Google: The Bear Case
No one else is writing this piece, so it will have to be me. I should say upfront that I'm not predicting that this will happen (yet), and I'm certainly not making a recommendation. I'm just laying out a scenario that could kneecap Google and take its stock back to, say, $100 a share.
Google's major weakness is that it is almost entirely dependent on one, high-margin revenue stream. The company has dozens of cool products, but with the exception of AdWords, none of them generate meaningful revenue. From an intermediate-term financial perspective, therefore, they are irrelevant.
So, the question is, what could happen to AdWords, and what will happen to the company (and stock) if it does?
The first thing that could happen is that, for a variety of reasons, AdWords revenue growth could slow. The reasons could include market saturation (one of these days, Google will have picked all the low-hanging search fruit) and/or a flattening of keyword price increases (recent anecdotal evidence such as FTD suggests that this is already happening in some categories). Both market saturation and price pressure will occur naturally someday, as they do with every business. The only question is when.
If/when this slowdown occurs, what will happen? The stock's multiple will compress. How much? At $460, Google is valued at about $140 billion, or approximately 50X-70X a 2006 free cash flow estimate of $2-$3 billion. If grows slows gradually, this multiple will probably shrink to 30X-40X. If it slows precipitously, the multiple will probably shrink to 20X-30X. Natural forces, in other words, should eventually compress Google's FCF multiple by 20%-60%. (I am comfortable predicting that this will happen. Again, the only question is when.)
And then there are the disaster scenarios. Chief among them: click fraud. Yes, to some extent, click fraud is just a cost of doing business--already factored into ROIs. And, yes, no one knows how big a problem it is, which means it could be a smaller problem than people think. And, yes, Google presumably has airplane hangars (sorry, Googleplexes) filled with rocket scientists working the problem. And, yes, they might get it licked.
But, let's say click fraud continues to increase as a percent of total clicks (which seems perfectly plausible to me). Eventually, all else being equal, ROIs will start to decrease, as the $1.00 keyword that delivers a profitable sale today will deliver an unprofitable one tomorrow. Then, two things will happen: First, marketing dollars will begin to flow back offline (a la FTD) or at least flow online at a slower rate. Second, keyword prices will start trending down. The latter will happen as the growth of (real) clicks is also slowing, compounding the impact. Search revenue the product of CLICKS X PRICE-PER-CLICK and, thus far in the industry's history, both have enjoyed consistent, impressive growth. If one of these two metrics starts to drop, overall revenue growth could stagnate, and then, ultimately, decline.
If this happens, Google's multiple will compress to the 20X-30X range cited above. Only this time, the multiple will be applied to a smaller free cash flow stream--at least until Google starts cutting pie-in-the-sky projects and firing people. And as this is happening, of course, Google's hiring--about 10 new geniuses a day--will get more challenging, because getting paid in Google stock options won't seem like such a great deal anymore. To combat this, Google will have pay more cash, which will put more pressure on margins and cash flow. And, of course, many of the pre-IPO billionaire managers and developers may decide that now is the time to start that start-up they've always dreamt about--("Enough of the big-company thing." "It's just not fun anymore.") And that's if the impact is gradual.
If the click fraud impact (or the impact of some other unforseen problem like a global recession) is sudden, then the above scenario will seem like a holiday. The one drawback of super-high-margin revenue streams is that they create the illusion of endless and effortless profitability. Google has so much money right now that one of its biggest challenges is finding ways to spend it ($200 million on Googleplexes, $600 million on server farms, $500 million worth of product development per year). What this translates to is a high and rapidly increasing fixed cost base--one that, on the income statement alone, now amounts to a run-rate of about $2 billion a year (excluding traffic acquisition costs).
Importantly, almost all of this $2 billion is fixed, not variable. If revenue drops, these expenses will remain the same--unless Google takes painful steps to cut them. Google's net revenue run-rate in Q4 should be something on the order of $5.5 billion, so there is plenty of room to spare. But having enjoyed a 55%-plus operating margin in the past, it's hard to imagine that Google shareholders are going to accept, say, a 20% margin--so the golden Google management team will find itself under intense pressure to cut costs and re-organize.
Would the company survive? Absolutely. The franchise is now so strong that it would take Enron-like fraud to destroy it. But when revenue and profits are plummeting, when global advertisers are running away from the the distaste, expense, and frustration associated with search marketing as fast as they are currently running toward it (and as fast as they ran away from the last miracle vehicles--display and email--in 2000), and when Google has transformed from a symbol of the American dream to yet-another get-rich-quick hallucination, it will seem as though Google is in danger of collapsing. Managers will leave en masse, in disgrace. Newspapers the world over will revel in front-page analyses of shortsightedness, arrogance, and what went wrong. And the cash flow multiple will compress to below 20X on a lower FCF stream.
Is such a scenario likely? Probably not. But it's certainly within the realm of possibility. (How do we know this? Because the same thing just happened to Yahoo!, AOL, and every other advertising-driven dotcom on the planet--except that in those cases, the fallout was worse). So let's put that in our Google-$2000 pipe and smoke it.
(http://www.internetoutsider.com/2006/01/google_the_bear.html)
