A Voice of Reason on Google

Morningstar GrowthInvestor editor Mike Trigg recently sat down with stock analyst Rick Summer to talk about the online advertising market and  Google (GOOG). A version of this article originally appeared in the October 2005 issue of GrowthInvestor.

GrowthInvestor: Rick, some people still don't understand how Google makes money. Can you explain it to us?

Rick Summer: Google makes money from selling online advertising. When someone uses its search engine, Google displays ads based on the keywords or phrases like “Hawaii vacation” used for the search. If the user then clicks on that ad (a clickthrough), the advertiser pays Google based on an agreed-upon price per click. Recent prices have ranged from $0.50 for consumer related keywords to more than $4 for mortgage related keywords. Google has a network of advertising customers that place ads on its Web sites and content partners' sites, which range from blogs to online shopping sites. Site traffic drives clickthroughs, which drives revenue.

Clickthrough pricing has been a real catalyst for the growth of online advertising. In the early days, companies were purchasing banner ads that were nothing more than static commercials on the Web. But advertisers had no way of tracking users or understanding the impact of the ads, so they became skeptical and decreased spending. However, with clickthrough pricing, advertisers pay for users that actually click on the ads. Clearly, these users are an obvious target audience. With the ability to track and measure returns, advertisers are moving budgets away from television and print to the Internet.

MGI: You make Google sound like an advertising company, but there's all this discussion about new products such as desktop tools, instant messaging, etc. Some people say that the company is creating an operating system.

Summer: Today, Google's success is certainly based on its ability to capture online advertising dollars. As you say, the company is more than an advertising network or a search box. While we believe calling Google the next Web operating system is a stretch, new offerings such as e-mail, instant messaging, and pieces of desktop software are an important part of the company's evolution. The more Internet users depend on Google for other services, the less likely it will be for them to switch to other search engines. We could call it a portal strategy or some other buzzword, but the important fact is that these new services tie users to google.com.
 
MGI: So Google does see itself as a technology company. How are  Yahoo  and  Microsoft (MSFT) approaching the opportunity?

Summer: The search business is dominated by Yahoo and Google today. Like the browser wars in the 1990s, Microsoft is playing catch-up. Both Yahoo and Google have built advertising networks, and Microsoft's should become commercial over the next 12 months. However, the overarching strategy between Google and Yahoo have been quite different: Google focuses on technology and user experience, Yahoo focuses on content and community. Of the three giants, Yahoo offers the largest variety of services and content, including fantasy sports, music, and a desktop companion that gives Web information without a browser. Yahoo has tens of millions of e-mail accounts and instant messenger users. We believe that Yahoo's community and services strategy is building incredible long-term value that Google and Microsoft will find difficult to emulate.

In the past, Google has explicitly stated that it's not a Web portal. However, the company has recently launched a few "me-too" services. First, registered users now have a Web portal through which they can personalize information such as news, weather, and stocks. Secondly, the company has launched a messaging product that is not interoperable with any major messaging product to date. These new services reflect an admission that the community strategy is more likely to keep users coming back. In terms of a community, Yahoo and Microsoft are the clear leaders with services such as music and blogging communities. Google's innovations are more technical, offering easier ways to access information. As most services are free, we are skeptical that any innovation will increase Google's market share of online advertising.

The other business for Google is the ad network. We see little differentiation across the companies as Google, Yahoo, Microsoft, and  IAC/InteractiveCorp's (IACI) AskJeeves will all have their own ad network and content syndication.

MGI: Not only is your view of Google unique, it's quite different from Wall Street's. What are those bullish analysts failing to recognize?

Summer: The challenge with Google is that most of the value is not determined by how well the firm does in 2005 or 2006. We feel there are two primary reasons that others may have more-optimistic views. First of all, we do not believe that Google has additional operating leverage left in its business model. In other words, spending will have to increase at a greater rate than revenues to support long-term growth.

Secondly, some analysts think that Google will take control of the user experience, and we will all be using Web applications on Google instead of PC applications sitting on a Microsoft operating system. We believe that concept of a Web operating system is substantially different than a PC operating system. Operating systems require a rich community of third party developers to create and improve applications. While this community is thriving on the Web, no company will necessarily need Google to develop or distribute applications. Also, there are many applications more suited for a PC experience.

With Google, the opportunities may seem boundless to some. However, when we
compare those opportunities to what we believe are realistic outcomes, we believe Google is changing a small part of the world, not the globe. Our fair value estimate of $217 assumes that Google maintains its market share in the online advertising market. Given the challenges, we believe this scenario is optimistic. Even taking into account our optimistic view, the stock is extremely overvalued at these levels.