Thursday, March 09, 2006

Down and Out in Mountain View

In its latest communication fumble, Google Inc. accidentally revealed an internal financial target for 2006 on its Web site but said it didn't constitute financial guidance.

—Wall Street Journal, Wednesday

Google Inc. said it agreed to pay as much as $90 million in legal fees and advertising credits to settle a lawsuit filed against it and other Internet companies last year alleging that the companies knowingly overcharged for online advertisements and conspired to continue doing so.

—Wall Street Journal, Thursday

The Cover Story Curse still holds: just three weeks after Time Magazine featured “The Google Guys” on its cover, those same Google Guys appear no more adept at running a public company than my dog Lucy.

Funny how perceptions change, and change quickly.

During the IPO process two short years ago, The Mainstream Press could not have been more dismissive of The Google Guys, their “Do No Evil” ethics, and the ad-driven search-engine business they had created.

A year later, after that same ad-driven search-engine business model had blown through pre-IPO earnings forecasts on the heals of some terrific new products—including Google Maps and Google Mail—and the stock had tripled, The Mainstream Press jumped on board the Mountain View Express.

Even CNBC, chastised into sobriety after its Bubble-Era cheerleading had come to grief, finally joined the caboose, giving full exposure to an analyst expounding a Bubble-Era, $2,000-a-share theoretical future Google stock price in the first days of 2006—which coincided precisely with the peak in Google’s stock.

Then came a disappointing quarter, and now comes word of two more Google Gaffes, straight on the heals of last week’s miscue by CFO George Reyes, a straight-arrow guy if ever there was one, who triggered panic-selling in the stock by making very rational comments about the likely diminution of Google’s growth rate.

Reyes’ comments should have surprised nobody who has been paying attention to the public comments of Google customers such as Blue Nile and FTD Group regarding the diminishing value of Google search—but Wall Street’s Finest, no doubt feel embarrassed to have finally embraced the Googlephoria at the moment it was about to evaporate, have not been mollified.

Somewhat obscured by the Google miscues was Tuesday’s excellent Wall Street Journal piece by Mylene Mangalindan regarding the heavy investment spending required by internet-based companies:

As the big survivors among Internet companies mature, they are learning a painful -- and unexpected -- lesson: Staying in the online game requires heavy, constant spending.

That is something has been dealing with for some time, and it triggered an excellent question on that company’s last conference call, when Mark Rowen of Prudential asked what I thought was very interesting question, foreshadowing the Wall Street Journal story:

“Jeff [Bezos, Amazon CEO], you have said for a long time that your model is more efficient that the traditional retail model because you don’t have to invest in real estate, which always goes up. Instead you can invest in technology, which goes down.

“But if I add up all of your expenses as a percent of revenue, and add in free shipping…I think in 2005 it was a little over 20% in the fourth quarter…which is 200 or 300 basis points higher than a company like Wal-Mart.

“So could you just sort of give us an idea…why is it that we are not seeing more efficiency, if, in fact, the model is more efficient?”

Mr. Rowen was not making his numbers up.

In calendar 2005, both Amazon and Wal-Mart generated roughly the same gross margin (24% and 23%, respectively) while Wal-Mart’s pre-tax margin came in half a basis-point above Amazon’s 5.04% pre-tax margin.

The difference between gross margin and pre-tax margin is cost-structure, and since Wal-Mart starts out with a lower markup to consumers but ends up with a higher piece of the gross profit dollars, it would appear that Wal-Mart—stodgy old brick-and-mortar Wal-Mart—is more efficient than technology-savvy

To Rowen’s perceptive question, Jeff Bezos gave a bland answer:

“Well, I think one thing to keep in mind is that if we were not investing in some of these new initiatives such as digital and Web Services, our cost structure would be different today. So if we were totally optimizing our cost structure for a kind of steady-state business, you would see a different cost structure…”

“If you look at the return on invested capital, the dynamics between our business and traditional retail are very different in large part because of the efficiency of our capital model, high inventory turns, low PP&E.”

All of which is very true but ignores the fact that Wal-Mart is always investing heavily in “new initiatives” and does not operate “a kind of steady-state business,” despite the fact that Wal-Mart came public back in 1970.

What does this have to do with Google? Well, Google management highlighted big capital expenditure plans at last week’s analyst meeting—which at a minimum would equal 19% of net sales.

Just for comparison’s sake, Caterpillar Tractor’s capital spending amounted to roughly 8% of sales last year.

How could a search-engine company dealing in bytes be spending more heavily, relative to its sales, than a brick-and-mortar manufacturer of earth-moving equipment?

When I first started using Gmail, which encourages users to never delete an email (see “Plastics” from January 9), I could literally watch the storage space available in my Gmail account rise, like a population count in Times Square, as Google added the servers and storage to accommodate all the data piling up from Gmail accounts around the world.

Then, about two months ago, that storage counter slowed to a crawl, and now increases modestly only every few days.

As a result, my use of the Gmail storage space allocated to my account has ballooned from 1% of my storage capacity to 24%.

24% is not sustainable: at the rate I’m going, it’ll be at 50% by summer and 100% by December.

Sure, I can revert to MSN methods of deleting all the emails I don’t especially need—and I’ll do it if I have to. But that wastes time.

Could it be the dot-coms have underestimated the long-term capital required to maintain, let alone grow, in the online world?

I don't know the answer to that question: but having trained its customers to expect “limitless storage,” Google needs to deliver precisely that, otherwise, it will start losing customers.

And if it starts losing customers, the “Do No Evil” Google Guys will not be able to do much good, for themselves or their fellow shareholders.

Jeff Matthews
I Am Not Making This Up

© 2005 Jeff Matthews

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews' recommendations.


SellToWhom said...

Wow, I am jealous. I wish I could have summed up the state of "New Economy" as eloquently.

For years I have been screaming to anyone who would listen that Amazon is a retailer. Nothing more, nothing less, and should be compared to other retailers and valued as such.

The idea that the costs of these internet storefronts (or in the case of Google, internet yellow pages) are "one time" was, and remains, foolishness.

Great piece.

Anonymous said...

Way to piece it all together for the top-down perspective. Although, one could argue that tech companies are filled with overpaid employees and loose capital expenditure decision processes. This is still a very immature business and costs will start being managed over the next few years. Caterpillar and Wal-Mart are at the peak of efficiency. Google and Amazon are not. Google and Amazon have a lot of OpEx they could squeeze if they decided to "efficiencize".

Barry Ritholtz said...

The Cover Story Curse has yet to impact Apple or Pixar, with Steve Jobs featured on Time Magazine a few months ago.

See this for more examples: The Magazine Cover Indicator

Anonymous said...

jeff, nice data mining on both the FTD and Blue Nile outlook. As irresponsible as that analyst who put out that $2000 price target, I was amazed at Eric Schmidt's recent comments on Google's damage control conference call where he said "we're building a $100billion dollar company", telling listeners to reach their own conclusions whether that meant market cap or revenue stream. That's a big, phony, at the same time cover your ass statement, if I've ever heard one. This notion that Google is going to get into this or that other business belies the history of tech companies. The list of companies that went from dominating one great business to building a portfolio of them is a very short list. Even the evil empire of Microsoft has never successfully made any real money selling anything other than operating systems and office suites, no matter how much noise they've made about xbox, msn, or whatever. Google was in the right place at the right time with this "monetizing of search", but to extrapolate their success to even a single other big business, well, "show me the money".

dkman said...

In my opinon Apple has definitely been a victim of the Cover Story Curse - stock peaked at $86 in January, it's struggling mightily around $65 right now.

Everyone seems to be announcing products that aim for iTunes or Apple's other products and even Apple's latest product lineup has not lived up to the expectations. There is definitely a lack of catalyst that would enable AAPL to reclaim its past highs.

It is amazing, however, what a great run the stock has had in the last 3-4 years - if only I had the courage to buy and hold...

Ed said...

where did you get 19% for 2006?

Bob M said...

Good analysis, but I wonder about the Gmail quota limit, as in:

"my use of the Gmail storage space allocated to my account has ballooned from 1% of my storage capacity to 24%.

24% is not sustainable: at the rate I’m going, it’ll be at 50% by summer and 100% by December."

Wouldn't Google be working toward a 99% storage capacity for everyone and a way of adding capacity as needed? That way they are using the storage capacity most efficiently and not throwing money away.

If so, I would expect to see my storage space go up to the number they wany as most efficient and then level off. We will see if that is the case.

Jeff Matthews said...


I based the 19% 2006 capex as a % of sales on a rough cut of various interpretations of what "significantly exceed" means.

It looks like a minimum of $1.2 billion, which is 19% of various sales forecasts (using net sales, not gross).

Good question, thanks--and I've clarified the blog to make clear this is my calculation, not a hard percentage given by the company.

Aaron Koral said...

"How could a search-engine company dealing in bytes be spending more heavily, relative to its sales, than a brick-and-mortar manufacturer of earth-moving equipment?"

My thinking here is that CAT is a commodity business, with high capex to plant and equipment. GOOG is not a commodity business. However, because GOOG must attract and retain intellectual capital (as opposed to the physical capital employed by CAT), GOOG must spent more on capex to maintain its competitive advantage in the internet advertising space.

With that said, what is interesting about GOOG is the ratio comparing the YoY change in CapEx spending to the YoY change in Total Revenues. I calculated the following figures from GOOG's Investor relations page:

2002 - 2003: 13.6%
2003 - 2004: 8.3%
2004 - 2005: 17.6%

I think the significant increase in YoY revenues from 03-04 to 04-05 was caused, in some small part, by the significant increase in YoY capex spending.

IMHO, I bet GOOG is thinking that the big capex spending in 2006 relative to its sales estimate should, once again, help bolster its sales growth for this year when put into context with what happened in 2005.

If I were an investor in GOOG, the one thing I would be worried about is click fraud: namely, how does GOOG know when click fraud actually happens, how often does it happen, and what is GOOG doing to detect/stop click fraud and win back the trust of advertisers?

Also, does detecting ad click fraud signal an opportunity for business intelligence companies to assist companies like YHOO and GOOG with this problem (hello, FIC)?

I could, however, be wrong in all of the above that I've mentioned...

I made this up said...

Your writing is usually a pleasure to read. However, the expression (you use it twice today) is "on the heels," not "on the heals."