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Get Four
|  | JANUARY 19, 2006
 TECH KNOWLEDGE Is Google Out of Steam?Downgrading its stock to sell, S&P's Scott Kessler explains why the search giant is vulnerable on several fronts. Key among them: click fraudHere's a gazillion-dollar question for investors: Has Google's (GOOG ) stock peaked? Since topping out at $475.11 during trading on Jan. 11, the stock has dropped to around $445. Although most Wall Street analysts are still bullish on Google shares, some bears are emerging. Scott Kessler, who follows Internet software and services stocks and is technology group head for Standard & Poor's Equity Research, downgraded the stock on Jan. 17 to sell from hold. Kessler spoke with BusinessWeek Online's Karyn McCormack about the challenges for Google and why he lowered his recommendation. Edited excerpts from their conversation follow: Why did you downgrade Google to sell? We downgraded it on Jan. 17 for two primary reasons. Something that we think all investors have to keep in mind is valuation. Our 12-month price target for Google is $428, and it closed yesterday at around $467 -- 10% higher than our target. The other consideration that we employed in this decision is risk. I think people generally know about risk -- that is, stocks can go down. But I think people have largely forgotten about the notion of risk relative to Google. What are the risks that Google faces? I think investors should know the ABCs of Google risk. "A" is for the absence of material revenue diversification. As good a company as Google is, it still generates 99% of revenue from one source: Internet search advertising. "B" is for building competition. Yahoo! (YHOO ) is investing aggressively in search. It is No. 2 in the Internet search-advertising area and is doing its best to compete. Microsoft (MSFT ) is slated to introduce adCenter in the second half of 2006. This will launch the company into Internet search advertising. We do think that Microsoft's entry into this category is going to have an impact. In addition, Ask Jeeves, which was acquired by IAC/InterActiveCorp (IACI ) last summer, says it will pursue a proprietary Internet search-advertising strategy. Last but not least is Fox Interactive Media. This was created in mid-2005 by News Corp. (NWS ), and includes MySpace.com, which has become an extremely popular destination for teens and twentysomethings. This is not speculation that Fox Interactive Media will pursue Internet search -- its executives have said they will do this. The question is how they will do it, either via acquisition or partnership. We don't expect it to partner with Google. Getting back to the ABCs of Google risk, "C" is for click fraud. This is relatively unknown to most Internet users and investors. It's relatively simple. A recent study suggests that up to 30% of online clicks could be fraudulent -- meaning not authentic, or not consisting of real users delivering clicks. We're talking about synthesized clicks by people or a box that automatically rings up clicks that benefit Internet search companies like Google. We think this problem is more pervasive than people think. We think it will affect advertisers' taste for Internet advertising and the prices they are willing to pay for ads. And this could have a negative effect on Google. So, essentially, my downgrade of Google is about valuation and risk. The stock is up 450% since its August, 2004, debut at $85 a share. We think there are notable risks to the stock, and investors should take action based on them. What should Google be doing to alleviate these risks? It's interesting, because some of the things they can do, they have already started doing. We started producing research on Google when it was private, and we saw its laser-like focus on Internet search advertising back in 2001 and 2002. We thought that at some point, Google would have to go beyond Internet search advertising. The efforts around things like Gmail, Google Talk, and Google Earth -- those are not very search-oriented applications. They have products that are not search products in and of themselves. It's pretty obvious they have to diversify in a number of ways. We've learned about the company's tests in print media, for advertising in magazines, and other traditional media. Its proposed acquisition of dMarc Broadcasting is related to the radio broadcast industry. When it comes to the building competition, part of what they're trying to do is diversify beyond Internet search advertising, but they are also trying to make their offerings more inviting and sticky to users. One of Google's shortcoming is that even though users like its search offering, they don't spend a lot of time on it. We're seeing Google trying to provide more personalized services -- enabling users to sign in, use e-mail, and access content that's preselected and determined by the user. Click fraud is a difficult situation. I don't know what is being done to stop click fraud on Google Web sites and on its AdSense network, which is advertising technology used by third-party, or other company, Web sites. They have to invest in technology and people around the concept of click fraud to ensure that it doesn't happen. At some point, this will become an issue that people will talk about in 2006. What does the deal to acquire dMarc Broadcasting mean for Google? I think it indicates Google's aspirations beyond Internet search advertising. It's not interested in a fee-based business model, which is interesting because Yahoo has been partnering with companies, and has co-branded Internet access relationships with AT&T (T ) [formerly SBC Communications], BT Group (BT ) [formerly British Telecommunications], Rogers Cable, Verizon Communications (VZ ), and BellSouth (BLS ) (the BellSouth offering is expected by yearend). Yahoo largely repackages its content for these offerings. Google doesn't seem interested in that business. It wants to expand its advertising platform, not only for radio but also for other broadcasting media, to broaden its opportunities. How does Google compare with Yahoo at this point, in terms of both competitive position and the valuation of their stocks? Yahoo is trading below our assessment for the stock's valuation. Our 12-month target is $40, based on discounted cash flow and sum-of-the-parts analyses. Yahoo has a stake in Yahoo! Japan, which has taken a big hit the last few days, in part because of investigations surrounding Livedoor. That has cast a pall not only over Yahoo! Japan, but the Nikkei as a whole. Google is the king of the hill in Internet search advertising. It has a decent market share in other areas, such as social networking, especially in Brazil, where it's very popular. Outside of search, though, Google has an uphill climb, whether it's comparison shopping with Froogle, e-mail with Gmail, or instant messaging with Google Talk. It's behind the competition in terms of market share. It's trying to become more like other Internet companies, but it's going to take time. On the other hand, Yahoo appears to have been losing share to Google in the Internet search area. That's somewhat worrisome because Yahoo has been aggressively investing in the search area. It's at a disadvantage in search, but it may close the technology gap. Could the recent weaknesss in Internet stocks spread to the entire tech sector? It's tough to say. That question really harkens back to 2000, when Internet stocks began falling before a lot of other tech stocks did, and the whole market followed. Internet stocks led the market down then. Now it's different. We just don't have as many high-profile Internet companies that people are invested in. There are only a handful of larger Internet companies. We have Google, eBay (EBAY ), Yahoo, IAC, and Amazon (AMZN ). Back in 2000, there were literally dozens, if not more than that. Moreover, these companies are very profitable, and they by and large have strong balance sheets. Also, I think people perceive these stocks as not necessarily indicative of what's going on in the broader market or economy. In 2000, Internet stocks were so ingrained in the market psyche that the focus was on how these companies were spending on technology, bandwidth, equipment, advertising, etc. This is not as material now as it was back then. So the answer to your question is no. But that doesn't mean that other tech companies won't have an impact on the market. Intel (INTC ) is an example. Yesterday, it reported a quarter that was disappointing -- it reported quarterly revenues, margins, and EPS that were below our forecasts. Intel is more relevant to tech stocks, and to the stock market as a whole, than Google and Yahoo.  All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is or will be, directly or indirectly related to the specific recommendations or views expressed in this research report. Standard & Poor's Regulatory Disclosure Any advice, analysis, or recommendations contained in articles labeled "Insight from Standard & Poor's" reflect the views of Standard & Poor's, which operates separately from and independently of BusinessWeek Online. It is possible that BWOL may from time to time publish information that is not consistent with advice, analysis, or recommendations that are published by Standard & Poor's. Standard & Poor's and BusinessWeek Online are each units of The McGraw-Hill Companies, Inc.
BW MALL
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