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).
I think you're onto something here regarding observing the patterns when comparing to Yahoo and AOL. Google is an innovative company that sees opportunity and is not afraid to take it --in fact they regurlaly encourage their employees to do this 20% of the time. Perhaps this same innovative spirit will figure out how to do this in another channel besides adwords
I don't know for sure, but can sure speculate that they're seeking many other streams of opportunity.
Posted by: Jeremiah Owyang | January 13, 2006 at 09:56 AM
Great article. Thanks for playing devil's advocate on Google. Its good to be reminded from time to time the peril of investing in the highly competitive high tech industry. Its unfortunate that "Blodger calls Google at $100" is now the top story/headline on Bloomberg system. The article completely takes your write up out of context. Even though you were one of the early few that touted Google. Now you'll be remembered only as the guy who called the Amazon surge and the guy who called the Goog's freefall. I feel your pain- people/media have selective memories.
Posted by: Tim Wang | January 13, 2006 at 10:08 AM
HUGE PROBLEMS UNDERNEATH THE SURFACE…. REVENUE RECOGNITION
1) Look at page 7 of the 10Q on the Revenue Recognition portion of the ADSENSE program. “REVENUE” comes in and is totally paid out to their partners…. INCOME Contribution ….ZERO…. but what does GOOGLE do, they count it both as revenues and expense…. WHICH INFLATES THE REVENUE GROWTH RATE WITH NO MARGINAL CONTRIBUTION TO INCOME
2) Then come our GENIUS analyst…. They point out that Revenue growth is astronomical (yeah right!!!)….. and then use a ridiculous multiple of REVENUES to justify a sky high valuation….
Here is an example…
Say the revenue from AD Sense is $500mm, All that money is paid out to their partners so Expense is $500mm, Hence Net Income contributiono is ZERO.
But our SUPER ANALYST would take that incremental $500mm, multiply it with a revenue multiple of $50 and say that should increase the market cap by $25 BILLION (yes that is Billion with a capital B)…….
It is the same sham from the Dot Com boom… but we never learn do we…. Why do you thing that they are paying $1 billion for the AOL deal, They will do the same revenue recognition magic and boost market cap by $20 or more Billion… nice game …..
Posted by: Kiran Kini | January 13, 2006 at 10:56 AM
"Newspapers the world over will revel in front-page analyses of shortsightedness, arrogance, and what went wrong."
Henry, i hate to say this but "... we've been fed this bullshit since the craddle."(to quote J. Conner from a movie)
The bankers and financiers(if any) would see this happen to the other portals of the world first before they'll let this happen to this billion dollar baby of theirs.
Don't get me wrong, the market is sensitive to cos that have outrageous or to quote your article with a phrase 'pie-in-the-sky' valuations but the market is saying will still give you at least one if not a couple!!... but its' got to be based on something concrete... hence forth Google.
But Google isn't the be all end all of internet cos or even an idea... there'll be other ideas and cos.
In this era it is all about Google. It is in control of its' own destiny.
Not many ideas going forward will be equal or bigger that this
;that's what the investment bankers are telling themselves...
"We can take this baby around the block a couple of times and make a fortune. Hey that's what they call us right (creative) capitalists. We invented it for G**'s sake"- Investment bankers
The fallacy of that thinking is they assume a 100% probability when it is actually more like 80%... that's what happened to Enron that 20% error
Common Henry, you should know better sell me a 10-15X compression and we'll call it a correction.
Posted by: P- | January 13, 2006 at 01:46 PM
Given that Google's Adsense network (the part vulnerable to click fraud) in Q3/05 represented 43% of their revenue or approx. $675M for the quarter are they likely to do anything that shuts down that revenue? I don't think so. Click fraud is not a bandwagon, it's a 5 mile freight train and it is not stopping for anyone.
As long as affiliates are paid commission by way of the cost-per-click model, click fraud will continue to grow. Bloggers know all about click fraud, I've seen countless blogs with statements like "don't forget to click on my Google ads, it helps pay the bills" should we call it 'cultural click fraud' ? Hmmm, who owns blogger.com? Someone should have a chat with them about that.
I found this earlier today, is Google's reputation sliding ?
-- Hot Keywords of the Day --
"Google Arrogance"
"Google Anti-Trust"
Posted by: Adam Sculthorpe | January 13, 2006 at 07:04 PM
www.fuckedgoogle.com
been reporting this kind of thing there for nearly 3 years.
Posted by: guy | January 15, 2006 at 01:20 AM
Henry,
You're nothing but a slimy crook like many of your brethren on wall street. Out to make a quick buck in good times and bad.
How come you're not in jail for your trading misdeeds during the boom? What goes around comes around...your day has yet to arrive.
Posted by: Nemrut | January 15, 2006 at 01:59 AM
As an advertiser that spends between $2000 and $6000/month on Google advertising for several years (almost from day 1 of AdWords), we've noticed that, even while keeping our bids constant, that our cost per conversion has jumped up 2x or 3x, depending on the keyword. For whatever reason, Google is sending us fewer qualified leads than they have before.
However, they have also lowered their minimum bids from 5 cents a click to 1 cent per click. So we lowered all our bids, some right down to 1 cent. Instead of the $150/day that we were spending before, we now spend about $40-$50/day, and we actually get more conversions than we did at $150/day. I suspect that we're an isolated case, since most advertisers bid far more than the minimum, but as click fraud increases cost per conversion, other advertisers will lower their bids to keep cost per conversion in line.
A previous poster pointed out that the largest advertisers have ways of detecting click fraud. The problem, though, is convincing Google of this. Even if you can prove that certain clicks were fraudulent, just try getting someone over at Google to answer a phone call and listen to your case. They may be hiring lots of PhDs, but customer support is almost non-existent. If you can find a customer support phone number for Google, you're a better detective than I am.
Posted by: Patrick | January 15, 2006 at 09:55 AM
I want to quickly add that Google is still the most cost-effective form of advertising out there. That's really the bottom line. I also have an account over at Yahoo/Overture, and their cost per conversion is nowhere near as low as Google's. So as long as the ROI remains competitive and click fraud doesn't get out of hand, Google may continue to siphon ad money from other sources (TV, print, radio, etc). When you look at Google relatively small market share in comparison to the overall advertising pie, it's possible that they could continue to grow for a lot longer before leveling off.
Posted by: Patrick | January 15, 2006 at 10:04 AM
How to Beat the Market!!!
Posted by: BTM | January 15, 2006 at 04:50 PM
For the person who stated that you can use the IP address to detect traffic coming from click-fraud warehouses, it's not that easy. A professional organization like this would likely be using some sort of IP spoofing to make it harder to detect the clicks (each click will look like it's coming from a different IP address). IP spoofing is mentioned in the Wired article on click fraud.
Another form of click fraud that's extremely difficult to detect is when an amateur webmaster who runs a low traffic site clicks on each ad on his site once a day. If this person has a dial-up account (and hosts it with an external hosting company like 1and1.com) then the IPs will appear completely unrelated from day to day, since dial-up accounts have no consistent IP address history. Since there are untold numbers of these little sites showing Google ads, I suspect the reduction in conversion rates is due to the proliferation of ads on these small sites (what Google calls its "Content Network"). On the other hand, at some point the ratio of small site to big site will stabilize, so perhaps the conversion rate will stabilize at some point.
We're keeping a close eye on the numbers here on our end.
Posted by: Patrick | January 16, 2006 at 04:32 PM
I really like that little picture of a bear at the top of the article.
Posted by: Me | February 01, 2006 at 02:09 PM
The real problem with GOOG is this: A new and better search engine will likely emerge in the not too distant future. This new search engine will more than likely be launched by a GOOG competitor. With this much money sloshing around it is just a matter of time before some Wiz at MIT or some other melting pot for the super smart comes up with a better idea. Just 11 years ago everyone was told that Netscape would own the web. We were told the "web browser" was what equaled domination of the internet. This turned out not to be the case. Remeber the first bath the portals took? Remember InfoSeek (seek) and Yahoo at 6 bucks a share after an itnital pop in the early 90's? They dropped like dog food because they were viewed as unimportant. The only one that ever thrived was YHOO becasue of its search and better layout. With all the talk about click fraud and the merits or demerits of AdWords, AdSense, ad this, ad that, the bottom line is this GOOG search may not look all that great in 2 or 3 years. Better technology will come. Also, believe it or not, a lot is in a name. Typing Google.com is cool. Typing MSN.com and then finding their skinny rectangular data entry point for your search words is not. Someone needs to get a a cool name, some good technology, and a better deal against click fraud for the real customers. When this happens, and it will as the engines of capitalism mandate these things, GOOG will go the way of WANG, BORL, and the Edsel. My prediction: GooG goes to 300 soon and if the earnings get real bad we will be looking at a 50 stock in 2008...
Posted by: Ames Tiedeman | February 11, 2006 at 04:41 PM
Just block all Google Ads with http://www.customizegoogle.com/
Posted by: Peter | February 13, 2006 at 07:33 AM
Google french ?
Posted by: math | March 14, 2006 at 05:40 PM
Google has entered into the Radio business by buying dMarc Broadcasting of Newport Beach, California.
Posted by: math | March 14, 2006 at 05:41 PM
It's not very difficult to create anti-fraud system for Google. They have to charge not more than one click coming from the same IP in one period (1 month for example) for single advertiser's domain. It will kill 99% of fraud activity. Manual clicking will be unuseful and software hitboting will be 30X times more expensive. On the other hand it wil decrease Google's profits. Gooogle do not do this because of loss profit side effect. It is not profitable for google today. We are receiving loses ang Google receives profits...
Posted by: ILYA -google's forex bidder | March 24, 2006 at 10:24 AM
The likeliehood of click fraud "leveling off" is slim to none. As long as anyone can become a "publisher" the candy store is open.
Everyone blows smoke about the technology involved with detecting click fraud talking IPs, patterns, etc but its really so simple, you lock the back door. My guess is if you took a look at where all those adsense checks were going a half witted fraud investigator could probably nail 90% of it, but as long as bouncy ball google keeps pointing at technologists and offering rhetoric as solutions no one will ever see the trucks backed up at the dock.
Posted by: Western Wrangler | April 05, 2006 at 05:44 PM
Since Google has lowered their minimum bit from 5 cent to 1 cent my renevue dropped sharply (90%).
For sure this will affect Googles balance sheets, but this company has still a lot of air to breath. They just buy up companies after companies and therefore have a large potential for creating and promoting new products.
Look out for a correction but not for Googles sell out. This wont happen.
Posted by: anonymous | September 30, 2006 at 03:46 AM
...by the way...the comments of this thread are mixed up with the the wrong poster name...
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