Why Google's a Long-Term Buy, WebSideStory and Overstock are Shorts, and the Jury's Out on Amazon (AMZN, GOOG, OSTK, WSSI)

by: David Jackson

In a somewhat sensationalist article, Search Engines as Leeches on the Web, usability guru Jakob Nielsen (pictured left) argues that search engines are "sucking out too much of the Web's value". The crux of his argument is this:

"In the long run, every time companies increase the value of their online businesses, they end up handing over all that added value to the search engines. Any gain is temporary; once competing sites improve their profit-per-visitor enough to increase their search bids, they'll drive up everybody's cost of traffic.

This is great news for search engines: they can double their income by doing nothing. Just sit and wait for all other websites to improve -- then skim off the increased earnings."

No doubt the title alone will attract much discussion of Mr Nielsen's article. But this site is about stocks, so I want to discuss the issue from a stock perspective.

Mr Nielsen highlights trends that investors in public stocks are already familiar with:

  1. As e-commerce companies increase the conversion-to-sale rates of their web sites, they can afford to bid more for pay-per-click search engine ads.
  2. Any e-commerce company that fails to improve its site will be outbid for ads by more efficient companies, and will therefore see declining pay-per-click ad traffic.
  3. Over time, the price of pay-per-click ads will rise as more companies move online and as web site conversion rates improve.
  4. The search engines companies are therefore incentivized to provide tools to help e-commerce companies improve their conversion rates.

These trends have three clear implications for Internet stocks:

GOOG: Google is the ultimate Long Tail business, because it benefits from the increase in the number of web sites on the Internet (how else can you find them?), and from the improvement in general web site design. As Mr Nielsen says, "This is great news for search engines: they can double their income by doing nothing."

WSSI: Google, Yahoo and MSN will offer their search engine ad customers ever more sophisticated optimisation tools for free, and will destroy the business of companies like WebSideStory (WSSI). Here's what I wrote when Google acquired Urchin Software:

Why does Google want to be a provider of web analystics? Because the value of an ad to a merchant is defined by: (1) how many people click on it, (2) the rate of conversion to sale, and (3) the value of a sale. As online merchants become better at converting site visitors to actual purchasers, their return on investment on keyword ads rises and they are therefore willing to pay more for keyword ads. This explains why keyword prices are likely to rise in the long-term, and why it’s in Google’s interest to help merchants improve their conversion-to-sales rates by providing web analytics software.

AMZN, OSTK and other e-commerce stocks: Internet retailers will face rising online marketing costs that will continually pressure their margins. The only avenue of escape is for them to focus on customer loyalty so that users come directly to a site instead of via a pay-per-click search engine ad. (Now you understand Amazon Prime.) The challenge: as search becomes more useful and incorporates comparison shopping, why shouldn't shoppers start with search every time? The solution: e-tailers gain competitive advantage in logistics and inventory control, offer the lowest prices, and get traffic from natural (not paid) search engine results due to low price. Perhaps Amazon wins after all.

We've already seen these trends and implications play out in actual numbers. Look at Google's dramatic rise in revenue, FTD's comments about search engine costs, Amazon's margin problems, and Overstock's stealth Q4 pre-announcement.

It's for exactly these reasons that I've been short OSTK in the past, am currently short WSSI, but would think long and hard before shorting GOOG.

Full disclosure: short WSSI at time of writing. No position in AMZN, GOOG or OSTK.