Google: A Contrarian Perspective
Given the preceding post describing the hype around ad networks, I thought a closer look at the uber-network might be useful. What I found surprised me.
Google reported $10.6 billion in revenue for 2006. Of this amount, $4.2 billion came from placing ads on non-Google-owned sites. They paid those sites' publishers $3.1 billion in "traffic acquisition costs", resulting in a gross margin from their AdSense ad network business of $1.1 billion.
In 2006, Google spent $1.2 billion on R&D, a little more than $800 million on sales and marketing, and a little less than $800 million on overhead, for total operating expenses of about $2.8 billion.
A simple allocation of this $2.8 billion to Google-as-media-firm versus Google-as-ad-network based on each's contribution to total revenue puts 40% of these operating expenses, or $1.1 billion, onto the latter. The resulting math makes Google's ad network business a break-even proposition in 2006.
Revenue from Google's own properties has been growing slightly faster than revenue from its ad network business, but since they already have half the search market, you might imagine future growth is constrained to the overall rate of growth in web search, on portal sites and other places that capability's deployed. It's not hard to imagine that more of Google's growth would be coming from the ad network side of the business in the future, even if we ignore the DoubleClick deal. So, at some point, the economics of its apparently less-profitable ad network business begin to pressure earnings.
Apparently. You have to buy how I allocated operating costs between the businesses, and you have to believe these costs will grow linearly with revenues. I can argue the case either way, so we'd have to see some data to make an informed guess. It's also worth noting that traffic acquisition costs as a percent of ad network revenue also grew slightly from 78% to 79%. Absent a major breakthrough in targeting technology, I'm not sure we'll see big changes in this line to bail out a lack of operating leverage in the ad network segment otherwise.
Am I missing a bigger picture about GOOG's potential? Here's some analysis that's off the topic of their network's profitability, but might still be interesting:
Online advertising still has lots of room to grow, as does search within that broader category. But I'd have to think that this simple perspective is already fully reflected (if not overweighted) in Google's stock price.
Costs of revenues (as a percent of revenues) are down 6% in absolute terms over the last two years. I'm guessing that Google is seeing enormous leverage from its recent data center investments to make this possible, and I can imagine that processing and storage cost curves offer a good proxy for further efficiencies, since as Google shifts to renewable energy sources for electricity (solar and hydro), these two will predominate. But overall gains in costs of revenues have to flatten.
Overall, operating expenses as a percent of revenue grew from 23.6% in 2005 to 26.7% in 2006. That's a lot.
The 6% drop in operating expenses offset the 3% gain in opex. But I wouldn't bet on net margin expansion forever -- especially off an unusually high base of 32%.
So is this as good as it gets for GOOG? If it is, how long can it last? As wonderful as Google's economics have been, I don't see the same high network effect advantages and switching cost barriers (yet) that Microsoft has had with Windows and Office for so many years. If I don't like the deal AdSense gives me, it's easy to switch. Despite the huge advantages of doing so, I don't yet use Google apps to author all my documents -- nor does most of the world. Search is a killer app, and Google has the biggest rep, but there's competition here. PageRank is nearly ten years old.
What do the markets tell us? Most recently, despite the boom in online advertising, GOOG's share price has mostly tracked what's been happening in broader indeces. [Insert "and no tree grows to the sky" reference somewhere here.]
Indexing all the world's information and tracking every piece of it we look at through all channels may make for doing really well by doing lots of good (or at least by Not Being Evil), but it's increasingly expensive and less attractive financially. It's possible there's a story out there for why Google's worth much more than 41x earnings, but lots of smart people now watch this stock. Every business is subject to diminishing returns at some point. The counter is often culture, but at the pace the firm's been growing, Google's has inevitably diluted, if not in Mountain View then elsewhere...
I have no axe to grind here BTW, I think the company's great and I respect it and its leadership enormously. It's still attracting great people. I just think it's worth exploring the data a bit, and I'm sure this is a pretty superficial start. Alternative perspectives with better information and insight exceedingly welcome...
December 21, 2007 postscript: Fake Steve Jobs' take