Internet Outsider

Google's Secret Sauce Revealed

Google opened its kimono for Saul Hansell of the New York Times last week, and (for me, at least) the glimpse was a revelation in explaining how the company has maintained its rocketship growth trajectory for so long. 

About nine months ago, when I was first playing around with Google revenue forecasts, the most important assumptions seemed to be 1) number of searches, 2) percentage of searches in which paid links appear ("coverage"), and 3) price per click.  Back then, the growth of global searches was steady but stately, and U.S. coverage seemed to have reached the stage of diminishing returns.  The growth of international coverage was going gangbusters--this was the main driver--but price per click seemed to be flattening. These observations led me to conclude that Google would probably have 2-3 more quarters of strong growth before international coverage matured and the low-hanging paid-search fruit disappeared.

What Saul's article made clear, however, is that over the last year Google has benefited from a fourth major growth driver: improving relevancy of paid links.  The company apparently devotes massive engineering and computational efforts to analyzing which ads will be the most likely to be clicked on by any given searcher, and then displays only these.  According to Saul, the system was introduced late last year (when I was concluding that U.S. growth was about to slow), and currently analyzes the user's geographical location, the time of day, and other (unnamed) factors that might improve relevancy.

It was not news that Google determines which ads to present on factors other than the price an advertiser is willing to pay: the company has long said that an ad's popularity with searchers is a big factor.  Until now, however, I at least had not realized the extent to which this selection process is proactive rather than reactive.  I also hadn't realized that the company might present different ads for the same search based on geography, time-of-day, etc.  Online media companies have been talking about both since the dawn of Internet time, but until recently, the reality has been disappointing.

Without metrics with which to analyze Google's business (searches, coverage, clicks, price-per-click), it is impossible to figure out how much juice relevancy improvements have added to the company's growth over the last year.  Similarly, without knowing how much of the company's global network is tied into the system, as well as how much more complex and effective the selection process can get, it is hard to assess how much longer relevancy will keep turbocharging the business.  This explains why, in part, Google's results have been hard to forecast and suggests that they will continue to be going forward.

It is important to understand that this is a different "relevancy" issue than most industry participants have been obsessing about for the last five years.  Relevancy-for-organic-search, where most of the arguments and development efforts are focused, is a subjective, eye-of-the-beholder advantage that may (or may not) affect which search engine a given searcher decides to use.  Relevancy-for-paid-links, meanwhile, is a direct revenue and profit driver: the same ten ads available to be shown for the same ten searches on Google might generate significantly more revenue and profit than they would on Yahoo!--even if conducted by the same searcher. 

This competitive advantage is more profound than any organic relevancy advantage, especially in a world in which, for most web users, Google has become synonymous with search (i.e., the results could suck and they wouldn't switch).  More importantly, it may also be more defensible.   It also allows the company to fulfill its other mission, improving the user experience.  Another key question, therefore, is how much money Yahoo!, Microsoft, et al, will spend trying to match Google's system. 

And then there is the last question: why Google is blabbing about all this to the New York Times.  Presumably the answer is "to tell advertisers about it," but it's not obvious why they would want to do that, especially since some advertisers might object to having their ads rejected (and not presented) by the system. Also, any discussion like this will only increase the odds that privacy freaks will jump all over the company again. 

   

Overstock Pride Goes Before Fall

Hate to join the crowd kicking this sick horse, but for those who have followed the Overstock story over the last couple of years, the company's pathetic Q3 results--and the sheer predictability of same--can only leave one shaking one's head.

For the last two years, Overstock CEO Patrick Byrne has howled and ranted on television, in print, and on conference calls about the evil conspiracy of "shorts" who have teamed up to take his company down.  Ever since the stock peaked at $77 last December, every downtick (and there have been many) has been attributed to the malicious machinations of a cabal of shorts, journalists, analysts, Eliot Spitzer, and a master-criminal Sith Lord, a group allegedly so complex and well-organized that, a few months ago, Dr. Byrne devoted an entire conference call (and several PowerPoint charts) to detailing its organizational structure and announcing a lawsuit designed to blow it apart. 

To experienced market watchers, a CEO ranting about shortsellers is one of the better predictors of future collapse: CEOs confident in their companies and decisions don't waste time or energy belittling a small group of detractors who are, in any case, wrong.  When the detractors are right, however, and when they are harping publicly about things the CEO doesn't like to hear (and, yes, usually exaggerating the bad news), well, then, it's hunting season.  So for more than a year, Overstock watchers have heard Dr. Byrne rip the dastardly "lickspittles"--with the added entertainment benefit of also hearing him claim that he doesn't care what they say.  Dr. Byrne, according to Dr. Byrne, practices "Buddhist non-attachment" with respect to non-believers.  He just "walks past the barking dog." 

All this was merely entertaining until the Sith Lord conference call of a few months ago (if you haven't listened to it or read the transcript, you must--it's here), at which point it crossed into the bizarre.  In the days following, the transcript was forwarded around Wall Street, and the reaction was no longer "get a load of this guy!" but a hushed silence as listeners felt they were no longer witnessing a garden-variety megalomaniac but a paranoic losing his mind.  Not surprisingly, at no point in the PowerPoint presentation, legal complaint, or amended legal complaint, did Dr. Byrne or the company address the defendants' primary argument, which was that the stock was going down not because of lies but because Overstock's fundamentals were deteriorating. 

Of course, the interpretation of fundamentals is, to some extent, subjective, so there has always been a chance that Dr. Byrne was right: his company was in solid shape; the shorts were criminals.  Dr. Byrne has always prided himself on his apparent forthrightness, so every time the company goofed (frequently), Dr. Byrne stepped up and took responsibility.  And that's what he did this morning, when the company posted a train-wreck of a quarter. 

"Q3 was rough," he said in the press release.  "My bad."  (The conference call is progressing as we speak--update to come).

So it will be interesting to see how the lawsuit--and company--play out from here.  Earlier this week, Dr. Byrne's exceptionally successful father, Jack Byrne, replaced him as Chairman.  One wonders now whether one of the elder Byrne's first moves will be to force his talented-but-distracted son to drop the anti-short jihad and focus on his job (running the company)--or at least acknowledge that maybe, just maybe, the stock is dropping for reasons other than lies.  And one also wonders whether, given their combined control of the company (70%-plus), the Byrnes won't just take Overstock private and end the fight with shorts once and for all.

If Overstock were the gangbuster Amazon and eBay killer that Dr. Byrne often implies, this would be a no-brainer: why put up with the crap of the public market if you don't have to?  If it isn't, however, and Dr. Byrne & Co. have benefited from Dr. Byrne's ability to charm his stock up--and if, as seems to be the case, Dr. Byrne loves to see his name in the headlines--then Overstock will probably remain public.  One hopes for the latter, if for no other reason to see how this soap opera unfolds.

Freebay or Toast? The Contrarian Argument

There has been much articulate commentary lately arguing that unless eBay makes its listings free--and freely searchable by Google--it is toast (see Marc Pincus, Fred Wilson, John Battelle, Bill Burnham and others).  The presumed killers?  GoogleBase, Craigslist, the free web, et al. At first blush, this argument seems a slam dunk: free seems a hard price to beat.  As yet, anyway, I'm not convinced.

The first point that trips me up is that I have heard (and initially believed) this argument before, way back in the mid-to-late-1990s, when eBay had just gone public and the biggest concern among investors was that Yahoo! was going into the auction business--and that its listings, unlike eBay's, would be free.  As one of my colleagues put it, "free's not a bad price," especially when offered by a company as prominent and reputable as Yahoo!.  And Yahoo! made its announcement and its listings were free, and eBay's stock temporarily took it on the chin.  But then, lo and behold, although Yahoo! immediately amassed jillions of listings, eBay's seller and buyer communities stayed put (and its revenue and profit continued to soar).  A few years later, throwing in the towel on free, Yahoo! started charging fees.  That didn't work, either.  So now they're back to free.

In this and other cases, eBay was able to defend itself because of the network effect: without the buyers, it was hard to retain sellers, etc.  In Yahoo!'s case, moreover, it seemed that free listings actually made the experience worse for users: because sellers didn't have skin in the game, they would list pure junk just to see if it would sell, and buyers would have to sift through reams of crap listings to find the few that were worth anything.  And, as time progressed, it also seemed that eBay's intense focus on auctions (and, later, commerce) allowed it to introduce ancillary services that Yahoo! couldn't keep up with, etc., all of which made eBay's fees worth the price.   

I realize that today, the situation is slightly different: now that we have Google, the theory goes, we can search the entire non-eBay web, and soon eBay's listings will be a tiny fraction of the total readily available to a buyer (and, if eBay refuses to allow Google to index its listings, eBay may even be invisible--the "dark web" theory).  This, the Freebay folks argue, will negate the network effect, and sellers will no longer have any reason to use eBay.

For this to happen, though, two things must be (or become) true.  First, eBay's listings must, in fact, be a fraction of the total available on the web in any given category (I suspect that this is not the case, but I haven't tested the theory).  Second, and just as important, the non-eBay listings have to be just as high-quality, fresh, and trustworthy as eBay's, or buyers will be reluctant to depend on them. 

I realize that Craigslist has fanatical supporters who loathe eBay (even though eBay owns 25% of the company) and that there will always be a segment of the web population that considers it the deepest of insults to ever be asked to pay for something.  The web being what it is, these folks will always have free marketplaces or communities where they can trade with one another. 

After watching eBay's experience over the last (near) decade, however, I am skeptical that the majority of sellers who absolutely positively need to 1) sell the item, and 2) get the highest possible price for it, will try to save the 10% or so by uprooting and moving to a free site.  Especially if they have to buy Google keywords--or share revenue with Google--to show up in its search results.

This does not mean that eBay will grow 30% a year forever.  It also does not mean that eBay can keep jacking up prices: the near-revolt that followed the last increase demonstrated that this source of growth has come to an end.  It may mean, as some have suggested, that eBay has to start offering volume discounts, better all-web promotions, cheaper listings in exchange for higher-priced ancillary services, etc.  It may also mean that eBay will forever have to persuade sellers that, although free is a viable option, it's worth paying for eBay. 

In any case, I think the consensus that eBay either 1) goes free, or 2) is toast, may be a rush to judgment that will later prove wrong (or at least prove a vast over-statement).  I don't think the "paid model is dying," as Fred succinctly put it, just as I don't think free office suites will suddenly take over the world.  I think the two models will continue to co-exist, just as they have since the beginning. But I'm happy to be persuaded otherwise.

Yes, Google is a One-Product Company

Well, okay, it's not a one-product company, but it's a one-revenue stream company, and, for our purposes, that's pretty much the same thing.  One revenue-stream companies--especially one revenue-stream companies with a massive revenue base--are significantly riskier than those with a diversified revenue base.  In this case, as goes search spending, so goes Google.

Yes, Google has a zillion cool products, many of which might one day generate meaningful revenue.  The trouble is, as with Yahoo! in 1999 (immediately pre-disaster), these revenue-less products won't do a thing to stave off a train-wreck if/when search spending stumbles.  The other trouble is that Google's search revenue stream is so huge that it will likely be years before another revenue stream provides some real diversification.

(Offering CPM-based ads is a good start toward diversification, but assuming the profitability for this service is similar to the regular AdWords profitability, this revenue stream will have to get massive before it makes much difference to the bottom line.).

Will search spending stumble?  I don't know (nor, I suspect, does anyone).  Most revenue streams do at some point.  To act accordingly, however, one has to to know when that point will be, and I don't.  Suffice it to say that anyone who wants a reminder about what happens to the revenue and profitability (and stock prices) of one-revenue stream companies when the revenue stream falters should check out Yahoo! from 1999 through 2002.

UPDATE: As two of the comments suggest, in the original version of this post, I mixed up some terminology (AdWords on non-Google sites / AdSense).  Fixed now, I hope.

Sorry, Google is Not a Technology Company

Google insists until it is blue in the face that it is NOT a media company, it is a technology company.  The stated reasoning appears to be that Google hires a lot of programmers and offers (some) products akin to those offered by (some) technology companies.

Such classifications, of course, are usually in the eye of the beholder, and when the beholder has a $100 billion market cap and Saturn V growth trajectory, most observers tend to nod meekly in agreement: Google is a technology company.  And this is fine except that in the only way that really matters--revenue--Google is absolutely not a technology company.

Yes, Google uses technology--boatloads of it.  Google's use of technology, moreover, is apparently the key to its competitive differentiation in many product categories (search being by far the most important).  But almost every company uses technology in one form or another, and many wouldn't be able to design or provide competitive products without it (car and plane manufacturers, financial-service firms, television and radio broadcasters, cable companies, phone companies, wireless phone companies).  The reason these companies are not called technology companies is because they don't sell technology.  And with the exception of its microscopic Google Mini business, Google doesn't either.

What does Google sell?  Advertising.  For better or worse, this makes it a media company (an online media company, but a media company).  From a financial forecasting perspective, this also means that the pool of Google's potential revenue, at least in the company's current incarnation, is global advertising and direct marketing spending, not global technology spending.  This is important, in part, because global advertising and marketing spending is not growing as quickly as global technology spending. 

On the positive side, advertising and marketing spending is less subject to nasty product cycles than technology spending, which means that Google doesn't have to obsess or worry about whether a cool new product will cause its customers to decamp en masse, or whether it can goad them into upgrading to the next release (as, for example, Microsoft does).  Also, Google does possess one advantage that is more familiar to most technology companies than most media companies: stickiness.  As long as the world's web users think that Google = Search, they'll keep coming back, no matter how poor a job the company's eyeball attractors are doing on any given day.

The coolness factor of the media business is low these days, what with the moguls in Silicon Valley and Seattle worth many multiples of the average dime-a-dozen Hollywood player.  But now that Google is the world's largest media company, maybe it will soon get cool again.

Phew...They're Human

Google's free cash flow dropped sequentially--to "only" $354 million--thanks to a sequential doubling of CAPEX to $293 million, mainly to build out the burgeoning Mountain View Googleplex.  Probably only temporary, of course (how many new headquarters do you need?).  But still, a whopping amount to spend in a single quarter on servers and cubicles.

Speechless

In the interests of decorum, professionalism, etc., analysts will no doubt offer careful assessments of Google's Q3 results.  And the wires will bustle with stories about how ridiculous it is that a stock that went public at $85 fourteen months ago is now trading at $350ish, etc.

The real story?  These results are absolutely staggering. 

Google's stock price--shocking though it is--is much less amazing than Google's fundamental performance, which is simply not to be believed.  A 7 year old company with a revenue run-rate of $6 billion, an annual growth rate near-100%, 43% EBITDA margins, 100%-plus return-on-invested-capital, a dominant global franchise, and already about half the cash flow of Time Warner (a 100 year-old company with 85,000 employees).  As folks at net-relic Compuserve might put it: Wow.

What happens from here?  God only knows.  But those who are only gasping at the stock price are missing the more astonishing part of the story. 

Disclosure: I don't own Google stock. I did own it, for a few minutes, after "winning" some shares on the IPO, but then I immediately flipped it on the theory that my Yahoo! and Amazon positions gave me enough Internet exposure and that I shouldn't be speculating.  Since then, I've felt like shooting myself.

Ebay Plays the Guidance Game

Yes, fine, as usual, eBay issued forward-year "guidance" that was below the Street's consensus estimate.  And, yes, as usual, the press flooded the wires with stories about how eBay had "cut its outlook" and issued a "disappointing forecast," etc.  And, yes, as usual, the stock tanked.

And that's fine.  But one of these days, it would be fun to see a headline like this: 

As Usual, eBay Plays the 'Guidance Game'--Issues low forecast now to 'beat expectations' later.

eBay is a master at this game, of course, which is why in all but one of the last umpteen quarters the company has shocked itself by posting results one or two pennies above its expectations.  (In that one exception, if memory serves, eBay met its expectations, and the market correctly interpreted this as a massive disappointment and smashed the stock).  In Q4, if all goes as usual, eBay will raise its expectations for 2006, and in a quarter or two its guidance will be at or above the consensus prior to yesterday's report. 

Disclosure: I don't own any eBay stock, but I often wish I did.  This post (and all posts on Internet Outsider) contains personal opinions with which you and other reasonable people may disagree. 

Yahoo! in Robust Health--But Watch Those Margins

Apologies for the recent lull...  After two weeks at this, my admiration for Fred Wilson, John Battelle, and others who post half-a-dozen mini-essays a day while also traveling, running companies, and herding kids has grown immensely.

Anyway, Yahoo! printed another strong quarter.  Since recovering from its near-death experience, the company has matured into a steady revenue and earnings growth machine, and in my opinion, many observers still fail to appreciate its extraordinary cash flow characteristics (shared by Google, eBay, and a few other Internet leaders).  In contrast to most businesses, Yahoo! generates more free cash than earnings.  This, combined with a big pile of cash and other assets, makes a standard P/E valuation less meaningful than most pundits suggest.

The one aspect of the quarter that raised a yellow flag for me was a slight deterioration of the gross and operating margins, which have otherwise expanded steadily for the past several years.  As Yahoo! becomes more content-centric (and ramps up hiring or licensing accordingly), and as it pumps out more broadband video, audio, etc., it is possible that the company's cost structure may change, eventually resulting in lower margins.  This has happened once already in the company's history--in early 2000, the operating margin stopped increasing for the first time ever--and, in hindsight, this was the first clue of impending disaster.

Today, Yahoo! is far more diversified and the Internet is far more mature than in 2000, so the train-wreck scenario seems almost inconceivable.  It does seem possible, however, that, as the arms race with Google et al heats up--and as Yahoo! takes the more content-intensive approach--margins might deteriorate (a condition rarely viewed favorably by the market). 

At best, it seems as though Yahoo!'s days of impressive margin expansion are behind it.  (CFO Sue Decker said on the call that future expansion will likely come from the international business, that the profitability of the U.S. business was such that the company was comfortable with the balance between profits and investment).  Even if things continue to go well, therefore, Yahoo!'s cash flow and earnings growth will gradually converge toward the revenue growth rate, removing the profit-accelerator of operating leverage that the company and its shareholders (myself included) have enjoyed for the past few years.   

It is important to note that Decker, Semel, & Co. are almost certainly taking the wisest approach here: Balancing near-term profit with heavy investments in personnel and technology are in the best long-term interests of the company and shareholders, especially as the industry consolidates.  But a slowdown in margin expansion is a sign of a maturing business and industry, and maturity, sadly, requires patience.   

Disclosure: I own a boatload of Yahoo! stock. I have owned it for several years and expect/hope to own it for at least another decade (and if I change my mind about that while still publishing in this forum I'll say so here first).  I don't think this affects my ability to view the company objectively, but you may conclude otherwise.   

What Comcast Sees That Time Warner Didn't

As we wait for another frantic AOL suitor to screech to a halt in front of Time Warner's shiny new headquarters (one reader suggested News Corp., with a tie-up  feeding Murdoch's Internet hunger and complementing the MySpace demographic), we should pause to consider what Time Warner hopes to get out of this (next post).  We should also take the company to task for some egregious missed opportunities.

For example, on the latter issue, we have been told that one of the AOL suitors is Comcast.  As discussed, Comcast presumably wants to grab some Internet ad/commerce revenue, get a real portal for its broadband service, and market to AOL dial-up subscribers, many of which could become Comcast broadband customers.  All this makes sense.  Which is why we should remind ourselves that Comcast is a cable company and Time Warner already owns a cable company, one that has taken almost FIVE YEARS to negotiate a similar deal with AOL.

Yes, AOL came into the Time Warner merger fantastically arrogant, sure that every Time Warner division would (or should) run to Dulles and beg for some Internet magic.  And, yes, one can understand why, given that attitude, the folks at Time Warner Cable would secretly rejoice as a dirth of cable distribution deals helped the dial-up giant implode.  But there's a difference between snickering in the boardroom and shooting yourself in the foot, and, as far as AOL is concerned, Time Warner did the latter.

Flawed though it was, the AOL merger was premised on a sound concept: that common ownership of old and new media assets might allow the company to lead both industries in developing next-generation online services.  As far back as 1999, it was clear that the Internet would permanently change the music, film, cable, and print media businesses, and that the incumbents might suffer.  The goal, therefore, was to work to lead this transition, rather than react to it, and to lead by working together, rather than competing internally.  Because the managers of any individual business are going to do everything possible to defend their interests, the responsibility for cooperation falls to senior management.  Time Warner's senior managers failed to achieve real cooperation, even when the company had 100% ownership control of both sides of each transaction.

So now, five years later, Time Warner Cable has finally announced a new broadband service that features AOL, but only after flushing a half-decade worth of brand-building dollars down the toilet to support the irrelevant Road Runner.  Apple is miles ahead in music and video distribution.  AOL and TWC are competing (or at least not cooperating fully) in Internet telephony (cable modem vs. soft phone)--another area that Comcast may want a piece of.

Perhaps, if Comcast takes an AOL stake, the aggressive Brian Roberts will show Time Warner how AOL might be used more effectively to forward the interests of the cable business.  If so, however, some of the value creation will flow not to Time Warner's shareholders but to Comcast's, as Time Warner's continue to shake their heads about a lost five years at AOL.