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Is Google Flying Too High?

A year and a half ago, plenty of investors were skeptical that the Google IPO was a good bet. In the spring of 2004, fund managers, analysts, and pundits hotly debated whether it made sense to buy shares of the Internet company, then known mainly for its search engine and its spare, elegant home page.

On Nov. 17, Google (GOOG) shares closed above $400 for the first time -- at $403.35, to be exact. It's a stunning climb for a company that was priced at $85 ahead of its IPO on August 19, 2004. The current market cap, $112.6 billion, is nearly five times its initial value of $23.1 billion. By contrast, Time Warner (TWX) has a market cap of $83 billion and General Motors (GM) is valued at just $12.8 billion. "We're in uncharted territory here," says Scott Cleland, CEO of tech researcher The Precursor Group.

Is the soaring valuation warranted, or is this the reenactment of a bad trip from the Internet boom late '90s? There are big differences between Google's success and the Internet's fleeting fortunes of the last decade. And while Google's valuation is tough to justify, that doesn't mean that the price won't climb higher.

GLOBAL COVERAGE. Google's financial profile is solid as a rock. It has annual profit of more than $1.3 billion on revenue that exceeds $5 billion. Its sales are soaring at just under 100% a year. The company has nearly $8 billion in cash and no debt. Shares are trading at a lofty 89 times earnings over the past 12 months. The future price-to-earnings ratio is 47. That's more than twice the market average, but headed toward more reasonable levels.

Google is essentially a play on advertising (see BW Online 10/21/05, "Google and Yahoo: Rolling In It"). Clients bid on the right to be associated with certain search terms. A car dealership in Phoenix, for example, can pay a fee so that its name appears high on the screen of users who enter the terms "auto sales +Phoenix," or something similar. Google is also developing search capabilities for local networks and for mobile users.

There's huge potential for growth in these areas. And the outfit's technology is great. Its Google Earth feature is based on satellite photo surveys of the entire planet. Punch in an address, and a picture of the building pops up. The names of local roads and the location of nearby businesses can be added as well. Companies will be enticed to pay for visibility on such searches. Clever, huh?

ROWDY RIVALS. Even though everyone agrees Google is pretty great, its valuation is still hard to justify. "Google's dominance is real," Cleland says. "Google's business is real. We're very respectful of that. But there's no legitimate altimeter for these nosebleed valuations."

In fact, several trends are working against the valuations. Competition is the biggest worry. Tech giants like Yahoo! (YHOO), Microsoft (MSFT), and Time Warner's (TWX) AOL division aren't going to sit on their hands while Google cleans up. They may be scared, but they're not paralyzed.

It isn't the only area where the search titan is battling the colossus of Redmond. Google and Microsoft are currently battling to strike a partnership with a newly revamped AOL. Here, Microsoft may have the edge, if for no other reason than it wants the deal more (see BW Online, 11/7/05, "The Stakes in the Fight for AOL").

Right now, the deal is Microsoft's to lose, says one investment banker close to the discussions. If Redmond's hopes come to pass, Microsoft and AOL will combine their sales forces and the customer bases. That would provide the pair unrivaled scale.

LESS STICKY. Google had 90 million unique visitors in October, the fourth-largest number of any site on the Web, according to researcher comScore Networks. But Time Warner and AOL ranked second and third, with 117 million and 115 million, respectively. And don't forget market leader Yahoo, which had 124 million.

Those companies may have an edge on Google in one important respect: People don't spend as much time with Google as they do using other sites. Yahoo had 43 billion page views last month, Time Warner had 30 billion, and MSN had 21 billion. Google just wasn't as busy. Its users generated 6.6 billion views. That's just over half the number generated by News Corp.'s (NWS) social-networking sensation MySpace, which had 11.6 billion.

While Google may rule the search market, its big rivals can approach the Web from a different vantage point. People spend more hours clicking on Web sites operated by News Corp. and Time Warner. And those rivals can keep visitors entertained for hours with social-networking offerings, music services, and entertainment imported from film and TV divisions.

DIVERSIFIED REVENUE. Over time, online ads will become more of a commodity. The link between advertising and Wall Street is becoming tighter, as publicly traded companies such as Google play a bigger role. As additional publicly traded rivals pour into the market, the competition will get even tougher than it is today.

To forestall overdependence on ad sales, Google hopes to diversify its revenue. It's even toying with plans to build its own wireless networks. It's a risky venture -- telecom is one of the most highly commoditized markets. Google may end up playing a role in telecom, but it's unlikely to dominate communications the way it has dominated Internet search.

Still, Google is more than just an Internet chimera. It surely deserves a high valuation on the stock market. But it is playing in highly volatile tech markets subject to constant technological change. And the forces that have propelled its stock over the last year can and will work to the benefit of other companies, too. That's why $400 seems a little rich.


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