Ask the experts: Where is Google going?

Google has been seen by the markets as the wunderkind of the technology sector since the company went public in an auction in August 2004.

The search engine’s shares on Tuesday suffered one of their worst intraday falls of more than 13 per cent after George Reyes, Google’s chief financial officer, told investors that growth was slowing and the company needed to find new ways to bolster sales.

“Growth will slow,” Mr Reyes said but added, “Will it be precipitous? I doubt it.”

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The shares closed more than 7 per cent lower on Tuesday. The company is still valued at more than four times its initial price, but views differ sharply on where Google is now heading. Our panel of experts lines up the bulls and bears to answer your questions on Google’s stock and long term strategy below.

The following webchat took place live on February 21, before Mr Reyes’ remarks.

On the panel: Cody Willard, hedge fund manager at CL Willard Partners, and Jeff Matthews, blogger and investment adviser; the FT’s columnist Stephen Schurr, and Henry Blodget, president of Cherry Hill Research, and a former Wall Street internet analyst.

Note to readers: In answering your questions, our panel of experts will give their views on Google’s prospects and strategy - this should not be construed as investment advice.

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I was wondering if in the short term GOOG has already made its bottom this past Wednesday at 338? With increasing competition from others, do you think GOOG will maintain its market shares and successfully beat its next earning? How will the federal government affect GOOG?
Chuatla

And I’ve no idea yet on what this quarter will shape up like. The Federales and other regulatory bureaucrats will do what they always do and make as much blustery headlines about any topic they think the American public might has some remote interest in. Google and Cisco and the other companies are going into China and driving the amazing revolution of information flow that is changing the world. The Chinese Communists in charge (apparently) have a lot to lose from freely flowing information.

And thus they are doing everything they can to keep control. They can’t. They won’t. They’ll lose. The internet democratises everything, and one of the reasons I’ve owned Google forever and plan to own for another forever is because they focus so much on maintaining agnosticism on content source and consumption. The revolution is bigger than either China’s Communist Party or the geniuses running around at Google.

Stephen Schurr: My guess is as good as yours, Google’s stock could have indeed hit a near-term low and may run back up towards previous highs before first quarter earnings are released in May. While I am certainly of the belief that expectations about Google will have to come down as competition heats up, it’s too early to guess whether Google’s first quarter earnings will hold another disappointment for Wall Street.

Initially, I thought Google might slide back closer to $300 before recovering. I’m not at all a technical stock analyst, but given how the stock traded on the way up – finding support around the $200, $300 and then $400 milestones – I thought it might fall back to that area before stabilizing. Even with the 22% drop, I think Google’s strong recovery suggested many investors remain quite bullish on Google.

Between now and mid-May, Google investors should mark their calendar for March 2, Google’s analysts’ day. Google’s first analysts’ day in February 2005 caused a modest sell-off in the stock as the company demurred on providing a forecast for its earnings growth. It will be very interesting to see if the Google guys give Wall Street more information – a recent TheStreet.com article reported that Google was quietly putting the feelers out to analysts about subjects they would like to discuss.

It’s just a hunch, but I think the analyst day may reveal a Google that is becoming more adroit at managing Wall Street’s expectations, even though they probably won’t offer forecasts. It’s possible that Google will make some sanguine comments about click fraud, which could push the stock much higher. They may also continue to make comments about how the company is focusing on the long-term, not quarter-to-quarter forecasts, but I think those holding onto Google are comfortable with this philosophy – at least until the earnings come out.

Regarding the government, I don’t think the governments in Washington or Beijing have a great deal of influence on the stock this year – except tangentially as indicators of how Google is dealing with becoming the new 800lb gorilla. Personally, I have some qualms about the ethics involved in appeasing China, but from an investor’s standpoint it was absolutely the right decision.

Lastly, the other big variable with Google’s stock is the broader market. If stocks turn south on concerns about an economic slowdown, support for Google and many other high-fliers may diminish.

Jeff Matthews: I never comment on valuation or make guesses as to stock movement.

I believe competition from Microsoft is already being felt in the form of Microsoft’s own shopping site (MSN Shopping) has been paying for Google keywords - and bidding up the value of the words to uneconomic levels for other Google customers.

This was discussed on the Blue Nile earnings call recently, when that online jewellery retailer disclosed a sharp sales slowdown, some of which it blamed on sharply increased costs for Google keywords, which resulted in lower conversion rates (the rate at which search users click on ad words that pop up during a Google search) and increased marketing costs for Blue Nile.

I do not think much of Microsoft’s own search product. Microsoft is late to the party and trying desperately merely to keep MSN users from switching to Google for search, but the fact is, MSN is losing users at a rapid rate (I am a former MSN customer who switched after repeated problems with my 12 year old MSN e-mail account).

Yahoo is a more formidable competitor, in my view, although under CEO Terry Semel (formerly of Warner Brothers) Yahoo has been pursuing a more content-oriented strategy and quickly lost its search franchise to Google.

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I would be interested in your take as to the potential long term strategy for Google, as some have surmised the following. Google is acquiring significant amounts of dark fibre and developing mobile data centres that can be located right at peer points. Google is going to let Telco and Cable build out IP-TV, knowing that it will still be the only game in town to pull the whole thing together: the ability to show every viewer the specific ads that companies will pay the most to show him at that specific moment.

What Google wants to do with these trailers is serve every TV commercial on the planet because only they will be able to do it efficiently. Only they will have the database that converts those IP addresses into sales leads, only they will have the servers and disk space close enough to the viewers to feed the ads. Only Google will have the ability to run a constant, real-time auction for the next ad every consumer is about to see, and then serve that ad at the moment the program goes to commercial. Ads tailored to the interests of the viewer based on search history.
Think it’s possible?
S Dennis

Jeff Matthews: This is a really interesting question. Google is like a nice version of Al Qaeda - instead of being rumored to be behind nearly every act of Evil on the planet, Google is rumored to be behind nearly every act of Cool Technology out there, ranging from your “dark fiber” scenario to the company’s interest in broadband-over-the-power-line technology through its investment in Current Communications Group.

That said, I think your idea is not far-fetched. Google’s ambitions are as grand as its “Do No Evil” motto, and nothing would surprise me - especially when it comes to putting television advertising closer to the individual consumer.

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What do you see in next quarter? I’m tempted to buy more - I think this is a sound, solvent and ever inventive company. Will they retain the lion’s share of their hold on the competition and get picked up by the S&P.
T Wovees

Stephen Schurr: It’s damn near impossible to say what will happen next quarter. Ultimately, I think Google’s growth will decelerate significantly, but I don’t think this quarter will show it – unless Jeff’s insights about Blue Nile and FTD are indicative of a very swift trend.

The index effect – when a stock gets added to the S&P 500 – is a factor in the stock’s performance over the short haul. Since there is about a trillion dollars indexed to the S&P, and managers must buy up shares of new additions, Google could see tremendous upside pressure. Yahoo shares soared more than 50 per cent the week before it got added to the S&P 500 in late 1999, if I remember correctly. I don’t expect that big a bump, but I do expect Google’s stock will be added this year. Many thought it would be added last year, but Standard & Poor’s added homebuilder Lennar instead.

I wouldn’t buy it just for the index effect, but it should give some additional comfort to someone interesting in buying the stock. However, I think there are better opportunities in this market than Google.

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QXL shared equal billing with the likes of Lastminute.com and Scoot.com as an internet wonderstock at the height of the internet boom. But financial gravity brought the online auctioneer down to earth as its performance failed to meet impossible expectations. QXL was the inaugural British member of the “99 per cent club”, named in tribute to web companies that shed 99 per cent of their stockmarket value. In April 2000 it was a pounds 2bn stock with a share price of 800p. Eight months later it was worth pounds 62m at 6.5p. Wouldn’t the competition from Microsoft and Yahoo make it difficult for Google to have the profit margin that they have, and a P/E of 73? Will financial gravity bring Google down to earth?
Lise Verga, Sweden

That said, it’s certainly possible that Google messes things up, loses its edge, customer base and strategies…and then sees its stock fall 99 per cent. Same could be said for every stock on the planet. Certainly, Microsoft and Yahoo and tons of other companies are doing everything they can to beat Google in any way they can. Those are inherent risks to owning this stock and there’s no denying those risks. But I think Google’s positioned to be a big winner in these wars, and that Google’s got a lot more upside if they do. They’ve certainly delivered to investors thus far.

Jeff Matthews: Google has what most of the dotcom sensations of the late 1990’s and early 2000’s lacked: real, cash-based revenue and actual cash-flow. Not for nothing Google has billions sitting in the bank, while the kind of companies you mention generally had very little in the way of real revenue or cash flow, and therefore went bust during the collapse.

Indeed, that difference is something the sceptics missed when Google went public: everybody thought it was just another dotcom, but it’s not.

That said, competition within Google’s own search business is diluting its ability to sustain past growth rates, because the rise in cost of Google keywords has risen so sharply that some internet advertisers–FTD Group and Blue Nile, for example–to cut back.

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At the current level of 74 times earnings, Google’s amazing growth would have to continue unabated for the next two or three years to justify the current price. Given that their competitors are hardly likely to sit on their laurels, and that the market for advertising is finite, doesn’t this make the current price too high for investors - and therefore acceptable only to speculators?
Edward Dixon,Cork, Ireland

Certainly, Google’s stock is a risky investment. But it also carries tremendous potential (and has thus far delivered) return.

Jeff Matthews: I never comment on valuation - it’s subjective.

Growth stock investors might find Google cheap based on still-high growth rates and the recent decline in the share price. Value investors might find Google wildly expensive.

I do think the recent quarterly earnings report revealed weaknesses in Google’s operating model that had been previously masked by high growth rates.

These weaknesses include accelerating expenditures on infrastructure and signs that some advertisers (such as Blue Nile) are scaling back online search spending.

Investors of all stripes should try to understand how these changes may affect Google’s future growth rates to determine whether the stock looks cheap or expensive to them.

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What could Google’s price target be by the year’s end?

Stephen Schurr: This question – essentially an investor Rorschach on Google - is impossible to answer with authority. You could answer $2,000 or $20 and have a reasonable argument.

So, it becomes a guessing game, and I’ll offer my best guess.

I am guessing that Google will climb back above previous highs in the first half of this year. Why? Well, first of all Google is a phenomenal company that “only” sports a forward P/E of 41. If expectations run high that its growth trajectory will continue on the recent course, and if first quarter numbers deliver, investors can feel justified in buying the stock.

However, my conclusion in examining Google and its prospects is that it faces the substantial risk of pricing pressure in search advertising, which comprises 99 per cent of its current revenue stream. Meantime, it is spending aggressively to compete in new arenas. Given how leveraged the company’s earnings are, I believe a slowdown in search advertising growth or price compression would could knock the stock down substantially. How low? Who knows. Either way, it will be volatile.

Don’t forget, Yahoo went from $119 to $4.50 and Microsoft, (perhaps a better comparison) traded at a split-adjusted $50 compared with $26 and change today.

Unfortunately, a reasonable price target could be almost anything.  If the company’s performance continues for the next three quarters the way it has for the last year, the Street’s higher targets are perfectly reasonable ($500-$600).  If there is any deviation from that trend, however—decelerating revenue, compressing margins, etc.—the stock could easily drop below $300 (this is what happened last quarter).  If the deceleration is severe, you could get to $200.  And if you have a major issue like click-fraud, $100 isn’t out of the question. 

Right now ($300-$400), the stock is trading at about 30-40x the higher free cash flow estimates for this year ($3 billion).  The low end of that is more comfortable than the high end, but anywhere in that range is defensible based on what we know today.

Jeff Matthews: You can’t be serious. But if you are, ask Jim Cramer on Mad Money.

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Google’s growth needs to be augmented by new revenue streams to justify their lofty valuations. Offerings such as Google Base, Google Video and Google software (Pack etc) hold promise but deliver little to the top line today. And there are endless rumours of Google Music, payments etc etc.What new revenue streams/offerings does the panel think will help Google meaningfully diversify their revenues in the mid term and what should that do for their stock price?
Philip L Letts

Jeff Matthews: Good question.

The biggest risk to Google’s existing revenue base may be dilution from its own success in search. More keyword bidders are driving up the cost of keywords to uneconomic levels - at least that’s what has happened at two large search marketing users, FTD Group and Blue Nile.

Google Mail, Google Maps and Google Base only exist to drive more search, which runs the risk of further diluting the search model. As I write this e-mail in Google Mail, ads are popping up alongside this email. There is such as thing as too many search ads chasing not enough clickers. Consequently, as you point out, I doubt Google Base or Maps or Mail adds much to Google’s search revenue.

As for Google branching into the pay-per-download revenue model via Google Video, the speed with which mainstream media is adopting a video download model (after watching the music industry fight the trend unsuccessfully) probably renders Google too late to benefit in a significant way from an Apple-style video download business.

Thus, like most great new technology innovators that break through with a new technology only to find it impossible to diversify into new businesses, I suspect the next big revenue stream for Google will be adopting its search model to a “click-to-call” model in which consumers can click a button or an icon and be connected with the company or service provider. The value of a live customer on a phone is far higher than a person who simply clicks on a web-based ad.

Stephen Schurr: One of the great conundrums in analysing Google’s prospects is understanding which of the 100 or so major initiatives the company is working on will have a meaningful impact on the bottom line.

My guess is that over the short term, the new revenue streams that will boost Google’s bottom line are ones that are very similar to what it does today: for instance, Google’s push into mobile searches. Mobile search just takes Google’s successful model and puts it in a new venue. The question remains whether mobile search ads truly represent a diversified revenue stream in the event of a recession that causes a slowdown in advertising.

Comparisons to Microsoft may seem facile, but I think Google does face similar challenges in successfully diversifying away from its core product.

I have some concerns regarding other new initiatives. Google Video is a case in point. While the company has been explicit in saying the video product is still in beta mode, I must admit Google Video comes off as pretty amateurish. I have no doubt that the company will improve the service – and the 70/30 profit sharing arrangement with content providers could be quite lucrative for Google. However, it is a highly competitive landscape and Google doesn’t appear to have quite as many advantages over its competitors when it comes to content. (For more on that point, you can check out these interesting comments: http://blog.searchenginewatch.com/blog/060106-142226).

Broadly speaking, my biggest worry with the new initiatives is that Google will never be able to replicate the high-margin, high-growth miracle that online search advertising has been for the company. That’s natural, but I don’t think the stock price reflects this. The moves to diversify are the right moves to make sure Google is positioned for long-term growth. However, I doubt they will happen upon a second golden calf; and if the first golden calf slows substantially, Google’s growth prospects will be diminished.

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Google is essentially a (fixed) internet search firm that generates its revenues and profits from highly targeted advertisement in its own and 3rd party sites. For some time they have tried to get a foothold on the mobile phone market. The T-mobile and Vodafone agreements are absolutely in the right direction. But where will the money come from? What’s the business model? Do we really believe in ads on tiny mobile screens?
Rolf Schmitz, Alzenau, Germany

As for ads on mobile screens, I suspect that forcing users to watch video clips won’t fly (it would be infuriating, and users would just look somewhere else during the ads). Adwords would be challenging because of the difficulty of searching on a handset. A subtle sponsorship logo might work, as would a sharing of revenue from subscription fees. But again, compared to the PC market, we’re not talking a huge opportunity yet

Jeff Matthews: Have you ever watched teenagers play games on “tiny mobile screens”? I have, and I have no doubt that in time those “tiny mobile screens” will display advertising - just as I have no doubt those “tiny mobile screens” will display TV shows and movies.

But whether this becomes a major advertising channel for Google and the carriers, I have doubts.

Stephen Schurr: The money will come from the same place the money comes from on the internet: search advertising. It’s simply a different, potentially highly lucrative new stream of revenue.

With its aggressive push into mobile advertising, Google could reach a customer base of more than 2bn mobile phone users, compared with 1bn global internet users. There is some debate about whether mobile can be even more profitable for Google; as FT’s Maija Palmer noted in an article last week: “Advertisers currently pay top rates to secure prominent spots on internet pages. On the smaller screen of the mobile phone, getting a top spot will be even more crucial - and could therefore command higher prices.”

Google’s success in the mobile arena will depend upon a few variables. First, the mobile-phone industry has been touting content as the next great wave for several years. I, for one, am a bit dubious about watching “mobisodes” or other content designed for the tiny mobile phone screens, but I’m not a teenage girl, either.

However, I can see search advertising over mobile phones being a potent force, especially local searches. To succeed, Google will need to deliver a unique product designed to fit the distinct nature of mobile phone search.

Google is endeavouring to do so in a highly competitive environment, not only from Yahoo and other internet companies going mobile but also competition from the mobile phone companies themselves. It will be an exciting land grab to watch, with a major potential new revenue stream for Google if it succeeds.

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So where are the screaming bull arguments? Cody, Jeff - I want to hear why I can’t possibly afford to miss this stock? How does it get to $600 by year-end?

Jeff Matthews: I don’t comment on valuation: beauty is in the eye of the beholder, and that holds true for stocks.

But I think the Google share price - $350, $400, $450 or whatever it is this minute - is a big problem when it comes to thinking about an investment case for or against the stock. People get hung up on the notion of a $350 or $400 or $500 stock price.

So I always suggest people divide everything Google by 10. This makes the stock a $35 or $40 stock, and it reduces the 2006 earnings estimates from $8.00 or so to $0.80 a share.

And that puts Google more in line with Yahoo and eBay when it comes to both absolute share price as well as PE multiple.

Having said all that, I make no recommendations for or against Google stock. That’s Jim Cramer’s job!

Stephen Schurr: I’ll take up your question, Henry, even though I’m officially a “bear” on Google’s stock.

As I see it, the one way Google could possibly soar to $600 is if pricing for search advertising gets pushed higher and higher by big traditional Corporate America advertisers. Ad budgets are definitely ramping up the internet component of the pie, and search remains hot with them – my sense is the big companies may not be as sophisticated about internet-ad pricing as Blue Nile. It’s possible that prices could keep inflating, allowing Google to blow past estimates. However, I expect prices will ultimately contract and rather substantially.

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Jeff Matthews: I never comment on valuation in public forums because that’s not my job.

I’m not a broker and I’m not a stock commentator - I write a blog about the whacky world of Wall Street, analysts, companies and the economy; not about stocks themselves. While you may think I own Google given my blog postings, I have never discussed it as a good or bad investment - only as a company that I thought was highly underestimated by most Wall Street types.

Valuation, as you say, does matter; but valuation is in fact entirely subjective.

For example, Google looked expensive - ridiculously expensive to many people - when it came public. And it was, as they say, a “four-bagger” from there. So all the commentators who decried Google’s valuation and the nerve of these two young punks whose motto was “Do No Evil” to try to go public without giving guidance and without splitting the stock and without paying attention to quarterly earnings and without doing a normal Investment Bank-fattening IPO were proven wrong.

Having said that, I of course pay attention to valuation when making my own investing decisions. But that is my own business, and not the subject of my blog, which is why I don’t discuss it here .

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Stephen Schurr: Henry, If you were covering this stock as an analyst, you would be forced to put a price target on it. What would be your price target? You are clearly concerned about Google’s prospects, but you have applauded other analysts on your blog who are sticking to $600 calls.

As for what my price target would be, I’m going to slip out the back door now… I’ll just say that I won’t be surprised if/when the stock trades at $600 or $200, that I don’t own it, and that I’m glad I don’t have to set price targets anymore. As Jeff says, they are highly subjective, and they mean much less than many folks think they do.

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I’ve owned Google since the day it came public and, as a long on the day the stock dropped 15% or whatever after that report, I sure can’t say I was happy about how the shareholder base treated the stock after earnings.

That said, I do so love that the company doesn’t cater to Wall Street “as a shareholder”. Given the outsized multiple that Google’s stock has traded (though if you go back and look, Google ended up coming public at only 12x 2005’s earnings, which is a much smaller multiple than Caterpillar’s or GE’s, though I digress.) at since it came public, their lack of catering to Wall Street’s machinations, could be considered as having been “rewarded”.

Regardless, as an investor in the company, want everyone at Google more worried about executing and performing in the real world and on the fundamentals, than ever spending energy selling (out) to Wall Street.

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Note to readers: In answering your questions, our panel of experts will give their views on Google’s prospects and strategy - this should not be construed as investment advice.

View the latest news and analysis on Google

Read Stephen Schurr on FT.Com: Is Google’s engine sounding clunky?

Read Cody Willard’s blog - and, Let the Googlympics begin

Read Jeff Matthews’s on: Google “Thesis Schmesis”

Read Henry Blodget’s blog, and at Google ; and Google - the Bear Case

Send your questions now to ask@ft.com