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Can Google grow like Dell and Cisco?
Google is positioned to exploit the most profit-rich avenues of the digital world. But can it really surge the way Dell and Cisco did in their glory days?
By Jon D. Markman
In a storybook sequence reminiscent of the late 1990s, brokerage analysts have tripped over each other in recent weeks to announce higher and higher price targets for online search provider Google (GOOG, news, msgs). With the stock now trading above $290, the analysts -- who are essentially, lets face it, just doing their job as salesmen -- vow that its heading for $310, $350 or better.
Brokerages have joined the groundswell for Google to exploit one of the singular curiosities of the psychology of the stock market: They know that the higher the price of a stock goes, the more famous it becomes and the more people seem to want it. Its the opposite of the way that sensible people run the rest of their lives, in which lower prices for cars and clothes spark buying interest.
In a world that blurs information and entertainment, Google has become as much a celebrity as it is a company, and has attracted the usual adoring crowd.
This time, however, the sell side may have a point. As Google has cleverly given employees great freedom to create and release software on the fly, it has tapped into creativity that has satisfied a yearning among consumers for transparency in the value and availability of things. More importantly, at the same time it has found brilliant ways to help marketing partners monetize that yearning without appearing greedy.
Nice guys and the holy grail
Although it has veered on the edge of annoying the privacy hounds with its innovation of posting highly targeted ads within its free e-mail service, the counterculture-tinged company may have discovered the Webs holy grail, as originally imagined by the hippie capitalists behind the pioneering service Netscape. Google is as profitable as eBay (EBAY, news, msgs), as ubiquitous as Yahoo! (YHOO, news, msgs) and as service-oriented as Amazon.com (AMZN, news, msgs), yet still comes across as a nice guy in a tie-died shirt.
Maybe nice guys do finish first. Google has positioned itself in some of the most profit-rich avenues of the digital world and become as essential to our experience of life and work as personal computers and networking were two decades ago. It is not overstating the case to suggest that Google, though only a year old as a public company, might ultimately fulfill investors dreams to find another Dell (DELL, news, msgs) or Cisco Systems (CSCO, news, msgs) -- and possibly in record time.
This is much harder than it looks, and it does not look particularly easy. To be another Dell or Cisco, from now through the next 10 years it must achieve annualized net income growth of 20%. While its boosters in the brokerage community seem to think that is a piece of cake, due to its proven ability to roll out one well-imagined product after another, investors should keep in mind that many other outfits have likewise been crowned by the securities salesmen as the next Dell or Cisco, and come up short.
Online storage -- forever
The big difference in this case is that part of the genius of Google is its not-so-secret plan to become the online storage unit for virtually our entire lives, and perhaps well beyond the grave. The method for this is its free e-mail service, called Gmail, which has had a powerful impact even though it has not been officially released to the public. Still in widespread beta, Gmail currently provides two gigabytes of e-mail space to users free, and it has promised to add another gigabyte annually on the anniversary of its release. That is 200 times more storage than computers provided Dell customers in the early 1990s ramp-up of its business.
As you probably realize by now, pigeonholing Gmail as an e-mail service obscures the fact that, at a time that almost anything can be instantly sent to oneself or friends through online mail over broadband connections, it actually becomes the central repository of every important thought, document, photo or song that one has ever harbored or shared electronically. Combined with its easy search functionality, this has made Gmail a sort of essential life cache for its hundreds of thousands of early users. And this is subtly but profoundly monetized by the company with text ads so well-targeted via advanced text-parsing algorithms that they seem more like helpful hints than obnoxious intrusions.
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To grasp the power of this business model, consider it in the context of that tired old phrase about the Internet being an information superhighway. As Google expands Gmail with personalized companion services -- such as maps, mobile-location guides and customized Web portals -- it is swiftly becoming the single most popular roadway in the world on which major corporate advertisers wish to post their billboards. This has put it in the sweet spot of the virtuous cycle for any media company, as user growth and usage growth have translated into increasingly higher advertising rates. The rise in revenues has fueled the companys kitty for research and development, which has in turn fueled further engineering advances.
It is better to be lucky than good, and if youre both -- watch out. Googles targeted advertising strategy has come along at a time when global advertisers have finally decided, after several years of waiting and watching, that they need to shift a very significant portion of their marketing strategy onto the Web. And it has also come along at a time when online sales have exited launch phase and are well into blastoff. The industry says overall online sales in May were up 45% over a year ago and now regularly hit $1.5 billion per week.
Ad money flows in
The path to those riches for Google is only partly through its retail-sales comparison search engine, called Froogle. Its primarily through the increase in prices advertisers are willing to pay to put their name next to the results of consumers searches on Google itself. According to a report by Fathom Online, as reported by an analyst at independent investment research firm First Global, keyword prices are up more than 9% this year above the Christmas holidays seasonally strong levels, to $1.75 per word. That is particularly significant, as a study by another industry research firm shows that most online buyers do a generic search for a product via a search engine before narrowing down their focus (e.g. running shoes, not Adidas). Each time one of those results is clicked on Google, it rings the cash register.
With ad budgets tight and global economic growth slowing, that kind of growth has drawn marketing money away from television, radio and newspapers, which is why traditional media giants such as Viacom (VIA, news, msgs), Clear Channel Communications (CCU, news, msgs) and Tribune (TRB, news, msgs) are struggling. Next to be affected are local Yellow Pages and smaller newspapers, as Googles new local search engine is expected to generate as much as $4 billion in annual revenues by 2009.
This is one street that goes both ways. Just as marketers have shifted a significant portion of their ad purchases from traditional media to Google keywords, institutional investors have likewise shifted a big portion of their stock purchases to Google shares. At $80 billion, the company currently has a market value thats half again larger than Clear Channel, Tribune, News Corp. (NWS, news, msgs) and The Washington Post (WPO, news, msgs) combined.
Now this is where the math gets tricky for new investors. For while its true that Google has performed extremely well fundamentally and shows no signs of slowing down, at a comparable period in their histories Cisco and Dell were much smaller companies. CreditSights pointed out in a note not too long ago that when those two companies had passed the threshold of $750 million in net income in a calendar year, as Google did in December 2005, they had had market caps 1.6 times and 3 times the average S&P 500 ($INX) technology stock at the time. Googles market cap is now about 7.5 times the average S&P 500 tech stock. Moreover, Dells forward price/earnings multiple at that milestone was 9x, and Ciscos was 16x. Googles is more than 60x.
Googles current valuation and future price targets are high because its past has been sterling -- capturing a stunning 57% of the entire search-engine market in 2004, by credible estimates -- and expectations are also high. It is at the very center of the most important trend to hit the modern lifestyle since the PC, and shows every sign of gaining ground. Dell and Cisco managed to avoid serious stumbles and defy their many skeptics at this stage in their histories, and make thousands of late-coming shareholders very wealthy.
Google could very well do the same -- though, because even more is expected of it than of its elders, its margin for error is much thinner. Go ahead and buy now if you believe, but beware that at these prices its most important search will be for the Fountain of Youth, for it must keep running at full speed and never, ever slow down to fulfill all those promises.
Fine Print
To see all the cool stuff that Google engineers have cooking, go to its Labs Web site. One is a MyMSN-like customized home page. Check it out here. ... There are lots of interesting blogs that follow Google. Here is its own.
Jon D. Markman is publisher of StockTactics Advisor, an independent weekly investment newsletter, as well as senior strategist and portfolio manager at Greenbook Investment Management. While he cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at jon.markman@gmail.com; put COMMENT in the subject line. At the time of publication, he held no positions in stocks mentioned in this column.
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