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Reader LC, with a prediction of $1.86 in revenue and an opening at $460. Also an honorable mention to Victor, with a revenue prediction of the same $1.86 and an opening of $450. Once we get through this panicked short-covering, Victor's number probably will look even better.
First things first: A hat tip to Google and its champions. It's hard to express how impressive the company is, both in the numbers it is posting and the amount of confidence and ambition it has. Given the awesome rate of growth in the last eight years, lesser companies, or lesser people, would have blown apart at the seams.
Second: It is also hard to express how pathetic Yahoo seems in comparison. Only a year ago, the company was firing on all cylinders, gaining market share, innovating, inspiring the same kind of confidence that Google now does. Now, it's hard to imagine what the company will be able to do to stop the market share bleed.
Third: Despite the strength of the quarter, I stand by the prediction that, if the online ad market weakens, Google will feel it. Given that YouTube and Sequoia agreed to an all-stock transaction, it seemed unlikely that we would see weakness in Q3, but Q4 could be a different story. And I continue to think that the signs from Yahoo and others are that the market has started to weaken.
Fourth: I'm glad I own the stock in an index fund, but I'm also still glad I don't own any more than that. Thanks to continued strength over the past year, the company is growing into its valuation, but it's not there yet--especially in the face of a potential market slowdown.
At $450, ex cash, Google's market-cap is about $125 billion. The free cash flow run-rate is about $2 billion, the same as it has been for the last year. If we assume that the company is over-investing in CAPEX and that it will soon throttle back, the "normalized" free cash flow run rate might be $3 billion. So the stock is trading at about 40X normalized free cash flow.
Is that a fair multiple? It could be--if revenue growth settles into a steady long-term growth rate of 40%-50% and margins stay the same. If revenue continues to decelerate, however, or the company stumbles, the multiple could easily compress to 30x, especially given the sheer size of cash flow. So, as excited as I am about the company, it's still hard to get that excited about the stock at $400-$450 a share.
But I am glad I own it in an index fund...
Yes, Yahoo has Yahoo-specific problems, one of which is competition. Some comments on the conference call, however, provide further evidence that the slowdown in advertising revenue is not just Yahoo-specific.
When asked for the second time about whether the weakness was confined to autos and financial services--and whether the weakness was continuing--Sue Decker said this (transcript courtesy of seekingalpha.com):
We did say that we had seen some weakness in September in those two categories. Those sectors were meant as examples. They are having some industry-specific issues in both cases. We have seen a couple of -- several of the various sectors showing some of that, but we think those are specific to those sectors, and we do think those will continue into Q4.
Translation: We are seeing weakness in more than the auto and financial sectors. The weakness is continuing.
The quick response from Google bulls is that PPC advertising is different, that advertisers view PPC as a "cost of sales" instead of "marketing spend," and, therefore, that a slowdown in general advertising won't affect Google. I continue to believe that this argument is wrong.
If advertising spending slows, it will slow because of weakness in consumer demand (which leads to lower revenue and, therefore, less money to spend on advertising). Although it is true that you have to spend money to make money, advertising is usually one of the first expenses to get cut in a slowdown. PPC advertising may be the last form of advertising to get cut, but it will still get cut.
Why? Because if consumers go from spending $1.00 on financial services to $0.90 on financial services, the ROI for any advertiser trying to attract that spending will drop. As ROIs drop, weaker advertisers will reduce spending, which, in the case of search, will eventually filter into either keyword pricing (fewer advertisers competiting for the same keywords) or fewer paid clicks (fewer consumers seeking financial services). The impact will not necessarily be disastrous, and it will not necessarily be as severe as it is for less-ROI-driven advertising, but there will be an impact.
Thus, I reiterate my prediction: Some of the weakness affecting Yahoo appears to be market-related, and if it is market-related, it will eventually affect Google.
It was clever of Yahoo to announce the initial Panama roll-out on an otherwise depressing conference call (a well-handled subterfuge that, for a few minutes, distracted people), and it was also a relief to hear Terry finally acknowledge that the company's performance has been weak instead of trying to protest that 19% growth is fantastic relative to all other media. This said, Yahoo!'s problems are deeper than a bad quarter caused by weakness in a few customers' businesses.
Yahoo! has lost the competitive fire that made it a powerhouse in the late 90s, and it has even lost the recovery momentum it developed in the early years after the crash. Some of this is the result of a maturation of its core business--graphical advertising--but more is due to the lack of a sense of competitive urgency. From the outside, it seems as though Yahoo!'s senior managers, having rescued the company from a brush with death, have collectively decided that they've done enough and that just being "good" is now good enough. (A less charitable interpretation, one I've floated before, would be that the company got fat, happy, and lazy.) Unfortunately, Yahoo is now competing against companies for whom being good isn't enough (Google) as well as against old media giants that are thrilled to finally be playing in the Internet big leagues (Newscorp). And these companies are kicking Yahoo!'s ass.
I am hesitant to point fingers without knowing more details, but it seems to me that Yahoo!'s lack of urgency starts at the top. It's not just that Terry often sounds as though he is delivering the quarterly conference call from a Barca-lounger (although if he speaks with this much urgency and passion when trying to rally the Yahoo troops, it's no wonder the company has hit the snooze button). It is that, despite the incessant delays in the new ad-serving system, despite the loss of market share to Google in almost every key product area, despite having to be embarrassed into action in Finance and email, despite an inability to compete for major acquisitions (YouTube), despite the inability to articulate a clear, overarching strategy, Terry appears to have made little or no effort to scare his team into shape. Given the company's stumbles this year--a year in which it has gone from being No. 1 to an increasingly distant and feckless No. 2--one imagines that at least a couple of heads should have rolled.
Yahoo is still brimming with talent--Terry, Sue Decker, Dan Rosensweig, and others--and its global brand and franchise remain the envy of every media company in the world. The company has clearly lost its edge, however, and if it doesn't regain it soon, the latter asset will simply wither away. If Terry doesn't want to grab Yahoo's people by the lapels and make them desperate to win again, then he should step aside and let someone else do it. And if he wants to, but can't, then Jerry and the other remaining folks who once had the fire should ask him to go.
Finally, the moment(s) of truth...
Were Yahoo!'s troubles a false alarm? Were Yahoo!'s troubles a real alarm but just Yahoo!-specific? Were Yahoo!'s troubles a canary in the coalmine that will soon spell temporary doom for Google, AOL, and the rest of the industry (MSN was doomed years ago, perhaps permanently). Was the recent decision by YouTube and Sequoia to take all stock on the buyout deal an insider indication that Google's revenue is still steaming along? Can Google finally bust out of its trading range and set a new high? Or will Google's slowing growth and soaring capital expenditures finally cause investors to decide that a free-cash-flow multiple over 50x is exorbitant--and reduce it to, say, 30x?
Ladies and gentlemen, time to place your bets!
Yahoo: A few weeks ago, Yahoo announced that revenue in the financial services and automotive sectors had weakened and that Q3 revenue was now expected to at the low end of the $1.115 to $1.225 billion guidance range. Was this a head fake? Will Yahoo now announce that the quarter finished strong--blowing out the new consensus, maintaining future guidance, and blowing up all who are short the stock? Or is the $1.115 expectation the right one and will Yahoo reduce future guidance. According to Safa Rashtchy, the Street consensus is $1.15B, although my sense is that the real expectation is less than that.
My prediction: $1.14B and reduced future guidance, already walloped stock stays put. (I own the thing, so I sure hope so).
Google: When Yahoo announced its woes, Google stumbled, too--sensibly, I thought (I'm in the canary in the coalmine camp). But then Cramer came out banging the drum, the YouTube afterburners fired, and, suddenly, two insiders in the know--Sequoia and YouTube management--announced that they were taking all stock on the deal (something they presumably wouldn't do had they been tipped off that Q3 or Q4 was looking weak). So if the industry fundamentals are, in fact, crumbling, it seems that they may not be affecting Google--yet. Per Safa, the consensus net revenue estimate is $1.81 billion, up 9% sequentially. (Safa's own "estimate" is $1.64, but he's still a bull, so one suspects that his real estimate is higher than that).
My prediction: Very modest upside--say, $1.83 billion--plus some vague but cautious remarks that will scare the bejesus out of people. No new high and stock soon back to $400. Lower if there's any sign of fundamental deterioration.
The Stakes: Full credit to the IO reader whose predictions are most accurate, both quantitatively and qualitatively (in the past, it's been all quantitative). Plus, as a special bonus, articulate arguments will be featured in posts ahead of time.
Gold stars to YouTube, Google, and their respective investment bankers for how they handled this one... Settle on basic deal terms and a provisional price, leak details so the market has a couple of days to chew on the idea, see how the stock reacts, neutralize the market's biggest concern (lawsuits) by announcing a distribution pact with the main guy who might sue you, fix the price, rubber-stamp the press release, and go.
It's also worth noting that Sequoia and YouTube could easily have taken some cash off the table, but instead chose to go long Google stock at more than $400 a share. Yes, there are tax considerations, but if you think Google's stock has top-ticked (or even if you just wanted to reduce risk), you would take some cash. Both Sequoia and YouTube obviously have insight into Google's performance in Q3 and the current quarter, and neither party, presumably, would want to celebrate the closing of the deal by loading up on a tanking stock. The exchange rate has yet to be set, so Sequoia and YouTube could be gambling that a bad third-quarter report will temporarily hobble the stock, but this seems a bit too clever. So, on balance, amid the Yahoo-problem-or-industry-problem worries, probably a positive stamp of approval on Google's current business trends.
(Thanks to Battelle for the cool graphic)
Ah, the luxury of having a $125 billion market cap. While analysts fret about whether YouTube is really worth $1.6 billion--or whether, as Mark Cuban put it a while back, anyone who buys YouTube is "a moron"--Google can shrug its massive shoulders and say, "Whatever." And then it can go out and buy the leading online video brand by giving up a mere 15% of its cash mountain or 1% of its equity.
Will this be a smart bet? Who knows? Will Google have overpaid? Who cares? Right now, for Google, $1.6 billion is chump change. (A fact that reveals yet another debilitating advantage Google now has over Yahoo!, et al: a market-capitalization five times as big.)
And one thing's for certain...regardless of what happens, Google's trading away 1% of itself to buy YouTube can only prove 1/10th as moronic as Yahoo!'s late-90s decision to trade away 10% of itself (my recollection) to buy, among others, broadcast.com. (Of course, as a regular reader and Mark Cuban pointed out, the YouTube risk is legal risk, not business risk. And legal risk can be unlimited).
Sorry for the digression, but it's a slow Internet news day, and something feels wrong here. Before I describe what, however, I need to discuss what is not wrong.
It is not wrong that former HP Chairman Patricia Dunn was publicly ridiculed for ordering and overseeing a cloak-and-dagger investigation of boardroom leaks. It is not wrong that Dunn (finally) resigned over this (she should have taken responsibility and resigned immediately, whether or not she knew about the "pretexting"). It is not wrong that HP board members like Thomas Perkins would be outraged about the investigation and quit the board in protest. It is not wrong that everyone thinks pretexting (a.k.a., fraud) is unethical--it obviously is. It is not wrong that everyone thinks Dunn made a bad business decision--she did. It is not wrong that HP has been globally shamed for engaging in such a practice--it should have been.
What feels wrong is that Patricia Dunn has been charged with four felonies. Unless the California attorney general knows something that the rest of us don't (possible), Dunn neither intended to commit a crime nor knew one was being committed. On the contrary, she took repeated steps to assure herself that the investigation was legal. She sought and received assurances from, among others, HP's general counsel, Ann Baskins--a legal expert far better qualified to know (and who, for some reason, has not been charged with the same crimes). Baskins reportedly concluded and still believes that the investigation was legal. Wilson Sonsini, HP's outside law firm, concluded and still believes that the investigation was legal. As do other legal experts.
So what more could Patricia Dunn have done? Used her own legal spidey sense to say, "Hey, my lawyers tell me it's fine, but I think they're wrong"? Again, the issue here is not whether the investigation was smart or ethical--it wasn't--but whether it was criminal. And it seems a more-than-fair defense for Dunn to say, "I consulted legal experts--not hacks, mind you, lawyers at the top of their field--and they assured me it was legal." Dunn will have an opportunity to make this defense, of course, but she will have to do it in court, after sacrificing her board seats, reputation, more than a year of her life, and tens of millions of dollars in legal fees. And given that hindsight is always 20/20 and juries aren't omniscient, she might still go to jail.
Meanwhile, the person who allegedly put some of these events in motion, an alleged leaker, Dr. George Keyworth, has been portrayed as a helpless victim, worthy of sympathy. Keyworth has every right to outraged that his employer defrauded the telephone company to get his phone records. He does not, however, deserve to feel holier-than-thou about his own conduct in the affair.
On the contrary, if Dr Keyworth did, in fact, chat secretly with reporters about ongoing board discussions, he betrayed HP, HP's shareholders, and the rest of the board. He violated his professional duty, and then (by not resigning when called on it), refused to take responsibility for his actions. Keyworth's defenders point out that he "had HP's interests in mind." Maybe, but secretly dishing to reporters about inner workings of board discussions was just what the board was trying to prevent, and, if he did it, he betrayed the company by doing it.
[UPDATE: Since publishing the initial version of this post, I have received polite notes from a Dr. Keyworth supporter who argues that there is no evidence that he leaked "confidential information" or that he did this "repeatedly", as I suggested in the initial post. This supporter also points out that despite the pretexting, etc., the investigative report of the leaks was "inconclusive." I still think sharing details about a board retreat, ongoing board decisions, etc., in the context of a explicit board-wide consternation about press leaks--which I think Dr. Keyworth has acknowledged doing on at least one occasion--constitutes a breach of trust, but I don't know all the facts.]
Was Keyworth's alleged behavior a crime? Of course not--just as what Patricia Dunn personally did to try to stop it doesn't sound like a crime. But it was unprofessional and a betrayal of responsibility and trust. So hold off on the Keyworth hagiographies, at least as far as his conduct in this affair is concerned.
The HP scandal is major embarrassment, one that deserved to lead to firings, resignations, regret, apologies, and bad publicity. Based on the facts that have been released to date, however, it does not deserve to lead to jail time or a criminal indictment, at least for Patricia Dunn.
UPDATE
A couple of smart readers have observed that 1) ignorance of the law is not a defense, and 2) Dunn's changing stories and refusal to take responsibility undermine her defense.
On point two, I am taking Dunn at her word in her Congressional testimony--which, as I recall, was that she didn't know the investigators were "pretending to be someone else" and that HP's corporate counsel, Ann Baskins, who did know, had pronounced the investigation legal. If either of these assertions is false, then the picture changes.
On point one, I agree that ignorance of the law is no defense when the law is clearly defined and when the accused knows that someone is violating it. In this case, although there should have been a law against pretexting, many legal experts think that there wasn't. More importantly, Dunn claims that she didn't know that the investigators were engaging in pretexting, so that even if it was against the law, she says she was unaware of it.
In other words, there is an important difference between ignorance of the law and ignorance that the law was being broken. The latter isn't a defense, either, if the person should have known. But if the person takes reasonable steps to assure themselves that a law is not being broken, I think this should be a viable defense. If it isn't, then every person who manages employees who commits crimes will be liable for those crimes--a situation that would deter most sane people from ever becoming managers.
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