Above the Crowd

On Google, Growth, Pricing Power, and Valuation Multiples

July 15, 2010:

Last night, Google reported financial results for the second quarter of 2010. While revenue growth was up 24% year over year, revenue was fairly flat compared with Q1 of 2010. Moreover, earnings fell short of average street estimates sending Google down $20 per share (4%) in the aftermarket. Based on current estimates (which might change tomorrow), Google currently trades at 18 times the street average for 2010 earnings, and 15.5 times the same number for 2011. These represent price/revenue multiples of 7.5 and 6.5 for 2010 and 2011 respectively. For a long-term tech investor, these valuation multiples seem surprisingly low for a proven market leader. What gives?

Over the past 30-40 years of tech investing, public investors have come to expect the market leaders in each sector to trade at valuation premiums. On average, these market leaders have had respectful PE multiples of over 30X forward 12-month earnings, and price/revenue multiples in the 6-10X range. As examples, Microsoft and Cisco held 30X+ PEs for many, many years. With this as a backdrop, many are surprised that Google, which is relatively young at only 12 years old, is burdened with a PE multiple that is typically associated with the senior-citizens of tech leadership. Google’s forward current PE multiple isn’t remarkably higher than Microsoft (12.75) or Cisco (15).

While there is no exact science for what leads to higher PEs, there are many theories. Some argue that PE’s relate to growth. That said, Google’s growth is much higher than Microsoft and Cisco, and yet it doesn’t have that much higher a multiple. My good friend, Mike Mauboussin of Legg Mason, suggests that higher PEs reflect more concrete competitive advantages.  I have always been a huge fan of this theory he calls CAP (which stands for Competitive Advantage Period). It also dovetails nicely with Warren Buffet’s competitive moat theory. However, when I look at Google, I see a company that is well positioned strategically. All attempts at dislodging their leadership have been unsuccessful to date. As such, I don’t think they suffer in this area. One other area typically cited is the more amorphous category of “execution.”  I also have a hard time seeing this as the culprit, as Google’s recent execution on Android is pure genius. Moreover, the Google Apps progress is extremely impressive.

So if its not growth, competitive position, or execution, what is the shortcoming that hurts Google’s valuation? Believe it or not, the problem is that their initial business model was “too good.” Before I explain take a look at the included chart. Microsoft was founded in 1975, it went public in 1986, reached $10B in sales in 1997, and fell below 20% growth in year 2000. Google was founded in 1998, went public in 2004, hit $10B in sales in 2006, and fell below 20% growth in 2009. So it took Microsoft 22 years to hit $10B in sales. Google did it in 8 years. Resultantly, Microsoft had growth of greater than 20% for 26 years; Google for only 11.

I would argue the reason for the noted disparity is pricing optimization and pricing power. When Microsoft first established DOS as a market standard, they reaped about $10/PC in royalties. By the heyday of Windows NT, Microsoft was receiving well over $120/PC in the enterprise. Additionally, they layered in Microsoft Office on top of the OS, which took revenue/PC well north of $200. That’s a 20X increase from where they started. Google’s brilliant bid/market based ad product optimized pricing remarkably quickly. As such, Google reached $10B in revenue in about 3X more quickly than Microsoft. Unfortunately, this coin has two sides.

With its ad optimization engine so amazingly efficient, Google has no obvious pricing power against its current installed base. There is simply no way to “double” the amount of spend from each customer, much less a way to take it up 20X. Additionally, they have not yet identified a product that would represent the Google’s version of Microsoft Office in terms of revenue leverage. The Enterprise Apps offering is phenomenal, but the numbers are simply too small relative to search. More importantly, the Entprise App product does not “sit right on top of” the search franchise (as Office was to Windows), limiting the ability to leverage the success of one product into the other.

Of course, there is little reason to weep for Google. As mentioned earlier, they appear to be rocking in many areas. Google mail and calendar are now used by over 2 million unique organizations. Also, the execution of the Andoid team will be talked about for decades to come. And even though they may be limited in their price leverage on core search advertising, they still have that blank wide open home page, that I suspect is at least $1 billion in forgone annual ad revenue.

23 Comments

  1. Spencer Rascoff July 16, 2010

    Bill,
    Great post. Really fascinating and insightful. I was poring over the equity analysts’ research on GOOG this morning and let’s just say that the sellside analyst community misses you.

    One thing you left out which undoubtedly affects trading multiples: good old-fashioned sentiment and momentum. Companies sometimes come into favor, and sometimes they go out of favor. The buyside (and the sellside analyst community) travels in a herd, and sometimes that drives valuations as much as pure fundamentals do. True, sometimes the herd starts to move away from something for a good reason initially, but then the herd usually goes too far. In this case, GOOG has fallen out of favor. The most common explanation among the sellside research analysts is that the market is frustrated by the continued opex increases and they don’t see any of the ancillary initiatives paying out anytime soon. (Note that their expenses excluding TAC increased 36% y-o-y and they added 1200 new people in the quarter!). But I think it’s also that GOOG is just no longer the darling of the Valley, it’s no longer the shiny new toy. Facebook, Zynga, Groupon, Linked In, Twitter and my company Zillow (ok, well not quite) are in the spotlight and GOOG isn’t the most popular kid at school anymore. In that regard, I actually think GOOG’s valuation is hurt by the fact that some of those companies aren’t public yet — people can’t see the huge multiple disparities between them.

    I applaud GOOG for continuing to invest in ancillary businesses (e.g., Android, Apps, News, Chrome) despite the criticism from the Street. If GOOG shut down everything other than search, they’d trim billions of expenses, but they’d hamper their long-term competitive advantage. The short-term valuation pop would be short-lived. Still, it must be frustrating to GOOG employees, and disruptive to a company culture which only a few years ago was used to meteoric stock price growth and now suffers from the cliche that affects most public companies, a pervasive feeling that “my stock price is undervalued.”

    Reply
    • Ben July 25, 2010

      I think there is an interesting argument to be made that Google has significant pricing power remaining within the core adwords search business. If you consider that there are many businesses who rely on reselling google Adwords at a premium that is rumored to be as high as 2x the adwords cost, with no transparency as to the margin they really take, (AT&T, AdReady, Atlanta Journal Constitution, Citysearch, Clickable, Comcast, Hearst Newspapers, Network Solutions, Orange Soda, ReachLocal, Dex One, SuperMedia, YPG, Yellowbook and Yodle), I’d argue that Google is pricing below value to the end consumer in many instances, and as they add complementary campaign management tools that some of those resellers now offer, people will value those same ads at higher prices (whether they bid more to reflect the desire for their ads being tracked by those additional campaign management tools, or Google charges for the tools directly).

  2. Rick Sherlund July 16, 2010

    Margin contraction is always a difficult issue for investors, even if it is on incremental business and drives incremental earnings growth.

    Reply
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  4. Nicolas Vandenberghe July 16, 2010

    Bill,
    This is a very interesting post, great analysis and comparison with MS.
    But it seems to me that you mis-named the problem: it’s not so much lack of pricing power as lack of “complement” revenues (see http://www.joelonsoftware.com/articles/StrategyLetterV.html) – like office revenues are to windows or Exchange revenues to NT.

    As you point out, Google has optimized its pricing power in its core search. Now it’s not about getting more dollars for the same product, it’s about adding new complement products.

    It may be argued that Google has a long term view and is in the process of commoditizing the world before re-building its revenues (see http://cdixon.org/page/5/ ). In that case growth will re-start once competition and potental competition have been neutralized. For example, once google apps essentially destroy the NT-Exchange-Outlook franchise, google will be able to raise its prices on it and make more money.

    In that sense you’re right there is a question of pricing power, but in the context of complement products. Don’t you think?

    Reply
    • bgurley July 16, 2010

      I think that’s half of it, but MSFT raised the price of the core OS by itself (without Microsoft Office). So i think what you mention is half of it.

  5. scrilla_gorilla July 16, 2010

    People who say Google’s execution is poor may be missing the fact that Google does not introduce new products in the standard corporate way.

    Most firms make strategic decisions at the top – “We need to introduce products/services A, B, and C” – and then delegate down the chain to make that happen, investing substantial resources in each project. This is efficient if the top-level vision and mid-level mgt execution is good, but it can also (especially if either vision or mgt is not great) lead to inertia, malaise, mediocrity, and a slow corporate death (see: Microsoft).

    Google, for the most part, doesn’t do that. Rather, they expand into new products/services by operating as essentially the world’s largest startup incubator. The fact that developers can devote 20% of their time to whatever they want, and then the finished products are released with no promotion, means you get a lot of flops (which are labeled “poor execution”). But it also means you have a much higher chance of creating “the next big thing” (see: Android) and avoiding the inertia, malaise, and mediocrity.

    Reply
    • bgurley July 16, 2010

      i said at least twice and maybe three times that i thought Google’s execution was outstanding.

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  7. amol July 17, 2010

    perhaps another way to think of pricing power is not with the advertisers but with publishers. the $ per ad google takes from an ad unit. this is the place where the network effects of their ad market could give them great power to take more $ of every ad they sell for their publishers.

    Reply
  8. vishi gondi July 18, 2010

    Googles push into banner ads and remarketing is what would keep the revenues up. It would remove issues with tight search inventory and allow monetization of low value content.

    It might take sometime to consolidate and integrate players like Invite Media, but am sure that it would boost revenues significantly.

    They just have to get around to purchasing all the parts and pieces in the display arena and provide a compelling value proposition for companies willing to spend money on online Ads.

    Reply
  9. Joseph Hosler July 20, 2010

    Bill,
    I think you have done a nice job at summarizing the various factors in valuation. I would suggest one more (most likely a subset to CAP) based on business model stability. Google’s core search is an exchange based business where value is derived by the adoption of it by the masses. Unlike MSFT, where it’s ecosystem (vast number of developers, installed PC base, etc) will prevent an overnight ‘run-on-the-bank’ event, GOOG’s model does not yet have that level of stability (though I think Android gets them closer).

    Reply
  10. Mark May July 27, 2010

    Thx for this post. Two comments: 1) if you’re trying to narrow down to just one reason for the decline in Google’s valuation, I think you’ve done that – I agree. But, I’d summarize your conclusion more simply – valuation multiples are largely a function of growth. And, Google’s multiple has fallen bc of slowing growth and has fallen more quickly that MSFT’s did bc its early growth was so much more explosive. And, 2) Your use of P/E multiples, particularly for historical comparison purposes, could be misleading as their are relatively new accounting policies like goodwill amortization that will skew comparisons to, for instance, Microsoft’s historical multiple. Moreover, GAAP earnings these days are not a good barometer for the cash earnings power of businesses because of some of the new accounting rules (like stock base comp and goodwill amort, which are already reflected/diluted in either share count or cash balances).

    Reply
  11. Steve July 28, 2010

    If only we bought google shares years ago – how much do you think google shares will get to over the next year?

    Reply
  12. Jane Cooke August 9, 2010

    I would disagree only about the 1 billion foregone revenue on the home page. If they put ads there or filled it up, it would cost them 1 billion in losses. Their simplistic home page is their biggest selling point in organic search. But the rest of the points are perfect :-)

    Reply
  13. PY August 10, 2010

    Bill, do you think GOOG’s two-tier ownership structure would have anything to do at all with this seeming multiple discount on the common shares? Or is it a non-issue for most investors?

    Given the passive roles taken on by large non-activist institutional investors (i.e. large mutual funds), I’m not sure how big a factor it is.

    Reply
    • bgurley August 11, 2010

      I think this is an excellent question. Of course, it always hard to know. When the stock dipped to $300, they used this executive power to reprice every employees options. This is the kind of thing that happens with this structure. There is also a bit of an attitude that says “we don’t value shareholders”. You could be right.

  14. mark may August 11, 2010

    The dual class structure has been in place since the ipo. Theoretically, this risk factor has been discounted since then and would account for the recent under performance (I.e., that risk factor hasn’t necessary chgd of late)

    Reply
  15. Adrian Scott August 28, 2010

    Neat analysis, thank you.

    While GOOG may not have the opportunity to have its customers double their ad-spends easily, they can extract a higher-percentage out of their market-providing service, like Ebay did. Certainly that only works up to a certain point, but they have a strong position for that.

    Reply
  16. Steve September 13, 2010

    I think GOOG’s relatively low multiple could have something to do with some of its less than shareholder friendly practices. For example, why doesn’t GOOG buy back the shares it issues through employee compensation schemes? It has the cash and the options + restricted shares are pretty dilutive. It also doesn’t help when the CEO doesn’t attend conference calls.

    Reply
  17. Daran September 14, 2010

    It is a lot easier to switch search provider (Google – Bing) than switching installed infrastructure (Microsoft, Cisco, etc). Look at the speed with which people switched from MySpace to Facebook; the same may happen to Google.

    The tech-savvy are already fed up with advertising and installing filter software in their browser. Look for that trend to increase; another risk for Google.

    Reply
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