30%+ Internet advertising growth over the next few years. Bottom line – the growth potential for global Internet advertising remains significant.
What will drive this potential will be a) continued Internet user growth (800MMish users worldwide growing 15%-20% Y/Y); and b) continued Internet usage growth (usage per user growing approximately 10%) driven by broadband adoption, wireless adoption, and increasing integration of the Internet into daily habits. We believe the drivers and impact of this increased usage remain underappreciated.
2. Direct exposure to search, one of the largest and fastest growth online advertising segments – In the U.S., search advertising accounted for $3.9B in 2004 (up 51% Y/Y) and 40% of total Internet advertising, per the Interactive Advertising Bureau. The Rich Media segment actually grew faster (up 66% Y/Y in 2004), although off a much smaller base. The 2 nd and 3rd largest segments (Display Ads and Classifieds) were each less than half the size of the Search segment.
While the current growth in search is very robust, the key question is how sustainable is that growth rate. Several factors give us confidence that the growth legs under search are relatively long. First, we believe that innovations in this segment are still early stage – e.g. behavioral-based search results have not yet been fully developed and alternative pricing models (cost-per-action, revenue share, etc...) are only just now being introduced. Second, to date the online search industry has almost exclusively attracted direct marketing dollars, but there are increasing signs from both search engines and ad agencies that branded advertising campaigns are beginning to use search advertising. And third, we believe the search segment is only beginning to tap into local advertising dollars.
Currently, approximately 40% of total U.S. advertising dollars are locally based vs. 60% national. And to date, the vast majority of online advertising dollars have come from national advertising platforms. We believe that while the Internet accounts for almost 4% of total U.S. advertising, it accounts for only 1% of total U.S. local advertising. In order for the Internet to better tap into local advertising dollars, three things need to happen. First, local advertising solutions need to be developed – and Yahoo! and Google only introduced Local Search solutions in mid-2004, with Google Local still in beta. Second, local merchants need to have local Internet ad solutions directly marketed to them. And third, Internet users need to increasingly change their behaviors and actually use the Internet for local search needs – e.g. searching for local bike rentals online rather than through the Yellow Pages.
These developments can take substantial time to occur. But that’s why we believe that the search sector’s growth legs could be reasonably long. To try and quantify this opportunity – were Internet penetration of local advertising to rise from today’s 1% to the current 5% penetration level of national advertising, that could be an incremental $4B in revenue, or almost the size of the entire search advertising market now.
3. The clear market leader in search – Google is the clear leader in the search segment. And its relative position seems to be strengthening. While the U.S. search market grew 51% in 2004, per the Interactive Advertising Bureau, Google reported 105% U.S. revenue growth. Thus, Google’s share of the U.S. search market increased from 41% in 2003 to 55% in 2004. The March quarter financial results indicate that Google’s U.S. search share has continued to expand in 2005. We believe that Google’s U.S. search share will expand for the full year, but we then assume that Google’s U.S. market share will begin to decline modestly in 2006 and 2007, due to increased competition, especially from Microsoft.
In terms of query volume, Google’s share in the U.S. has increased from 34% in Q1:04 to 36% in Q1:05, per comScore Media Metrix. Yahoo! has remained the clear #2, with query share climbing from 30% to 31% over that period.
But it’s in international markets where Google’s leading competitive position is clearest. On a global search query basis, Google accounted for 50% of total queries in the March quarter, vs. 36% in the U.S. This global share is 2X that of Yahoo (24% in the March quarter). And Google’s relative market share position has been strengthening – the 50% is vs. 43% in the March 2004 quarter.
The math from the two exhibits above points to clear conclusion that it’s in international markets where Google’s leading competitive position is clearest. Outside of the U.S., Google held a 61% marketshare in queries in the March 2005 quarter, up from 51% in March 2004. It’s our POV that one of the most underestimated aspects of Google’s is its very strong international competitive position.
4. Significant international exposure – Given the materially higher international vs. U.S. international growth rates, we believe a key investing theme for Net stocks is international exposure. In the March 2005 quarter, Google generated a record high 39% of its revenue from outside the U.S. We believe the company’s increasing international presence is a positive for Google and should help maintain robust revenue growth rates going forward. We estimate that by 2007, international will contribute 47% of Google’s gross revenue.
5. Underappreciated potential for expansion into areas beyond “traditional