Analyzing Safa's $600 Google Target

Ah, memories...

So Safa Rashtchy of Piper Jaffray upped his Google price target from $445 to $600.  Is he INSANE?

No.  He simply assumes that Google's recent growth trends will continue in pretty much a straight line for the next two years and that the market will put the same multiple on the stock next January as it does now.  And unlike most of the pantywaist Google analyst herd, he's bold enough to stick his neck out.  (If Google reports another bombshell of a quarter, watch the rest of the targets creep up to Safa's--and watch the world yawn.)  This is what valuable sell-side analysts do: Take positions that make you think--even if your thinking leads you to conclude that they are morons.  So raise your glass to Safa and team, regardless of what happens.

Of course, "bold" does not necessarily equate to "prescient" or "wise," and anyone can plug numbers into a spreadsheet.  So it's worth analyzing Safa's key assumptions.  According to the report, which John Battelle kindly links to, these include:

• Search spending grows 41% next year and at a 37% CAGR for the next five years.
• Google continues to gain share, thus growing faster than the market.
• Google's operating profit margin continues to increase modestly, ending at 57% in 2007.

None of these assumptions are ridiculous. They do strike me, however, as more likely aggressive than conservative.  Safa also does not address (or forecast--at least in this report) the metric that I think is most relevant to Google's valuation: free cash flow.  Google's capex spending is so out of hand (an estimated $800 million or more this year) that EBITDA does not provide a fair picture of the company's value, and neither does pro forma EPS.  But on to the assumptions:

Search has grown phenomenally over the past six years and is now a $10 billion global business.  Safa's growth assumptions call for it to nearly triple again in five years, to nearly $30 billion.  I don't object to the $30 billion assumption so much as the corollary assumption that search will then have experienced an entire decade of phenomenal growth without so much as a hiccup.  Most online advertising projections back in 1999 looked very similar to Safa's current search projections: up and to the right (with the slope of the line getting steeper with every amazing quarter).  And, on average, that's what the market has done.  But 2001 and 2002, we all remember, were anything but up and to the right.

What could slow the growth of search?  Click fraud, for one.  An economic slowdown.  And probably about a dozen other factors that, if they occur, will be screamingly obvious in hindsight.  In my opinion, the conservative assumption is that something will cause a hiccup in search growth in the next few years, even if we don't yet know what.

On to Safa's second assumption: Google will continue to gain share. Seems likely to me.

And the third assumption: Google's profit margin will continue to increase from an already incredible 50%-plus.  If you believe that search will grow steadily to $30 billion, this will probably happen (Google's incremental revenue in search is probably as profitable as Microsoft's with Windows--i.e., 95%-plus).  If you believe, however, that market growth will stumble, and that what might cause the stumble would be something like click fraud, then the assumption is aggressive.  Additionally, if you believe that Google will one day add other services, the margin assumption seems even more aggressive.  It is hard to believe that any other product Google could roll out in size would have profit margins like search.

As for the market maintaining a 50X forward EPS multiple on the stock for another year, this is anyone's guess.  If the future unfolds as Safa predicts, and the rest of the stock-market holds its valuation, then 50X is perfectly reasonable.  Of course, 25X or 30X or 60X would be perfectly reasonable, too.

So, no, Safa's not nuts.  In my opinion, there's about a one in three chance that Google's future will be as good or better than he predicts.  But that leaves two chances in three (again in my opinion) that it will be worse--and at least one in three that it will be temporarily disastrous.

Comments

[Stan Ridgeway]

If it hits $500...I know how I am playing it.

[Tim Wang]

Thank for the in depth analysis. its always a pleasure to read your blog. One also has to look at Google from an institutional investors' perspective. Google has become a "must own" amongst the pros. With analysts raising their price target, portfolio managers now have even more ammo to ask their credit committee to increase their Google allocation. One can expect Google buy orders to start coming in the next month. The general consensus this year is that market will be flat. So it make sense that people will be calmoring over the only promising, high-growth, and proven high tech firm Google.

[Henry Blodget]

Tim: Thanks. I agree, especially given that Google will almost definitely be added to the S&P 500 at some point and is presumably underowned by indexers and closet indexers who will be forced to snap up every share they can find. Safa's target wasn't based on "latent demand" and "scarcity" theories, which was why I didn't discuss it, but these undoubtedly move stocks in the short and intermediate term. Long-term, of course, the stock should gravitate around the cash flow, and as the last few years have shown, popular "must own" stocks can become unpopular "must sell" stocks in a hurry.

[Sam Foster]

The reason why Wall Street analysts are insane (and I´m not saying Safa is per se) is because they only look at the numbers. But a business is about a lot more than numbers. Has Safa ever actually owned a business that advertised with Google? Has he actually owned a site that got paid because of Google Ads? If he had, he would understand that Google is ridiculously overvalued because its only source of revenue, Text Ads, will at some point collapse because:

A. They do not work.
For the large majority of small to medium businesses, that are bread and butter of Google, Google Ads do not work at all. Yes Google Ads may have worked several years ago, when prices for ads were cheap, but the price per clicks for decent words are simply absurd now and they cannot be justified by any intelligent business person. And it is not only the PPC model. The CPM model at Google is likewise absurd. At some point, businesses will wake up and realize how much they pay Google and how little they make back on their investment. Then they will all leave Google and drop text ads forever. Google´s business will then collapse.

B. Fraud.
Beside the well-known issue of click fraud (20% of Google´s business is completely based on click fraud), there is a new fraud in town: CPM fraud. Ever wonder why high trafficked websites place Google Ads low on the page and in places where nobody clicks? As you asked in another post: Who clicks on these ads? The answer is nobody. But it´s simple, Google pays these sites for Google Ads even if nobody sees them or clicks on them. With banner ads, at least you are gauranteed a position on the site where your ad might be seen. With Google CPM Ads, Google gets paid based on impressions irregardless of where your ad is seen. So there is a huge incentive for highly trafficked sites to place Google Ads at the bottom of the page and just cash the checks.

All in all, a ton of Google´s revenue is clearly fraudulently generated. When advertisers wake up to this fact, they will stop using Google in masse.

It´s only a matter of time before Google´s revenue collapses. Its projected cash-flow, multiple etc. are all meaningless once nobody gives a hoot anymore about online text ads. It´s not as if Google´s search engine is the best anymore by any means.

[Rick James]

HB: I agree with your logic...the scary part is trying to time shorting GOOG. I would bet shareholders of lesser know search engines are responsible for a lot of the click fraud.
Now what does everyone think of a nice safe utilty (WTR)?

[Sam Foster]

It´s not third-party search engines. It´s all the major content sites that are now back in vogue in Wall Street. Just go to About.com. Look at how many Google Ads they show way, way beneath the fold. What advertiser in their right mind would want to be seen that low on a page? Who even looks there? But Google charges advertisers and pays About.com for these types of ads (the price for these ads is in fact not much lower than a banner ad in full view), so both are in bed together. The same can be said for all the big content sites. The revenue from this type of advertising "scam" is huge. It will collapse some day. I don´t know when. I´m boggled at how people don´t realize what is going on. But there is too much money involved for this to come out anytime soon.

The only difference between this new Internet bubble and the last is that the Internet companies are now taking money from small businesses credit cards, instead of small-time investors brokerage accounts. And with their huge cash hoard, it is nearly impossible to get reimbursed by Google for what are clearly fraudulent billings.

[Stuart MacDonald]

More great commentary, Henry. As stated above, your thoughts are always a great read. While I believe that the paid serch gravy train is running out of steam for a bunch of reasons, I am interested if you have a view on GOOG's possible upside in the apparent next-wave of online advertising, that being brand building as opposed to pure selling that paid search has been about to-date?

- Stuart

[Jack Miller]

As an unabashed Google fan, I must remind you folks that search is in its infancy. In the near future, search will be a great tool on millions of WiFi enabled portables and for volumes of video and audio content.

The total market will be extremely huge. Yahoo will make money, MSFT will make money and Google will make boat loads of money.

The comments in regard to the problems with search are like the comments made 90 years ago about putting glass windshields in cars. Most commentators thought it was a terrible idea. Search is like the early car in that it will be improved and adapted. It will become a necessity.

Clearly $600 is only a guess. I have purchased Google all the way up and will continue to buy. Promise me $520 this year and I'll buy more in an instant on margin.

[Jack Miller]

I forgot to mention that Google is preparing to sell video. We tend to think of search as being only supported by advertising. When billions of people have come to depend on Google to find stuff, much of the stuff they find will cost real money.

[charles]

Is it possible to buy both puts and calls on GOOG, and make money on either direction? I've never bought options so I don't know...seems like it would work if it doesn't stay at the same price - and its not limited by a short timeframe.

[franck]

I'm not sure I agree. While an economic slowdown would definitely be bad news for Google, I have a hard time figuring out how click fraud could have any significant impact on their business. And for following reasons:

1. Targetted ads. The biggest attraction of the online model is the fact that ads can be highly relevant. That might change in the future in the offline world but today only the online world can prevent the waste. Sure click fraud does add some level of waste, but it's ridiculously low compared to the level of waste in TV ads.

2. Visible ROI. On of the big differences between online advertizing and other types of advertizing is that with online advertizing you have a much better grasp of what your ROI is. Sure, the ultimate model is PPS (pay-per-sale) and not PPC (pay-per-click), but it is also a lot more expensive. PPC is a good compromise between PPM and PPS. Google will utlimately sell all three models. If click fraud is a huge concern an advertizer can always opt for PPS which Google has been trialing for a while.

3. The auction system. Adwords are actually auctioned away. That's the beauty of it and what worked so well for eBay is working very well for Google as well. Because of that auction system, the price is always optimum, for both the seller and the buyer. It might not be effective for FTD to buy some keywords, but it is defintely effective for someone else. If click fraud increases, prices will go down and the adjustement will be automatic. But because of the immediate feedback, we can be sure that Google will do everything it can to reduce it. That's part of their core job actually: the relentless pursuit of relevance. They've been very good at it so far and this is one of the reasons they have been able to keep their lead over the competition.

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