Technology Investor 

Harry Newton's In Search of The Perfect Investment Newton's In Search Of The Perfect Investment. Technology Investor.

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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 click 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 lecture.

Google: 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.

Google's major weakness is that it is almost entirely dependent on one, high-margin revenue stream.

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.

If/when this 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 is when.)

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 costs).

Importantly, 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 Blodget

The 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 reported:

As much 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.

Chief Executive 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.

Many analysts 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 analyst forecasts.

The 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!"

The virtues of eating pig -- Part 2:
A priest and a Rabbi found themselves sharing a compartment on a train.

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 or twice."

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?!"

Recent column highlights:
+ Munich, the movie. A must-see. Click here.
+ Identity Theft precautions. Click here.
+ Dumb reasons we hold losing stocks. Click here.
+ How my private equity fund is doing. Click here.
+ Blackstone private equity funds. Click here.
+ Manhattan Pharmaceuticals: Click here.
+ NovaDel Biosciences appeals. Click here.
+ Hana Biosciences appeals. Click here.
+ All turned on by biotech. Click here.
+ Steve Jobs Commencement Address. The text is available: Click here. The full audio is available. Click here.
+ The March of the Penguins, an exquisite movie. Click here.
+ When to sell stocks. Click here.

Harry Newton

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 click on my email address. You have to re-type it . This protects me from software scanning the Internet for email addresses to spam. I have no role in choosing the Google ads. Thus I cannot endorse any, though some look mighty interesting. If you click on a link, Google may send me money. Please note I'm not suggesting you do. That money, if there is any, may help pay Claire's law school tuition. Read more about Google AdSense, click here and here.
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