Internet Outsider

Calling All Guest Writers!

Apologies...I'm gone this week and most of next.  So I figure this is a good time to try an experiment I've been meaning to try for a while: guest posting. 

Some of the comments on this blog are excellent, and we would all benefit from them being more visible.  With this in mind, please send any on-topic comments you would like published (Google, Yahoo, Amazon, eBay, Web 2.0 Bubble Bursting, etc.) directly to me at share@internetoutsider.com, along with your full name (real name, please).  You can also obviously post them in the comments section, and if there's duplication, fine.  I will then post the ones I think would be of interest to the community as separate posts under your name.  I'll be online only intermittently for the next two weeks, so please give me a couple of days to respond.

Depending on how this goes, I may make it an ongoing and more-formal process, with guest writers, etc.  Despite the latest web crash, there's a ton going on, and I can only cover a small piece of it.

Thanks.

Google: So Long, Free Cash Flow

Okay, back to the trees...   

Last year at this time, Google was on track to generate about $2 billion in annualized free cash flow.  This fantastic sum--half the free cash flow generated by the largest media company in the world, Time Warner--combined with the free cash flow growth rate (100%-plus), made the stock's valuation tolerable.  Street projections of free cash flow for this year, 2006, soon soared beyond $3 billion, and it seemed only a matter of time before Google's cash flow exceeded Time Warner's (as it someday must, if the company is ever to justify a valuation far in excess of Time Warner's, which it already has).

But then the company began to ramp CAPEX at the same time that new accounting rules forced it to reclassify some of its operating cash flow to financing flow (tax savings from stock-option exercises).  And then it started buying buildings, data centers, etc.  And then free cash flow stopped growing...and then started declining.  Precipitously.

The net result of all this is that the company generated a paltry $142 million in free cash flow in Q2 and, so far this year, has generated about $600 million.  Back out the $319 million the company just spent on its Googleplex, and you get about $900 million in "normalized" free cash flow for the year.  Double that for Q3 and Q4, and you're about where you were at this point last year--on track to do about $2 billion in FCF, a far cry from the $3 billion-plus the Street expected earlier this year and zero year-over-year growth despite a near doubling of revenue.

What does this mean?  Hard to say for sure.  A significant chunk of the current CAPEX appears to be one-time in nature, so the company will probably be able to cut the spending at some point in the next year or two.  Even so, the Google business model seems to require more capital than it appeared to a year ago, a condition that will likely require a permanent recalibration of analysts' free cash flow expectations, as well as a reduced ROI.  All else being equal, this should translate into multiple compression (especially P/E multiple compression), and it is probably one of the reasons the stock is well off its high.

A Google Appreciation Moment

Before losing the Google forest for the quarterly trees, I need to express nothing short of amazement at what this company has become. 

Eight years ago, Google didn't exist.  Five years ago, it didn't have a business model. Now, it has a $10 billion revenue run-rate, $10 billion in cash, $4 billion of operating cash flow, 8,000 employees, dominant global market share of the fastest-growing and most profitable advertising business in history, and $120 billion of well-deserved (if still expensive) market capitalization.  Google is already not only the largest Internet company in the world, it is the largest media company in the world.  It is coming up fast in the rearview mirror of one of the largest technology companies in the world--a giant that, when Google was born, was the largest and most powerful company in the world (a giant that now, in part because of Google, is worth half of what it was worth back then, and, in Google's business, is little more than an also-ran).

What's more, Google has BALLS.  Already this year, the company has spent about $1 billion on land, buildings, servers and technology, about as much as three of its biggest competitors combined.  It is successfully attacking entrenched incumbents that in a decade of the industry history no one had been able to lay a glove on (Yahoo! in search, Yahoo! and Microsoft in email, Yahoo! in Finance, eBay/Paypal in commerce).  It has stolen the industry's excitement, innovation, and fire, made everyone else look lazy and incompetent in comparison.  It has announced, with pleasure (and a wink), that it is building the infrastructure necessary to support a $100 billion company--and with each passing quarter it is making this plan seem ever more sane.  It has matured in its communications and decision-making.  It has delivered a dozen spectacular quarters in a row.  It has...

Are there "buts"?  Yes, of course there are "buts."  But to focus on the "buts" is to miss the forest for the trees.  There's no way to know how long Google can keep this up, but as long as it does, the only appropriate big-picture response is awe.

Yahoo! Fizzles; Implications for Google, et al.

The good news, such as it was, was that Yahoo! managed to stretch and claw its way to its numbers.  The bad news was that it did this by slowing hiring and postponing advertising spending.  Why is this bad news?  Because when times get tough, advertising and hiring are usually the first expenses to go (suggesting that times are getting tough), and, more importantly, because Yahoo! lives on advertising spending. 

And then there was the stoppage in registered user growth (flat q-to-q) and the postponement of the new search-ad system.  Of these two downers, the ad-system is, in one sense, the less worrisome, as the delay should (let us pray) be temporary.  But one does begin to wonder whether Yahoo! will ever get its act together in this regard.

So what does this mean for Google?  Unfortunately, for the intermediate-term, it's mostly bad news. 

Yes, on Thursday, Google's relative performance should once again look (and be) amazing.  Yes, Google should gain some more share.  Yes, Google will once again demonstrate that what it does is far more difficult than it looks and that its leadership position is defensible.  Yes, Google will have the option of using its strong currency and cash flow to snap up companies, invest in R&D, and explore strategies that Yahoo can no longer afford (a long-term advantage).  But over the intermediate-term, the Yahoo! news is more ominous. 

A significant chunk of Google's growth is coming from market-share gains, and Google already has more than 50% of the world search market.  If Yahoo! and Microsoft continue to sputter (likely), Google will probably coast to 70%-80% of the world search market over the next year or two.  After that, however, there won't be much more share to gain.

Also, assuming any of Yahoo!'s issues are market-related--and, more broadly, assuming they are indicative of a slowdown in search or ad-spending--Google will not be able to dodge this bullet forever.  Given its dominance, it will survive unscathed for a quarter or two longer than most, but, eventually, in the event of a broader slowdown, it will feel the pain. 

Step Right Up and Place Your Google Q2 Bets

It's that time of the quarter again--time for the Google Quarterly Earnings Sweepstakes.  For the last two quarters, the IO reader consensus has been more accurate than the Street consensus, as well as a better reflection of what the Street's real expectations have been.  So here we go again...

As in the past, please submit your Q2 estimates for:

1) Net Revenue (revenue after deducting traffic acquisition costs)

2) The price at which the stock will open the following morning.

3) Your logic.

You may update your estimates based on earnings from Yahoo, etc., until 4pm on Thursday, July 20.  The winner will get his or her name in lights (on this blog) the following morning.

All things considered, this quarter has been a yawner for Google watchers.  No Three-Alarm-George comments knocking the stock down 20% in 20 minutes, no 5% appreciation per day, no massive announcements, no huge controversies, and...no new high.  I believe, in fact, that this is the first quarter in the company's public market history in which the stock has not hit a new high.  The stock has yet to really recover from the "earnings miss" in early January (which wasn't really a miss), and, since then, a few thousand hedge funds have moved on to more exciting pastures.  Still, if the company blows out its numbers this quarter, all will be forgotten and forgiven. 

Several analysts have issued earnings previews, with some suggesting that Google will crush its numbers and others being more cautious.  Safa's hanging in there with his $600 target and predictions of a blow-out.  Perma-bear Jordan Rohan is warning investors not to get carried away.  So, it's time to get your own voices into the game.

My thinking:

Net Revenue: The current Street consensus is about $1.6 billion, up 80% y/y, with a range of $1.45 (up 63%) to $1.68 (up 89%).  Even the highest estimate represents a continued deceleration of the y/y growth in Q1 (93%) and Q4 (97%), which is reasonable.  A deceleration to 63% (1.45B) would be an unmitigated disaster.  Even a deceleration to the purported consensus, $1.6B (+80%) would probably be a disappointment.

Stock Price: Having held essentially flat for six months, the stock is gradually becoming less expensive, at least on an earnings basis.  As previously described, however, my free cash flow estimate has not budged in a year (bad news, given the huge revenue growth), and the stock is now trading at about 40x-50x a 2006 free cash flow estimate of $2.5B to $3B.  This is a vast improvement over the 70x-80x multiple when the stock neared $500, but it's still hefty.  So there's still no room for error.

So my own entries in the sweepstakes are:

Net Revenue: $1.66 Billion, up 86%.  I haven't seen any changes in trends that lead me to expect the company's growth to hit a wall, and some of the Comscore query numbers suggest that Google rate of share gain is increasing.  Similarly, however, I haven't seen anything that makes me think the company will shock everyone on the upside.  Those days, I think, are gone.

Stock Price: $420  The stock's still expensive, the broader market is weak, a $1.66 billion number would qualify as strong but not spectacular, and I see no reason for the multiple to expand.  Also, Google has now posted about 20 quarters in a row without a real stumble, and each strong quarter brings us one quarter closer to that inevitable day when even the best companies screw up.

Look forward to reading your thoughts...

The Trouble With AOL's Hail Mary Assumptions UPDATED

The WSJ has another excellent article detailing the projected financial impact of AOL's plan to eliminate subscription fees for users who already have online access.  (Time Warner has clearly decided to pursue an informal "comments welcome" period before the plan is voted on, perhaps so the Board doesn't approve it and then get laughed out of town). 

According to the article, AOL expects to remain profitable through a three-year transition period, but lose an estimated $2.7 billion in revenue and about $1 billion in operating profit.  To hit these numbers, the company will have to continue growing its advertising business 25%-30% per year AND crank up the advertising operating profit from 17% to 42%.  This latter assumption depends on the online advertising market and AOL's traffic remaining strong (neither of which is a given).

The company's biggest challenge, which the article does not mention, will be to ensure that subscribers who drop their subscriptions but continue to use the service generate as many pageviews as subscribers who keep the service.  Right now, the big flaw in AOL's portal model is that subscribers generate the vast majority of the company's pageviews (mostly through email usage).  If subscribers who quit the service generate fewer pageviews than they did as subscribers, then AOL will have lost two ways, and the free-subscription gambit will have failed. 

The article also does not explain another mysterious assumption of the plan: How AOL expects to boost the profit margin in its remaining subscription business from an estimated 38% today to some 53% in 2009.  Per the article, the subscription business currently generates $4.2 billion in revenue and $1.6 billlion in operating profit (38% margin).  In 2009, the article reports, the company expects revenue of $1.5 billion and operating profit of $800 million (53%).  Given that the main driver of increased subscription profitability--declines in the cost of telecom services--is flattening, how is the company going to increase the subscription operating profit so much while cutting its scale by almost two thirds?

AOL apparently expects the plan to knock its overall operating profit down into the "mid-single-digits."  Given the apparently heroic assumptions above, however, shareholders would probably be wise to brace for losses.  The company is probably still smart to pursue the plan, but shareholders are not likely to get off this easy.

UPDATE:

A perceptive reader pointed out that AOL has another big expense it can slash if it waves the white flag on the subscription business--marketing.  Assuming the company is still spending a big pot of money preaching to deaf ears, this would instantly boost the margins in the subscription business well above the 38% reported by the WSJ.  If the company is still spending, say, $1 billion, and is able to cut this number to zero (unlikely, given that the company will now have to establish a different brand identity, but for the sake of argument...), the profit margin in the subscription business would leap to 62%, which would make a 53% margin on a smaller business seem far more feasible.

eBay Gets The Lame Award for Google Checkout Ban

Hard to know where to start on all the eBay news today.  Paypal president out, possibly for performance.  Rookie Skype president Rajiv Dutta parachuting in to save day (and who will run Skype, another critical eBay division, albeit one that eBay shouldn't have bought, now that Rajiv's headed back to CA?).  A detailed analyst report (Mark Mahaney) concluding that Google Checkout is actually a viable threat to PayPal.  And an unbelievably lame response on eBay's part to Google Checkout, which was to forbid sellers from using it.

Only one word is required to riff on the Google Checkout ban: pathetic.  "OOOOooo, scary, a new product that our customers might actually prefer.  Quick--outlaw it!"  Not the best way to win customer hearts and minds.  And along with the management changes, a graphic illustration that the fear quotient is running high.

AOL May Bet Company; Scary But Smart

  The WSJ reports that AOL is considering making online access to its service--including, importantly, email--free.  (AOL email users currently have to pay for one of the company's subscription plans, although much of the rest of the company's content is already free.)  Per the WSJ, this move would vaporize about one-quarter of the company's revenue, or $2 billion.  The company estimates that it would also result in the loss of 8 million paying subscribers.

This is a scary, but smart, move.  AOL is between a rock and a hard place.  If it does nothing, it dies slowly.  If it makes moves like the one described above, it deeply wounds itself but hopes that it will recover and have a long-term future.  Neither option is appealing.  But only one--the latter--gives the company a chance of being around for the next few decades.

If it chooses this route, of course, the company will have to do a lot more than cut and pray.  It will have to immediately retool its email system to make it competitive with other free options, such as Yahoo and Gmail.  It will have to build a clear portal identity--and target audience (presumably the MySpace and existing AOL-user crowd)--and win over a segment of the market that has not yet pitched camp at Yahoo, Google, and MySpace.  It will have to find something, anything, that it is better at than anyone else, (which will probably be communications-related).  And then, ultimately, it will have to combine with one of the dominant portals.

Will it be able to do all this?  The odds are probably less than one in three.  But even these odds are better than certain death. 

Vonage Underwriter-Analysts Pee on Stock, Further Insulting IPO Buyers

The Vonage IPO continues to be a black comedy.  A month after the deal was shoved into the hands of customers and others at $17, it is trading at $8.25.  And now, in an action that demonstrates the drawbacks of the "new era" of Wall Street research, in which analysts have no role in the IPO process, two of the underwriter analysts have dissed the stock.  One is troubled by the company's execution.  The other is worried about competition, heavy spending, and IPO lawsuits.

Now, let's look at this from the perspective of an IPO buyer.  Your trusted Citigroup or UBS financial advisor calls up and says, "We've got this great new IPO you should buy--a cool Internet phone company that's growing like mad."

You: "Sounds great.  What do your experts think of it?"

Advisor: "Well, our analysts aren't allowed to tell us what they think anymore, because that would be a conflict of interest, but our bankers are experts, too, and they LOVE it!"

You: "Awesome, sign me up!"

Now, thirty days later, you've lost half your money.  And you learn that, in fact, the analysts at the firm that sold you the stock wouldn't touch it at $8.25 a share, much less the $17 that you had to cough up for it.  You learn that, with the exception of the IPO lawsuit issue, their concerns have nothing to do with anything that has happened in the last 30 days.  Rather, the analysts are concerned about issues that were exactly the same when you bought the stock.

Question: Wouldn't you have liked to have known that these analysts thought the stock wasn't worth $8.25 before you paid $17 for it?  Or, if that was impossible (as it was under the old system, as well--although not in the more-sensible European system, in which the analyst writes a report before the IPO is priced), wouldn't you have liked to have been confident that the analyst had signed off on the deal before it was sold to you?  Don't you feel a bit shafted that you were sold a stock at $17 that the only real expert at the firm thinks is not even worth $8.25?

The old system had drawbacks, too, of course.  But as far as the IPO process goes, the new one is far from perfect.