Internet Outsider

Google: Fun While It Lasted

The early brouhaha about an "earnings miss" seems overblown, because much was attributable to the company's gift of $90 million to the Google Foundation and a spike in the tax rate.  This said, expenses did jump--sales and marketing especially.  Despite the marketing juice, moreover, revenue suffered the first real deceleration in a year, and more probably lies ahead.  Most importantly, for the first time since Google went public, it failed to exceed the Street's printed revenue estimates.  This suggests that near-term investor expectations have finally exceeded reality.

With respect to deceleration, the main revenue drivers over the past year have been: 1) Google Sites, and 2) International.  Year-over-year growth of Google Sites revenue had been screaming along at 110%-120% for the last four quarters.  This quarter it dropped modestly, to 107%.  While this was truly a modest drop (and still amazing performance), it came despite the company's having a full quarter of "3 term" instead of "2 term" links at the top of each search page.   International, meanwhile, had posted year-over-year growth of 130%-150% for five straight quarters through Q2.  Q3 was 120% and this quarter 102%.

One likely cause of the deceleration, in my opinion, is market saturation: After five spectacular years, the company may finally be picking the last of the low-hanging search fruit (virgin queries).  Eventually, growth will converge on the product of query growth and keyword price growth, which isn't anything like 100% a year.

When factoring out the Google Foundation gift, Free Cash Flow came in around $500 million, up about 60% year-over-year.  This is an extreme deceleration (Q3 growth was 120%, Q2 600%, and Q1 217%), and it suggests that a $3 billion estimate for 2006--at the higher end of Street expectations--is probably a stretch.  At the very least, it suggests that FCF estimates aren't going to keep rising ad infinitum. 

This, in turn, suggests that multiple compression is probably upon us.  How much?  Given the growth trajectory, 30X-40X seems more reasonable than the 50X the stock commanded a few weeks back.  And that's assuming something nastier isn't lurking over the horizon.

In any event, stay tuned for the winners of the Google Earnings Sweepstakes!

Last Call for Google Earnings Sweepstakes...

Any last-minute thoughts?  Changes of heart?  Weakness in knees?

Comments must be time-stamped by 4:00 PM EST to be eligible for the grand prize.  Click here for the latest reader-generated odds.

MSN Falls Farther Behind

The press hype about a coming "war" between Google and MSN has mercifully abated in recent weeks, perhaps because it is becoming clearer that, far from being a credible Google challenger, MSN isn't even in the same league.

Last week, Microsoft reported MSN's December-quarter results, which were, in a word, weak.  Advertising revenue rose a dismal 12% year-over-year, continuing the deceleration trend of the last few quarters (by comparison, Yahoo!'s growth was 39% and a poor showing for Google will be in the 100% range).  Operating income dropped 55% to $58 million, as salesforce and developer headcount ramped.  Any indication that this investment will ever pay off will have to wait for another quarter.

The key to MSN's recovery (and relevance) is search, and search revenue was awful.  The company's display advertising revenue grew 20%, only half of Yahoo!'s growth rate but far better than MSN search, which apparently posted growth in the low single digits due to a 20% year-over-year drop in revenue per search.  The company attributed this trend to the adCenter ramp-up (Overture's revenue per keyword is presumably higher than adCenter's) and weak performance from third-party partner sites.

The one important bright spot--and, considering the rest of the division's performance, it's a head-scratcher--is that search query growth was in the "low to mid double digits" (presumable translation: 20%-45%).  This means that all is not lost.  If the company can get its act together and stabilize revenue-per-search, query growth alone should produce nice revenue growth.  Based on recent trends, however, this seems anything but a lay-up.

As argued here, MSN is, at best, competing with AOL for distant third place in the web wars.  The December quarter results--combined with AOL's recent partnership with Google and broadband distribution deals--suggest that MSN is even losing ground in this race.  Google, meanwhile, is so far ahead that it's not even visible over the horizon.

Bravo! More Signs of Intelligent Life at AOL

Well, it took five years, but AOL has finally plugged the Titanic-sized hole in the bottom of its hull.  This morning, the company announced multiple broadband deals that, together, should allow it to offer an AOL broadband solution to most of the million-odd subscribers who call up to quit each quarter.

The big problem with AOL's "portal strategy" has been that the vast majority of the people who use the portal are AOL subscribers, who are unknowingly dumped there when they click links and buttons within AOL.  When subscribers defect to broadband services, therefore, they take their portal pageviews with them.  Until now, AOL has had no credible solution to offer broadband-bound defectors; rather, it has simply had to beg and plead with them to keep the AOL service or, at least, their AOL email address, and occasionally come back for a visit.  Unfortunately, only about 1 in 4 broadband defectors have been doing this.

Now, however, the company should be able to offer the broadband defectors better broadband deals than they can get with their local cable or telco (most of the new plans are priced at $25.90, less than many AOL-less broadband offerings and only a couple of dollars more than AOL's all-you-can-eat dial-up plan).  If the company can smoothly integrate the conversion process, moreover, it should be able to allow subscribers to upgrade to broadband with much less hassle than it would take to leave the company. 

Bottom line, therefore, the broadband offerings should allow AOL to increase its "save rate" of defecting subscribers, and thus retain their precious eyeballs.  The new rate may encourage some of the lazy cash-cow $23.90 subs who wouldn't have converted to convert, thus resulting in a near-term cash flow hit (because AOL is likely only getting a few dollars of subscription revenue share from its broadband partners, as opposed to $10 or more of operating profit from the fat-margin dial-up subs).  By sacrificing some cash in the near-term, however, AOL is giving itself a better chance to survive over the long term--something that Time Warner shareholders should applaud.

(For more on AOL's key problems--and why this move is critical to fixing them--please see the Cherry Hill Research report linked to in this post.  Thanks to Forbes.com for the heads-up.  Disclosure: I've owned the lead balloon known now as TWX for the better part of a decade )

Google Earnings Sweepstakes: Reader Consensus

The readers have spoken. 

In the last day, approximately 25 Internet Outsider readers have entered the Google Earnings Sweepstakes.  I have eliminated one outlier that seemed preposterous (famous last words) and averaged the rest.  Here's what we've learned:

IO Reader Google Q4 Net Revenue estimate: $1.379 Billion

IO Reader Google "Next Morning Open" prediction: -0.006%

The average Net Revenue estimate calls for sequential growth of 32% and year-over-year growth of 111%.  The 32% sequential growth would modestly exceed last year's sequential growth in this period of 30%.  The year-over-year growth would constitute a modest acceleration from the 109%, 110%, and 108% in the first three quarters of the year.  The IO Reader consensus is in line with the highest Street analyst estimate (per Yahoo! Finance) and 7% above the Street consensus of $1.29 billion.

Interestingly, the average Reader Market Reaction estimate is, essentially, zero (-0.006%).  This means that, in aggregate, IO readers think the market is doing what it is supposed to: appropriately discounting the expected Q4 results.  It also means that the true market (or, at least, reader) expectation for the quarter is $1.379 Billion, not the $1.29 Billion that the Street is formally forecasting.  Of course, Street analysts tend to aim low, especially when they like a stock, so it seems reasonable to assume that the IO Reader expectation is pretty much in line with the real Street expectation.

Which suggests that, all else being equal (which it isn't--we're only talking revenue), if Google does less than $1.379 Billion in net revenue, the stock will drop.  If it does the printed Street consensus of $1.29 Billion, the stock will drop a lot (the word "tank" seems appropriate).  If it does $1.379 Billion or more, the stock will rise.  And if it does $1.45 Billion or more--in line with the higher IO Reader estimates--the stock will skyrocket.

What do I think?  I think the IO Reader consensus is certainly within the realm of reasonable.  If you put a gun to my head and made me play, I would put my estimate around $1.325, slightly above the Street and slightly lower than the IO Reader consensus.  I would expect the stock to drop modestly on that (still remarkable) performance.

Given Google's extraordinary performance thus far in its history, it is certainly possible that the company's growth will accelerate on a year-over-year basis, but there is no way I would be comfortable estimating that.  Even suggesting that the company will be able to MAINTAIN its shocking growth rate is scary.  At some point, gravity--and market saturation--will take hold, and growth will slow dramatically (and take the stock price down with it).  The only question is when.

Reminder: I don't own Google and this blog does not contain investment advice.

Hey Google Gamblers! Belly Up To Q4 Craps Table

As Google's recent gyrations have illustrated, the stock is now firmly in the thrall of fear and greed.  Down 9% one day.  Up 5% the next.  Up 2% at 10am.  Down 2% at 11am.  "Eighty times free cash flow--We can't take the risk!"  "Biggest opportunity in the history of the world--We can't afford to miss it!"

Making matters more interesting is the stock's apparently frightening valuation.  No investor in his or her right mind would ever pay 60X forward estimated free cash flow for a company this size, so the (sane) bulls must believe that estimates are still too low and that Google will at least double free cash flow this year and grow it another 50%-75% in 2007 (making the real cash flow multiple a more palatable 30X-40X).  Any hint that Google will no longer blow away Street estimates, therefore, and the stock will tank. 

On the other hand, given the hair-trigger panic demonstrated last Friday, there does seem to be some skepticism around.  As Battelle noted, a Yahoo! search employee has predicted a Google Q4 whiff, and his blog has no doubt been extensively scrutinized by bulls and bears alike (presumably contributing to Friday's panic).  So blow the numbers away again, and the stock will pop.

What's the risk/reward profile?  Probably an instantaneous gain or loss of at least 10%-20%.  Is it possible to get enough of an information edge to make the odds of either outcome better than 50/50?  Given that Google is probably the most-analyzed stock in the world right now, I doubt it.  But this presumably won't stop thousands upon thousands from placing their bets.

So in the spirit of entertainment--which, for those who lack material inside information, is all this really is--Internet Outsider hereby inaugurates the first quarterly Google Earnings Sweepstakes. 

As of this writing, the Street consensus net revenue estimate for Google's Q4 is $1.29 Billion.  To enter the Sweepstakes, please post a comment containing:

1) Your Google Q4 Net Revenue estimate, and

2) Your prediction, expressed as a percent, of where the stock will open the next morning (e.g., "+13%" or "-21%").

To increase the entertainment value, please feel free to share some of your logic.

What do you get if you win?  Glory.  A prime posting of your name and winning prediction on Internet Outsider.  Of course, because market forecasting involves two assumptions--1) fundamentals, and 2) market perception of such fundamentals--the Sweepstakes may have two winners.

Good luck!  May the best soothsayer win...

Google Makes Right China Decision

According to the WSJ, Google will soon launch a new Chinese search service in which it will censor results to avoid offending the Chinese government.  Although this decision apparently created much angst within the company and will no doubt trigger howls of outrage from certain followers, it's the right decision for Google, its shareholders, and, ultimately, Chinese Internet users.

With China projected to soon become the largest Internet market in the world, Google simply has to be there (especially if it wants to index all the world's information).  And if it is to be there, it has to do business the way the Chinese government wants it to do business, regardless of how offensive some of the restrictions may be.  Although individual expression in China still has miles to go before becoming anything like free speech (at least with regard to criticism of the government), it's much better than it used to be.  If the Internet continues to proliferate and the economy stays strong, moreover, it will continue to improve. 

The Chinese Internet industry, meanwhile, will grow with or without Google, so the company doesn't have the luxury of being able to sit around and wait until the Chinese government relaxes its censorship to a point that Google senior management deems acceptable.  In this case--as with Yahoo, Microsoft, and others--agreeing to work with the Chinese government does not mean supporting all of its policies, and doesn't make Google "evil."  So hats off to Sergey and Larry for making a tough, mature, and pragmatic decision.

Yahoo Waves White Flag in Search War

Yahoo! has apparently read the writing on the search wall that everyone else (except Microsoft) has been reading for years: The search game is over and Google has won. 

"We don't think it's reasonable to assume we're going to gain a lot of share from Google," Yahoo! CFO Sue Decker said in a Bloomberg article on Jan 23.  "It's not our goal to be No. 1 in Internet search. We would be very happy to maintain our market share.''

Decker and Yahoo! get points for self-assessment and straightforwardness.  And as neither she nor most of the company's current senior managers were there when Yahoo! fumbled the search ball back in the 90s (to go chasing after content and other seemingly sexier pursuits), it seems pointless to reiterate how disappointing this is, that the search game was once Yahoo!'s to lose.

Still, denial never helps, so hats off.  Now, if the folks up at Redmond can only follow this example, perhaps Yahoo! and MSN can combine forces and become a stronger No. 2.

UPDATE: Upon further consideration, I think this comment was probably intended to reset Wall Street's expectations.  The Street has been all over Yahoo about search for the last year, and the company's repeated promises to "fix the algorithm" have only created more disappointment.  So Decker was presumably just resetting the bar to a level the company can more easily clear.  (Judging from recent market share losses, though, even this target may be hard to meet.) 

AOL: Talk About Underwhelming

After weeks of secret strategizing and planning about a bold new future for AOL--interrupted only by an occasional press release complaining about how crappy a job Time Warner management is doing--Carl Icahn and team have finally leaked word about how they're going to save the erstwhile colossus: By merging it with another second-rate portal. 

Details, it is said, will be released next week.  Excuse us if we don't wait on the edge of our seats.

Implications of Yahoo! Underwhelm

  The key question is whether the revenue deceleration (from 51% in Q2 and 46% in Q3 to 39% in Q4) is:

1) the result of a broader industry slowdown, in which case Google is screwed, too, or

2) the result of Google eating Yahoo!'s lunch, in which case Google will probably have another strong quarter or two.

In any case, the global online advertising industry no longer seems to be growing fast enough to justify the sector multiples--Google's included.  One lesson from 2000 is that, when the rest of the industry is grinding to a halt, the market leader can't keep going like a bat out of hell forever, no matter how much share it steals.