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Stock Strategist Industry Reports

Is Google's Moat Widening?

Google shares look undervalued, despite its dominant position in a growing industry.

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The last several months have been defined by falling stock prices, a credit crisis, and overall economic weakness. However, we thought it would be an opportune time to highlight a company that we feel is poised to emerge from the rubble better positioned than ever:  Google (GOOG).

Most forms of traditional media can't be tailored to reach a highly targeted audience. Search, on the other hand, delivers a very targeted audience because users are explicitly stating an interest in a particular product, service, or topic. By not wasting time, effort, and money on uninterested parties, search advertising provides a high return on investment relative to other forms of advertising. In addition, search advertising is also very measurable relative to traditional advertising, as marketers can track the number of consumers who have actually viewed an ad, "clicked" on it, and taken a specific action (purchased a product, filled out an application, signed up for a subscription, etc.). We think the inherent advantages of search and the continued growth of Internet usage will lead advertisers to allocate more of their ad budget to search, resulting in good growth prospects for the industry for years to come.

The principal beneficiary of the growth in search advertising over the last several years has been Google. Its superior product offering and brand strength have led to impressive gains in market share of search queries (see the chart below). Due to this dominance, many advertisers don't even bother to use alternative search platforms, which has led to an even larger share of search dollars than search queries for Google. The profits generated by Google's search business can be reinvested in additional computing power and human capital to make its search engine even better. Additionally, Google's massive scale of search queries and clicks gives the company unparalleled insights into which search results are most popular with users. This data intelligence can be used to further tweak its algorithms, leading to more relevant search results and an even better user experience.

Search engines also rely on the historical click-through rates to determine which sponsored search results (search ads) are most popular with users. These data help search engines determine which ads are most likely to be clicked on in the future. Thus, the search ad platform actually gets "smarter" with more use, as it partially relies on historical data to determine which ads to display in the future. Due to its massive scale, Google has a vast lead on competitors in terms of this intelligence as well, especially for the long tail of more obscure keywords.

We think the need for scale in queries was a primary factor in  Microsoft's (MSFT) initial interest in  Yahoo (YHOO). Even if Microsoft was able to develop a first-class algorithm, a user-friendly ad platform, and the necessary data centers to index the entire Web, it would still be missing a vital component needed to provide a comparable search experience: scale in queries and clicks. Only by acquiring Yahoo could Microsoft instantly gain this key ingredient. Yahoo's scale in search queries would also help Microsoft attract advertisers to its platform. Now that Google has walked away from its proposed search ad partnership with Yahoo and Jerry Yang has resigned as Yahoo's CEO, we would expect Microsoft to pursue a new deal with Yahoo, at least for its search business. We think a partnership would be the best option for Yahoo's shareholders and may be Microsoft's only chance of remaining relevant in search over the long run.

At first glance, walking away from its proposed deal with Yahoo may be viewed as a negative development for Google, as the company is foregoing some incremental revenue and allowing its two biggest rivals to potentially partner together. However, we view this positively, as we think a (semi)strong competitor will prevent Google from becoming too complacent and force Google to continue investing in its search technology. More importantly, it saves Google from a protracted legal battle that could have damaged its reputation with the Department of Justice, its advertisers, and its user base. An example of another company that has similarly benefited from having a (semi)strong competitor is  Intel (INTC), as  AMD's (AMD) presence has kept regulators at bay and has forced Intel to strive for continued innovation.

Google competes in a variety of high-growth and emerging business lines, making it very difficult to forecast the company's cash flows with precision. If Google's growth prospects from nascent business lines like mobile search or online software ever take off, our growth forecasts may be too low. On the other hand, Google's revenue could fall short of our expectations. However, we believe any weakness in Google's short-term revenue growth would be a result of macroeconomic conditions and would not reflect the company's long-term competitive advantages, which we think are solid. Due to the uncertainty in forecasting Google's future cash flows, we assign a high uncertainty rating, which means we would demand a large margin of safety before assigning a 5-star rating to the shares. Due to this large margin of safety and our belief in Google's long-term prospects, we would be happy to recommend the shares at our 5-star price.

 

Larry Witt does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.