The BW Web 20: Google Makes the Cut


By Timothy J. Mullaney Google is now a publicly traded company, but the controversy around it hasn't much abated since it made its Nasdaq debut on Aug. 13. For our purposes at BusinessWeek Online, though, the real question is whether it belongs in the BW Web 20, a basket of Web stocks we've put together to give investors an aggressive but risk-conscious way to play the Internet. We're wary of high-price stocks like Google (GOOG), but in cases like eBay (EBAY) we've decided the potential outweighs the risk. Is that true of Google?

The answer is yes, we think -- but it's not an unambiguous call. We added Google to the index immediately before its IPO, after we learned that BW Online's bid to buy IPO shares at $85 had succeeded (see BW Online, 08/20/04, "I Came, I Bid, I Profited").

We've since sold the shares to comply with BusinessWeek policies prohibiting writers from owning stocks of companies we cover. But it's still part of the BW Web 20, which is a kind of hypothetical mutual fund. Google offers real risks -- and the potential for real rewards. So the call here is that it belongs in a well-diversified portfolio of bets on the future of the Internet, made by savvy investors who can absorb some risk, even at its current price of $106 a share. But no, I wouldn't urge my elderly mother to put her life's savings into it.

First, let's lay out the reasons to buy Google:

It's the leader in a fast-growing market. In the U.S., ads tied to search keywords were about a $2.5 billion market last year and is expected to hit $5 billion by 2008, according to Jupiter Research. Google alone is expected to reach revenues of nearly $3 billion this year and $5 billion next year, according to Standard & Poor's analyst Scott Kessler.

The Web-search market is a fundamental improvement over what it replaces. Google is an online Yellow Pages that's more convenient for many consumers. And advertisers swear by the cost-effectiveness of so-called cost-per-click advertising tied to search results. Last week, for example, an acquaintance told me he'd spent $400 on a digital camera, at a store he found through a Google ad. At current prices, that ad cost about 75 cents. No wonder advertisers are flocking to Google.

It has ample opportunities for operating leverage. Google is expected to earn $338 million this year and $767 million next year -- and that's before it gets serious about controlling spending. The estimates (from S&P's Kessler) assume Google will more than double spending on general and administrative costs next year. But there's no reason it should have to keep that up. If Google keeps overhead costs at their current percentage of revenue next year, that would add $95 million to profits. That's worth $12 to $15 a share right there.

The stock isn't that expensive -- even now. I can make Google sound expensive or cheap -- it's all in what measurement you use. An S&P estimate that Google will make about $900 million next year (factoring out noncash expenses for stock options that Google counts against earnings but peers eBay and Yahoo! don't) puts Google at trading around 32 times next year's earnings. Yahoo (YHOO) is trading at 61 times next year's earnings per share, and eBay at 53. Leave the options in, and Google's multiple climbs only to 37. That's still pretty low for the kind of growth Google promises.

And here are four reasons -- almost as good -- not to buy Google:

Revenue forecasting is, at best, a black art. Kessler says Google's revenue, up 141% to date this year, will rise about 66% in 2005. Janco Partners analyst Martin Pyykkonen looks at the same data and predicts Google's revenues will grow 37%. If he's right, Google profits will be well short of S&P's forecast, supporting a fair value of only $74 a share. The point is, no one knows for sure.

The stock is likely to be extremely volatile. In case you haven't noticed, Google has its enemies. Wall Street buzzed with guesses that the shares would trade down $20 or more on the opening, instead of rising $15. But with a much higher multiple than the overall market's and opinions about its prospects all over the lot, it'll react violently to good and bad news alike. "Google will be the beta king among Internet stocks," American Technology Research analyst Mark Mahaney predicts, referring to its volatility.

It's relatively expensive on 2004 earnings. As I said, you can make Google look cheap or expensive by choosing a measurement that fits your argument. Using Kessler's estimates, Google trades at 84 times this year's likely profits. Take out stock options, and the price-earnings ratio is 47. Yahoo trades at 84 times 2004 earnings, and eBay at 69.

It's unclear how management will handle the coming competition. Microsoft (MSFT) has made clear that it's spending heavily on search research and development. And Google's management has struck a number of investors as callow and arrogant, plus its management troika structure, in which CEO Eric Schmidt shares power with co-founders Larry Page and Sergey Brin, makes some investors nervous.

So why do I think Google belongs in the BW Web 20? First, because revenue-growth targets, while aggressive, aren't unrealistic. Sure, growth will slow, but it's unlikely to fall two-thirds in a year, as bears project. Second, I think Microsoft is a smaller threat than many other pundits do. After all, Microsoft is already in the search business, and it gets its share, but it's not killing anyone. In fact, Web-search capability is built into Microsoft's Windows operating system through its Web browser -- the killer app many skeptics fear will cripple Google -- without having had any noticeable effect.

Finally, Google has as many assets as it has mountains to climb. A great brand and market-leading search technology should help it meet its challenges. And Google has a track record of meeting and beating competition. In 2001 and early 2002, the first people to figure out what a great business cost-per-click search advertising could be were the leaders of Overture Services. Google then changed tactics and pulverized Overture at its own game, relieving it of such key distribution partners as America Online (TWX) and forcing Overture's sale to Yahoo. Skeptics think Google's next big round of competition will be its first. They're wrong.

WIN MOST, LOST SOME. At $100 or so, Google poses a reasonable balance of risk and reward. It's not for widows and orphans since the possibility of loss, especially short-term, is very real. That's why the investment banks covering the stock in its early days are mostly rating it a hold, rather than a buy. If Google keeps hitting its targets for sales and revenues, its current stock price could be left far behind. And if it doesn't, the other 19 stocks in the index can help pick up some of the slack.

The Web 20 has had a good run since we added new names and dropped some others on Aug. 10 (see BW Online, 08/12/04, "Riding the Web-Stock Roller Coaster"). The index is up a nifty 11.3% since. The biggest impact, as you might expect, came from Google. Since we got in at the auction price of $85, we're up 26% since. Sweet.

Google replaced University of Phoenix Online (UOPX) in the Web 20 as of Aug. 18 because the University of Phoenix is being reacquired by Apollo. Effective at the close of the market Aug. 23, we replaced 1-800-Flowers (FLWS) with its rival Provide Commerce (PRVD), which runs Proflowers.com and went public last December.

We've done well with some other picks, too (see table below for a look at how the BW Web 20 was doing as of the market close on Aug. 25). Newly added Blue Nile (NILE), which we caught near its recent low, is up 14%. Priceline (PCLN), eBay, and Ameritrade (AMTD) are also up more than 10%. A half-dozen others are up 6% or more. Enjoy the gains -- just don't spend them.

BW Web 20

SYMBOL

SHARES

CLOSING PRICE

CHANGE

% VALUE CHANGE

AMTD

100

11.75

0.25

10.95%

AMZN

100

40.30

1.25

8.63%

AQNT

100

8.86

0.02

-0.11%

CKFR

100

27.85

1.3

7.12%

CTRP

100

30.94

0.46

1.11%

DRIV

100

25.30

0.3

3.56%

EBAY

200

85.66

1.79

13.10%

ET

100

12.13

0.36

10.68%

GOOG

100

106.00

1.13

24.71%

IACI

100

24.23

0.45

6.79%

INFY

100

51.42

1.64

5.85%

NDE

100

34.35

0.13

1.93%

NFLX

200

15.67

0.21

-8.58%

NILE

100

26.68

0.24

13.82%

PCLN

100

21.45

0.63

12.30%

PRVD

100

18.00

0.19

0.00%

SINA

100

22.99

3.14

6.24%

SYMC

200

48.85

0.61

5.55%

WBSN

100

39.10

0.35

3.30%

YHOO

200

29.37

0.96

8.18%

As of 8/25:

11.30%

S&P change since 8/10

2.40%

Nasdaq since 8/10

2.9

Mullaney is e-Business editor for BusinessWeek in New York


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