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Google and AT&T: Is bigger better?
Investors are betting that profits at Google and AT&T will climb as each company grows, but they may be wrong. Let's look at the scenarios -- and at the case of Amazon.com.
By Jim Jubak
What do the share prices of Google and AT&T have in common?
In each case, investors who own the stocks are betting that bigger is better. In the first instance, I think that's dead wrong. Investors who are buying Google (GOOG, news, msgs) now because they believe the company's profit margins are going to increase from current levels are likely to be disappointed.
In the second, I think the answer is yes. The purchase of BellSouth (BLS, news, msgs) by AT&T (T, news, msgs) makes sense, and bigger can be better. But forget about all the Street talk about bundles of new technology driving phone-company profits. It's good, old-fashioned land-line phones that make this deal make sense.
And both these stocks have another thing in common. Investors aren't paying enough attention to this question: How do these businesses scale?
Ideally, profit margins go up as companies get bigger and they're able to spread fixed costs over a larger base of sales. Margins also increase as they use their size to wring variable costs out of their business by means such as negotiating lower prices from suppliers (the Wal-Mart Stores (WMT, news, msgs) model) or using larger profits to invest in cost-cutting equipment (the FedEx (FDX, news, msgs) model).
But the real world is almost never ideal. The greatest risk that investors are taking now is that profit margins will sink, not climb, with size.
Related news and commentary on MSN Money
A peek at the scale
Let me use Amazon.com (AMZN, news, msgs) as my template for a company where bigger isn't turning out to be better. I think that's fair, since the company has long stated that its strategy was to build unit volumes, even at the cost of current profit margins, because large volumes would ultimately result in higher margins. The stock is down 22% in 2006, however, largely on the news in the company's fourth-quarter 2005 earnings report that the long-delayed improvement in margins was going to be delayed yet again.
Amazon continues to grow unit volume -- unit growth was 22% in the fourth quarter of 2005. But Amazon just can't seem to hit that magic point where it can reduce investment in the company as a percentage of revenue. For example, in the fourth quarter of 2005, spending on technology and content climbed to 4.1% of sales, an increase of 1.2 percentage points from the fourth quarter of 2004. Even as the company grows in size, operating profit margins are falling. For 2006, the company forecast sales growth of 16% to 23% and a decline in operating margin to 5.1% to 6.2%, down from the 6.6% of 2005.
That's especially disappointing because Amazon seemed to be on a profit-margin roll back in 2004, producing the best operating margin, 7.3%, in the company's history. A drop to the neighborhood of 6% in 2006 would be a huge step backward.
So what exactly is the problem? In a nutshell, Amazon's business hasn't scaled according to schedule. By this point, for example, Amazon should be able to hold what it calls investment in technology and content relatively stable, even as the company grows in size.
Yes, the company will continue to need to invest in its business. But Amazon's brand and its clout in the marketplace should let it reduce that spending as a percentage of revenue as revenue grows. Instead, the company's spending in this category jumped 57% in the fourth quarter of 2005.
And Amazon isn't getting any leverage on operating expenses or shipping costs, either. Those two rose by 31% and 17%, respectively, in the quarter.
Google looks Amazonian
I've spent so much time on Amazon because Google is showing symptoms of the same failure to scale on schedule. Google's hiring rate in 2005 of 88% just trails its revenue-growth rate of 93%. Capital spending was up 163% in 2005 over 2004. Research and development costs rose 115%. Sales and marketing, up 79%. General and administrative costs were up 140%.
Maybe Google is still too young for any of this to be an issue. Its 2005 revenue of $6.1 billion was, after all, only about 15% of Microsoft's (MSFT, news, msgs) $40 billion in revenue for the fiscal year that ended in July 2005. But the company is certainly building a costly cost structure that will have a huge impact on future profit margins and earnings growth. For example, all those new employees get stock and stock options that could total $600 million by 2010, up from $200 million in 2005. (Microsoft is the parent of MSN Money.)
But when a stock trades at 73 times trailing earnings, I'd argue that these numbers do matter, and that investors shouldn't assume that Google's profit margins will grow as its revenues do. That's especially true when the company starts to talk about paying Dell (DELL, news, msgs) $1 billion over three years to load its software on new Dell PCs. And about building a 1 million-square-foot research park for collaboration with NASA.
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