Internet Outsider

Huge Net Capex: One-Time or Permanent?

The WSJ describes a key issue facing the big net companies, especially Google: massive (and increasing) capital spending.  Last week, for example, Google stated that 2006 CAPEX would "significantly exceed" 2005's mind-boggling $800 million, prompting analysts to toss out 2006 estimates in the $1.25 to $1.5 billion range.  Yahoo! spent $400 million last year, up from $250 million the year before.  Amazon's cranking up spending...

This gives rise to three key questions:

First, what on earth are they (or at least Google) spending that much money on?  I understand the need for "servers," but why has this need exploded so much in the last two years?  GDrive? GMail?  Neither of these ideas are revolutionary. Video is a CAPEX hog, but is the difference that vast?  Also, why does Google need $400 million more than Yahoo! and eBay do?  I shudder to recall this, but CAPEX is where companies occasionally stuff expenses they don't want to flush through their income statements right away (e.g., Worldcom and Homestore).  I have huge respect and confidence for Yahoo!'s financial team, and there is no conceivable reason for Google's team to play such games.  Without having more detail about exactly what the money is being spent on, however, the possibility of shifting capitalization policies can't be ruled out.

Second, is this simply an up-front investment necessary to build out global capabilities, in which case CAPEX will moderate in future years, or has running a global Internet operation become much more expensive?  If the answer is the former, today's CAPEX is largely irrelevant: The companies can afford it, and a future easing back on spending will drive free cash flow growth rates through the roof.  If the spending is permanent, however, these companies (again, Google especially) aren't going to generate anything like the free cash flow the market is currently expecting. 

Third, returning to a point raised in question one, why is Google spending more than twice as much as Yahoo! and more than Yahoo! and eBay combined?  Again, explanations about "storage" and "computational power" just don't ring true.  eBay and Yahoo! need storage and computational power, too, and, right now, Yahoo! handles more traffic than Google does.  The difference between the CAPEX levels, moreover, is so vast that it seems safe to assume that either Google is overspending (in which case, the question is "on what?") or Yahoo! and eBay are underspending (in which case, free cash flow is about to take a hit at both of those companies as well). 

When Google releases its 10K, we'll get more insight into where that $800 million went.  But this won't provide any into where this year's estimated $1.25 billion is going--or how much CAPEX as a percent of revenue will be required to run these companies for the next 10 years.

Amazon Music Strategy a Wrong Turn

The WSJ reported Amazon's plans to offer an Amazon-branded iPod competitor and digital music download store.  I haven't done much work in this area yet, so please weigh in, but this strikes me as a startlingly bad move.

First, Amazon's entry into this business is shockingly and annoyingly late.  As with the Netflix DVD business, Amazon could have owned this category, but in the name of moving deliberately (or of trying to become all things to all people), it allowed other competitors to build a dominant market position.  No matter what the company says, winning significant market share in digital music is going to be much harder now than it would have been three years ago.

Second, non-iPod digital music players are a dime-a-dozen.  The reason they haven't taken off, in part, is that they are not compatible with what has rapidly become the (legal) industry standard--iTunes.  Some of them, at least to these rapidly aging eyes, even look cool, but this has proven irrelevant.

Third, the hardware business sucks.  Unless you have a unique product, as Apple does, it's the last place you want to be.  Why Amazon wants to become yet another manufacturer of branded music players is beyond me--especially when there seems to be another, far better, strategic alternative.

Lastly, on this point, Amazon would seem to be in an ideal position to launch a digital music store featuring all music standards, one that allows users to choose formats, payment plans, etc.  The labels must be clamoring for this (anything to disrupt Apple's dominance) and even Apple would probably benefit from having another source of distribution. 

Yes, the latter would be a tough sell, but the mistake Apple made in the PC business was not separating its hardware and software products.  The Apple OS could have pounded Microsoft Windows for years if PC manufacturers had offered it as a pre-installed option, but because one was forced to also buy an Apple PC to use it, the OS became an also-ran.  Right now, there are enough competitors in the music business that Apple would benefit from allowing a few, carefully controlled licensors to distribute the iTunes format, especially licensors like Amazon, which can sell a boatload of iPods.

The WSJ story also suggested that Amazon's jumping into the hardware player business might cause Apple to shut it down as an iPod distributor.  If this is really a risk, it seems a dumb one to take.  Amazon isn't the dominant global powerhouse it once was--and even in those days, it had trouble cracking some new categories.  In digital music, moreover, Amazon needs Apple more than Apple needs Amazon.

Disclosure: I've owned Amazon for years.