The case for Google
October 13, 2007
As investors push Google's stock ever higher and Wall Street analysts, those paragons of rationality, dutifully lift their price targets, reasoned assessments of Google's prospects become all the more necessary and valuable. So it was good to see, in this morning's New York Times, a long article on the risks facing Google by the imperturbable technology writer Steve Lohr. Lohr reviews the various factors "that could dim the aura of inevitable success that surrounds the company." Being something of a skeptic myself, I tucked into the piece as if it were a medium-rare, well-salted ribeye.
But something strange happened. By the time I'd finished the piece, I was actually feeling more positive about Google's business prospects. Lohr does raise some red flags, but it seems to me that the explicit case he makes against Google is outweighed by the implicit case he makes for the company.
Here are the key risk factors Lohr explores:
The law of large numbers. Yes, maintaining a particular rate of growth gets harder the larger a company becomes, but Google's annual revenues, at between $11 and $12 billion, remain modest by big-company standards. (IBM's sales are $91 billion, Time Warner's are $44 billion, and Disney's are $32 billion.) There's little reason to assume that Google will necessarily bump its head against a ceiling any time soon.
Overhiring. Lohr points out that Google continues to bring on employees "at a torrid pace" and that there are signs that it has overhired. I think that's a valid observation, and it's true that, in the short run, overhiring is a negative signal for investors. It leads, obviously, to high costs and, even more important, it reveals a lack of management discipline. But taking a longer term view, the fact that a company has more employees than it needs is actually a positive signal. It reveals, after all, that a company is intrinsically more profitable than it appears to be. Once pressure to rationalize the work force is felt, the company will respond, firing some workers or at least not hiring new ones, and its profit margin will expand. (In contrast, a company that has fewer employees than it requires is usually a bad investment; its current profit margin is unsustainable.) For a company growing as rapidly as Google is, it could curtail its hiring and fairly quickly take up the slack, pushing its profits up. Indeed, it may be true (and this is speculative) that Google, a company whose core business is very highly automated, may be massively overstaffed (and have other large, unnecessary expenses). Google may be a far more profitable business than its current results indicate.
Increased competition. An analyst tells Lohr: “The great risk to Google is that someday it will face real competition in search." That's certainly a risk, but it's a risk that people have been talking about for a long time, and "someday" has yet to arrive. Lohr presents a remarkable statistic: "In September, Google’s share of Web searches in the United States was 67 percent, up from 54 percent a year earlier, reports Compete.com." Where's the long-awaited intensification of competition? As Lohr notes, "The company’s market lead is so large that advertisers tailor their technology to work best on Google ad networks, and Web publishers design their sites to best pull in more Google users." What the numbers and the market dynamics suggest is that Google may be the winner in a winner-takes-all market.
Reluctant partners. As Google's scope and power expand, companies may become more wary about partnering with the company, argues Lohr. That's certainly true, but I'm not sure it matters all that much. In the end, companies will follow their economic interests, and if Google has power and money, it will, more and more, be able to call the shots. Many companies will face a stark choice: Do we partner with Google, or do we let a competitor partner with Google? One market researcher, talking to Lohr from Europe, says, “Nearly every company I meet here, as in the U.S., sees Google as an enemy or a potential enemy." That actually strikes me as far more of a positive sign for Google than a negative one. What it indicates is that Google has growth opportunities spanning many industries. If those companies said, "We don't take notice of Google because it has no stake in our business," that would be far more worrying for Google investors.
Public and regulatory backlash. This is a big risk for Google, as the scrutiny of its proposed acquisition of DoubleClick shows. But so far, at least in the US, public anxiousness about Google has been muted. People seem to like the company, and to be fairly happy forking over information about themselves to it. Google will face growing pressures in this area, but it may be able to manage them without suffering substantial damage to its business prospects.
Historical patterns of decline. Dominant technology companies, writes Lohr, "look invincible for years until they are unseated by the next wave of previously unforeseen innovation." Again, very true. But, again, very theoretical. Even if we assume that Google will eventually fall victim to this fate, we can't assume it will happen any time soon. Dominance can last a long time, and it may be that Google's reign is only just beginning.
The risks that Lohr presents are real, but Google's strengths and opportunities would appear to be even more real. That said, I think the biggest risk facing Google is one that Lohr glances over: a slowdown or even a downturn in the online advertising market. That would cause a wholesale reevaluation of its business model and growth prospects. Given the dicey current state of the overall ad market, it seems to be a fairly sizable risk at the moment - though Google, an atypical company, may be shielded from some of the effects of such a blip in a way that traditional ad-dependent companies are not. That remains an open question.
I'm still a skeptic, and I think the market's current assessment of Google's value is irrationally high. I'm not going to run out and buy a share of Google for 600-plus bucks. But, then again, I didn't buy a share when, not so long ago, it was going for less than 100 bucks. Perhaps the wisest words in Lohr's article come from another skeptic, Fred Hickey: “You cannot short a mania.”
Good points Nick. I think the overhiring has turned Google into one of the world's biggest skunk works, in the best sense of the term. We're going to see a lot of software and even hardware innovation emerge from all the kids working there.
I'm surprised no one mentioned click-fraud and the uncertainty over the intrinsic value of Internet advertising. From the little I know, this value could go either way and bump Google up or down, but surely it's a source of risk.
Posted by: tom s. at October 13, 2007 01:14 PM
I don't think search is a "winner takes all" product. Each user decides for him/herself where to search, and there are no benefits to searching from the same search box where others enter their searches.
If one of the competitors ever made a search that produced more relevant results (or had other improvements, such as better spelling check), then users would gradually shift their queries to this other search engine.
The article mentions some "new" competitors that are trying natural language, which is almost certainly laughable as an attempt, because users only want to type 2-3 words. But even though these new search engines are surely doomed, there could be other new ideas coming out, or Yahoo, MS, or Ask could finally improve their relevance sorting, spell check, etc.
Users will go where they get the most useful results. Advertisers will follow, since it's a pure ROI play: if you pay less per click than you get out of conversions from those visitors to your site, then you should run the ad. Doesn't matter whether a search engine is large or small.
If anything, there are benefits to advertising on a search engine with fewer other advertisers, because that will allow lower bids and thus higher ROI. Thus, it's definitely not a winner-takes-all market on the advertising side, assuming that other search engines improve enough to get users.
It all comes down to whether some other company will invest enough in search to build more useful search results. Yahoo and Microsoft can't continue to be clueless forever, so I think it will happen.
This is in contrast to the situation when Microsoft took over the office software market because Lotus and WordPerfect were clueless. Once everybody used MS Office, it didn't matter if Lotus could have shipped a better spreadsheet in a later year, because there *are* benefits to using the same office software as everybody else.
You're absolutely right that the search market doesn't appear to have the classic lock-in features of winner-takes-all markets and that a better mousetrap should be able to displace the Google engine. And a superior search engine may well come along (from a company other than Google). Still, we've known this (and the critical importance of search) for a while, yet Google continues to gain share, to the point where now it has a remarkable and still growing dominance. So if it's not a de jure winner-takes-all market; it's looking like a de facto one.
Moreover, as Lohr notes, companies are beginning to build their advertising/SEO systems around Google's engine, which does raise switching costs, and should personalized search results prove of value to searchers, that would raise switching costs on the user side as well.
But, still, you're right: the network effect in search is muted at present, and a better system should be able to gain market share from Google.
@toms: one reason you don't hear a lot about click fraud is because the very people who would report on it (bloggers, other media hoping to get a slice of the advertising pie) indirectly benefit from it.
In fact, click- impression- fraud is rampant (as an advertiser, I discovered this the hard way), and only the most naive click fraud is detected. Eventually, advertisers will discover this, but it can take awhile.
Remember, you don't want to call the very model of click/impression-based advertising into question. That would ruin the party.
Network effects are not the only forces that produce oligopolies. If search technology is characterised by "learning by doing" then a lead in expertise can snowball - it becomes much more difficult for outsiders to build good mousetraps. In Google's case this expertise may extend to their storage technology of course.
The other thing is costs of entry, which in the case of Google is now becoming huge - a great search algorithm is one thing; a set of massive server farms is another. Search technology is becoming capital-intensive, as our host has demonstrated many times over.
Posted by: tom s. at October 13, 2007 05:54 PM
Seems to me Google's sky high valuation rests less on their remarkable success than on the dangerous assumption that the other key players will continue to fail as dramatically as they have thus far. So the question for GOOG investors should be "how long can everybody else fail?"
Posted by: Joe Duck at October 13, 2007 06:27 PM
I think all the points that were pointed out on this very post probably already been discussed inside Google's boards. I don't think Google has place all of their eggs in one basket. They probably have already come up with ways that bringing in revenues beside their advertising ability; I hope. Many people had doubt about Google, but Google's stock continue to drove upward, and still is.
Google is fear by many due to its ability to invade other fields since the company has the cash to invest. Also the mobile phone advertising is heating up... Google is probably has its hands inside this cookies jar too.
It was a big bang that promote Google to the top... It probably will take another big bang to pull Google down, or the other way around again...
Posted by: xufon.com at October 13, 2007 11:12 PM
When Google IPO'd, I was one of the few who defended its valuation against the many critics. Its business model and staff were good. These days though, I think Google warrants a lot more caution, ironically due to its success.
First, the huge hiring spree is a danger, not a benefit. It will start to saddle the company with unexpected organisational problems, and certainly doesn't represent a linear extrapolation of innovation.
Second, Google's transition to a media and advertising company will shift power away from the engineering culture, creating discontent and blunders.
Third, core engineers will probably spin out to form their own ventures in competition against Google. Those innovators will be able to attract lots of venture backing and good staff.
Fourth, Google already exists in cloud land, and that hubris will probably lead to powerful clashes with the public and regulators down the track. Google won't win all those fights.
Google is basically a very good search engine company struggling with the excesses of its IPO.
I agree that Google's biggest threat is the online advertising market's health. Then again, AdSense is advertiser-friendly given you only pay for clicks as opposed to a CPM-based model.
In terms of search competition, there's no lack of it but I have yet to see a viable alternative since Google emerged on the scene. It's not just an edge in technology but Google is now the search default (aka The Kleenex of search).
Posted by: Mark Evans at October 14, 2007 11:52 AM
Another upside to valuation that I don't hear being discussed is Google's increasing abilities to displace Microsoft's applications, at least at the consumer level. I recently bought a new HP PC and I looked forward to using it in my home office. Only one small problem: it doesn't have Microsoft Office capabilities. A simple oversight by what should be a sophisticated buyer! However, I had an immediate need to edit and share microsoft documents so I turned to Google Documents and Spreadsheets. Guess what, they worked fine for most of my basic needs. It's been several months -- I still haven't bought Microsoft Office and now I'm not sure that I need to.
This is a big threat to Microsoft that could be another significant business for Google if they can figure out how to monetize it. If they cross this hurdle, then the current valuation starts to make more sense.
You can take this logic take a step further: If Google truly does get a handhold in the personal productivity applications space, they can start providing cross-document "mash-ups". It would be easy to create a document with a Google map in it or put a workflow checkmark into that document that integrates into a BPM/APM process. This starts to add a lot of value to small businesses that are process oriented around documents. And what is the value of that?
However, Google's counter-reality is that they are the same company that tried to create a video product and wound paying $1.6B for YouTube because they weren't successful.
It should be interesting to watch how this plays out.
It sounds so much 2005, but still true: want some comments? Talk about Google!
Posted by: Bertil at October 15, 2007 05:25 PM
Since the 10Ks numbers are 99% based on online advertising, I'd say that Google should be most concerned about that. And though it might fit under the "regulatory backlash" heading, it might be worth explicitly mentioning the issue of trademarks and AdWords. Personally, I don't see this as a major threat to Google's revenues, but it is probably at least as big an issue as Google "aura of success"
And, at the risk of self-promotion, here's a 70-page paper on that particular topic (that spends some time on Google's history):
If anyone has any comments, please send me an email...
Posted by: greglas at October 16, 2007 07:46 AM
I think displacing Google is going to take a whole lot more than a better search engine simply because Google isn't just a search engine anymore. If anything, Google is the most pervasive and "intelligent" ad platform and ad delivery network of which search is the most popular medium. In other words, a search engine can't simply just generate better search results for the user, it's gotta produce better context-sensitive ads for its clients. That's a much bigger deal than anyone talks about. If I'm running a florist shop, I wouldn't bother advertising with some hot new search engine if it was lumping my ads in with search results for mesothelioma. At the same time, Google has the reach to put ads in even more context-sensitive locations - websites and blogs that cater to an advertiser's core audience.
So in my view, Google's biggest threat isn't a better search engine, it's an ad platform that can put ads in more places with better context and at lower cost. An ad platform that can do that would force Google's hand and they'd have to start carrying the new ad platform's advertisements or watch their revenue base shrivel. Think about it this way: if Yahoo/Excite/Infoseek had developed PageRank in-house but continued to splash random banner and link ads without any regard to context, would online advertising be as hot as it is today? Personally, I highly doubt it and I think that the development of AdWords is what cemented Google's current position, not PageRank. If you want to take out Google, you've got to go for the head and stop aiming at the chest. Search is sexy but advertising is where the money is at.
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