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Google and Microsoft – Separated at Birth?

A very interesting cover of Barron’s today with the headline Google Gets the Gong. Barron’s thinks Google is grotesquely overvalued, and they are absolutely right.

It amazes me how short the memories of both laymen and analysts can be. Google is valued at 41 times earnings. It’s market capitalization (the value of all of its outstanding stock) is about $112 billion, more than Coca Cola or Cisco Systems, and barely less than Intel. That’s right, Intel. That’s insane. Doesn’t anyone remember 2000 and 2001?

Google is a terrific company, but it’s not worth the money that has been thrown at it. This cycle goes back to Henry Ford — innovation, growth, maturity, ubiquity. In the innovation phase, Google can charge what it wants for ad space. That’s why it has grown the way it has. Profits go way up, people (including analysts who should know better) want to be part of it, and they shower the company with money. Other companies see the profit and the interest and get into the market. The companies competing for customers drive the profit margin down. Any college economics course covers this concept in the first week. More on this later.

As an example, I will never forget sitting in the conference room at Modem Media the day we went public, watching the bid and ask prices go up like the spinning dial on a slot machine. We started at 13, and made it all the way up to 80. At the time we were losing several million dollars a year. I remember wondering how people could possibly make a living valuing companies.

Anyone with a calculator can figure out that this has happened every time a company in the innovation stage comes to market. There’s not enough room here to list all of them stretching back past the Industrial Revolution.

Two terrific examples, again cited by Barron’s are Dell and Microsoft. Barron’s rightly points out that in 1999 Microsoft peaked at a multiple of 68 times earnings. Remember 1999? Internet usage reached 150 million, and the buzzwords were ecommerce, collaboration and device integration. All were just getting off the ground.

In his Letter to Shareholders in Microsoft’s 1999 Annual Report, Big Bill was positively giddy about sticking Microsoft Windows into any device with a chip in it — thermostats, lightswitches, handheld PCs, telephones, you name it. He gushed about friction-free knowledge-management systems, and touted Microsoft as being in a unique position to web enable anything that moved, help anyone buy anything anywhere, and hook everyone together to enable the flow of information (and money).

Let’s not forget that at the time the Internet was just becoming integrated into our daily lives. 1999 was all about collaboration and commerce. We were becoming comfortable with buying stuff online. There was a lot of innovation in the marketplace, including some (Active Desktop, IE5.0 and Microsoft-owned sites like Carpoint and MSN Money) from Microsoft.

Microsoft was throwing money around like a drunken sailor, offering stock options to college professors to entice them to come onboard for research, spending $5 billion to grab a piece of AT&T (someone misread their powerpoint presentation on that one) and snapping up tons of smaller companies.

Any company (CommerceOne, up 2700% in the six months after IPO, Purchase Pro, up 1750%) that showed innovation in those areas found itself showered with cash. The ultimate innovator had to be Microsoft, right? Analysts were talking about the incredible growth machine that Microsoft had become, and how they were going to use their might to exert dominance over the Internet, making billions and trillions of dollars.

That’s all people had to hear. They saw the innovation, saw the potential, and then priced it into the stock with their checkbooks and 401K money.

A few words on the word potential. In his terrific book Freakonomics, Stephen D. Levitt wrote a great blurb on real estate agents and the words they use in their advertising. Basically, the word potential is used to distract people from today and point them toward the future. I spend a good amount of my time valuing businesses. When I ask someone why the business is priced so high as a value of earnings or sales or something concrete and they tell me it reflects the potential of the business, I know its time to get the bread, because here comes the baloney as my grandfather likes to say.

So, fast forward to 2006. We know now that Microsoft didn’t win the Internet battle, though they certainly are a player. There are players (like Google) who jumped in to grab a piece of the gazillion dollar pie. Microsoft talks a good game, and it wielded a big wallet to come up with some good innovation, but in the end they are number three in search engines (with no contextual advertising engine) and number two in online services due mostly to spending a bazillion dollars on promotion and buying up smaller online services and infrastructure companies.

They had some terrific ideas, and a lot of them panned out. But the smaller, more agile competitors (the ones they didn’t buy) ate their lunch. That is the essence of Capitalism, and that is the way it works in the good old USA.

Let’s get back to Google. The guys there have made it clear that they want to be the Microsoft for the twenty-first century — the operating system of the Internet.

They yearn to be a lot of things. Most of all, they seem to yearn to beat Microsoft. They constantly yank Bill Gates and company’s collective chains. They have hired away a lot of talent from Microsoft, including Kai-Fu Lee, a top exec at Microsoft that became the head of Google’s China operations, and Mark Lucovsky, a key engineer on the Microsoft Windows team.

This has apparently angered Microsoft CEO Steve Ballmer so much that he went ballistic when Lucovsky went to his office to resign, as chronicled in a Lucovsky court affadavit:

At that point, Mr. Ballmer picked up a chair and threw it across the room hitting a table in his office. Mr. Ballmer then said: “Fucking [Google CEO] Eric Schmidt is a fucking pussy. I’m going to fucking bury that guy, I have done it before, and I will do it again. I’m going to fucking kill Google.” ….

So Google has attracted an enviable team. But what’s the goal? According to author Steven Arnold, Google aims to be the network computer platform for delivering so-called “virtual” applications, or software that allows a user to perform a task on any device with an Internet connection.

They’re building an application delivery system that would be browser based. Okay, that sounds terrific, and maybe I’m just missing the point, but who cares? Google Earth is an example of this technology, and while it’s cool, it’s only a tiny piece of what the Internet is capable of.

Furthermore, no matter how many engineers or architects or famous Internet guys like Vint Cerf they can employ, 90% of their revenues still come from search engine advertising.

There is no question that Google’s brillance was in moving the search engine off the Internet and onto the desktop (along with contextual advertising). Their next trick is supposedly going to be to move the operating system from the desktop to the Internet, which seems kind of boring to me.

While it presses on, Google’s bread and butter advertisers are just beginning to realize that conventional pay-per-click advertising just isn’t that cost effective, and as Barron’s points out, the smart money is flowing out while the dumb money is flowing in.

So while the demand is starting to wane, the supply is increasing. Microsoft will soon unveil its contextual ad program, while Amazon readies one of its own. Both look like imitations of Adsense, but will cut into revenues just the same.

Everyone wants a piece of Google. They are getting sued by The Association of American Publishers for copyright violations. The phone company wants a piece of Google’s pie for delivering content (which is like the county suing UPS for using the road to deliver packages).

So what is Google going to do next to battle Capitalism? How will they keep the smaller companies from eating their lunch? Nobody knows, and Google isn’t talking. They have many pie-in-the-sky ideas, and lots and lots of potential. But in its core business, it looks like Google is about to take a big hit.

Costs are rising, revenues per unit are falling, and while Google has about half the market, its product is becoming a commodity.

Microsoft in normal times (if you call today normal) is valued at about 22 times earnings. That would put the price of Google at about $175, which is about half its current value. What would I call the other $175 in Google’s $350 per share price? Potential.

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