Harry Newton's In Search of The Perfect Investment
Newton's In Search Of The Perfect Investment. Technology Investor.
8:30 AM Wednesday, January 11, 2006: Human
frailty means we're often lazy and in denial. Too many of us eschew exercise,
are overweight and smoke. The New York Times diabetes series (for today's article
here) underlines how it's so easy to postpone healthy living. Reading
about New York's diabetes epidemic is getting to me. Listening to my friends
justify their unhealthy life styles has gotten to me also. End of ultra-boring
The Bear Case: Google closed last night at $469.76.
Could it drop to $100? If you own Google, it's not unreasonable to take some
of your hefty profits off the table. Yesterday, the infamous Henry Blodget posted
this piece on a site called Internet Outsider (click
here). The piece is worth reading, whether you
like Blodget or not.
No one else is writing this piece, so it will have to be me. I should say upfront
that I'm not predicting that this will happen (yet), and I'm certainly not making
a recommendation. I'm just laying out a scenario that could kick Google in the
kneecaps and take its stock back to, say, $100 a share.
weakness is that it is almost entirely dependent on one, high-margin revenue
The company has dozens of cool products, but with the exception of AdWords,
none of them generate meaningful revenue. From an intermediate-term financial
perspective, therefore, they are irrelevant.
So, the question
is, what could happen to AdWords, and what will happen to the company (and
stock) if it does?
The first thing
that could happen is that, for a variety of reasons, AdWords revenue growth
could slow. The reasons could include market saturation (one of these days,
Google will have picked all the low-hanging search fruit) and/or a flattening
of keyword price increases (recent anecdotal evidence such as FTD
suggests that this is already happening in some categories). Both market saturation
and price pressure will occur naturally someday, as they do with every business.
The only question is when.
slowdown occurs, what will happen? The stock's multiple will compress. How
much? At $460, Google is valued at about $140 billion, or approximately 50X-70X
a 2006 free cash flow estimate of $2-$3 billion. If its growth slows gradually,
this multiple will probably shrink to 30X-40X. If it slows precipitously,
the multiple will probably shrink to 20X-30X. Natural forces, in other words,
should eventually compress Google's FCF (free cash flow) multiple by 20%-60%.
(I am comfortable predicting that this will happen. Again, the only question
And then there
are the disaster scenarios. Chief among them: click
fraud. Yes, to some extent, click fraud is just a cost of doing business
-- already factored into ROIs. And, yes, no one knows how big a problem it
is, which means it could be a smaller problem than people think. And, yes,
Google presumably has airplane hangars (sorry, Googleplexes) filled with rocket
scientists working the problem. And, yes, they might get it licked.
But, let's say
click fraud continues to increase as a percent of total clicks (which seems
perfectly plausible to me). Eventually, all else being equal, ROIs will start
to decrease, as the $1.00 keyword that delivers a profitable sale today will
deliver an unprofitable one tomorrow. Then, two things will happen: First,
marketing dollars will begin to flow back off-line (a la FTD) or at least
flow online at a slower rate. Second, keyword prices will start trending down.
The latter will happen as the growth of (real) clicks is also slowing, compounding
the impact. Search revenue the product of CLICKS X PRICE-PER-CLICK and, thus
far in the industry's history, both have enjoyed consistent, impressive growth.
If one of these two metrics starts to drop, overall revenue growth could stagnate,
and then, ultimately, decline.
If this happens,
Google's multiple will compress to the 20X-30X range cited above. Only this
time, the multiple will be applied to a smaller free cash flow stream -- at
least until Google starts cutting pie-in-the-sky projects and firing people.
And as this is happening, of course, Google's hiring -- about 10 new geniuses
a day -- will get more challenging, because getting paid in Google stock options
won't seem like such a great deal anymore. To combat this, Google will have
pay more cash, which will put more pressure on margins and cash flow. And,
of course, many of the pre-IPO billionaire managers and developers may decide
that now is the time to start that start-up they've always dreamt about --
("Enough of the big-company thing." "It's just not fun anymore.")
And that's if the impact is gradual.
If the click
fraud impact (or the impact of some other unforeseen problem like a global
recession) is sudden, then the above scenario will seem like a holiday. The
one drawback of super-high-margin revenue streams is that they create the
illusion of endless and effortless profitability. Google has so much money
right now that one of its biggest challenges is finding ways to spend it ($200
million on Googleplexes, $600 million on server farms, $500 million worth
of product development per year). What this translates to is a high and rapidly
increasing fixed cost base -- one that, on the income statement alone, now
amounts to a run-rate of about $2 billion a year (excluding traffic acquisition
almost all of this $2 billion is fixed, not variable. If revenue drops, these
expenses will remain the same -- unless Google takes painful steps to cut
them. Google's net revenue run-rate in Q4 should be something on the order
of $5.5 billion, so there is plenty of room to spare. But having enjoyed a
55%-plus operating margin in the past, it's hard to imagine that Google shareholders
are going to accept, say, a 20% margin -- so the golden Google management
team will find itself under intense pressure to cut costs and re-organize.
Would the company
survive? Absolutely. The franchise is now so strong that it would take Enron-like
fraud to destroy it. But when revenue and profits are plummeting, when global
advertisers are running away from the the distaste, expense, and frustration
associated with search marketing as fast as they are currently running toward
it (and as fast as they ran away from the last miracle vehicles -- display
and email -- in 2000), and when Google has transformed from a symbol of the
American dream to yet-another get-rich-quick hallucination, it will seem as
though Google is in danger of collapsing. Managers will leave en masse, in
disgrace. Newspapers the world over will revel in front-page analyses of shortsightedness,
arrogance, and what went wrong. And the cash flow multiple will compress to
below 20X on a lower FCF stream.
Is such a scenario
likely? Probably not. But it's certainly within the realm of possibility.
(How do we know this? Because the same thing just happened to Yahoo!, AOL,
and every other advertising-driven dotcom on the planet -- except that in
those cases, the fallout was worse). So let's put that in our Google-$2000
pipe and smoke it.
Posted by Henry
relentless quest for a better laptop: Last weekend I emailed the
head of Toshiba's product marketing a sweet note begging him for simple improvements
on his otherwise excellent laptops. Sadly, he is a burdened by a gigantic bureaucracy
that moves glacially. Writing the note was a gigantic waste of time. Not so
with Apple, run by one remarkable man who moves like lightning. Yesterday, Steve
introduced a line of Intel-chip based laptops and is shipping them -- long before
his PC competitors (including Toshiba) are. Today's Wall Street Journal online
at center stage yesterday as Apple's new generation of computers was an exhibition
of the innovation and showmanship behind the company's financial success and
pin-up status in the tech world.
and chief muse Steve Jobs unveiled the early fruition of the Intel-Apple partnership
with a series of dramatic announcements, among them Intel Chief Executive
Paul Otellini arriving in a cloud of smoke and clean-room suit, declaring
"Steve, I want to report that Intel is ready," the San Jose Mercury
New notes. The new iMac with the Intel chip, clocking in at two to three times
faster than the old iMac but at the same starting price of $1,299, began shipping
yesterday -- months earlier than expected. And the Messrs. Jobs and Otellini
said next month would see the debut of the MacBook Pro, the first laptop with
the new Core Duo processor chip, which combines two processors on one chip,
allowing it to run multiple programs at the same time while using a third
less battery power. Mr. Otellini said Intel had more than 1,000 people working
on the new chips to bring them in ahead of schedule.
watching the presentation at the annual Macworld Conference & Expo interpreted
the alliance as a subtle warning by Intel to its traditional PC partners that
they need to innovate more, the Los Angeles Times says. A TV commercial promoting
the new iMacs and MacBook Pro says Intel processors have been "freed"
from being "trapped inside PCs -- dull little boxes -- performing dull
little tasks." Apple's switch from IBM to Intel processors requires an
investment by Mac software developers to revamp their programs if they want
them to run natively on the new Intel-based machines, the Seattle Post-Intelligencer
notes. The show also saw the announcement of a new agreement committing Microsoft
to make Word, Excel and other Office programs for Macintosh computers for
at least five more years. While the deal doesn't include an investment in
Apple by Microsoft, as a previous agreement did, people inside Microsoft's
Mac Business Unit tell the PI they hope it alleviates concerns among Mac users
about Microsoft's software plans.
Mr. Jobs also
introduced an update of Apple's iLife suite of software that is intended to
make it easier to create, edit and distribute online photographs, movies,
podcasts and other digital content, and Apple added the introduction of a
new device to allow iPod users to listen to FM radio stations. The announcements
were in keeping with what the New York Times calls Apple's broader strategy
of building on the success of the iPod with new hardware and services in the
growing realm of digital media. Mr. Jobs said Apple had sold eight million
videos and television shows since it began selling videos for computers and
video iPods in October. Apple has also been offering a remote control with
new iMacs that allows customers to operate the computers as they would a television
or DVD player. Thanks to the iPod's continuing success, Apple had holiday
sales that were far above company and analyst forecasts, The Wall Street Journal
notes. For the three months ending December, Apple had revenue of $5.7 billion,
up 63% from $3.49 billion a year earlier. Apple sold 14 million iPods in the
quarter, two million to three million more than some of the most optimistic
virtues of eating pig -- Part 1:
A rabbi was bothered by the fact that he had never been able to eat
pork. He flew to a remote tropical island and checked into a hotel. He immediately
got himself a table at the finest restaurant and ordered the most expensive
pork dish on the menu. As he eagerly awaited it to be served, he was shocked
to hear his name called from across the restaurant. He looked up to see 10 of
his congregants approaching. Just his luck - they'd chosen the same time to
visit the same remote location.
At that moment, the waiter came with a huge silver tray carrying a whole roasted
pig with an apple in its mouth. The rabbi looked up sheepishly at his congregants
and said, "Wow - you order an apple in this place and look how it's served!"
virtues of eating pig -- Part 2:
A priest and a Rabbi found themselves sharing a compartment on a
After a while,
the priest put down his book and opened a conversation by saying, "I know
that, in your religion, you're not supposed to eat pork... but have you really
never even tasted it?"
The Rabbi closed
his newspaper and responded, "I must tell you the truth.Yes I have, on
the odd occasion."
The Rabbi had
his turn of interrogation. He asked, "I know that in your religion, you're
supposed to be celibate.. but..." The priest interjected, "Yes, I
know what you are going to ask, and yes, I have succumbed to temptation once
The two resumed
their reading.There was silence for a while. Then the Rabbi peeked around his
newspaper and said, "Better than pork, isn't it?!"
+ Munich, the movie. A must-see. Click
+ Identity Theft precautions. Click
+ Dumb reasons we hold losing stocks. Click
+ How my private equity fund is doing. Click
+ Blackstone private equity funds. Click
+ Manhattan Pharmaceuticals: Click
+ NovaDel Biosciences appeals. Click
+ Hana Biosciences appeals. Click
+ All turned on by biotech. Click
+ Steve Jobs Commencement Address. The text is available:
Click here. The full audio is available. Click
+ The March of the Penguins, an exquisite movie. Click
+ When to sell stocks. Click
This column is about my personal search for the perfect
investment. I don't give investment advice. For that you have to be registered
with regulatory authorities, which I am not. I am a reporter and an investor.
I make my daily column -- Monday through Friday -- freely available for three
reasons: Writing is good for sorting things out in my brain. Second, the column
is research for a book I'm writing called "In Search of the Perfect
Investment." Third, I encourage my readers to send me their ideas,
concerns and experiences. That way we can all learn together. My email address
is . You can't
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