Commentary: Google This: Investor Beware

The Web search outfit's business is terrific, but its long-term outlook is cloudy

When Google Inc. predicted a wallet-cleaning price range of $108 to $135 for its shares on July 26, few on Wall Street flinched. And why should they? Despite a valuation as high as $36 billion for its offering expected in August, the search kingpin's business continues to dazzle. Growth in sales and profits have rocketed over 100% so far this year. And analysts project Google will generate more than $350 million in 2004 net profits. Even with stepped-up competition, Google's share of the U.S. search market has grown five points in the past year, to 37%, giving it a comfortable 10-point lead over Yahoo! Inc. (YHOO ), according to researcher comScore.

Sure, IPOs are inherently risky, but Google stock may be especially unwise at this nosebleed price range. At the midpoint price, Google's would-be $33 billion valuation is a step down from its closest competitor, Yahoo, a seasoned Internet giant with a diverse revenue stream and a market value of $40 billion. Compare projected 2005 earnings against these valuations, however, and Google's multiple is just a speck below Yahoo's. That's troubling, since Google is largely a one-trick pony, with no easy means to diversify its business and hefty management challenges. "It's priced for ultimate perfection," says a skeptical Google investor who plans on selling after the IPO.

Long-term investors should be very wary of Google's single-barrel business model. Selling ads that appear next to search results, or paid search, contributes over 80% of Google's sales. According to Forrester Research Inc (FORR )., the U.S. search ad market grew 94% in 2003 to $1.9 billion, but growth is expected to slow from 45% in 2004 to 16% in 2007. As long as Google remains so heavily dependent on a single search market, it should trade at a discount to Yahoo, says American Technology Research Inc. analyst Mark S. Mahaney. Citing its quiet period, Google won't comment.

Google co-founders Sergey Brin and Larry Page aim to expand into new businesses, but that won't be so easy. The most obvious foray would be into so-called branded marketing, the multimedia ads that adorn most Web sites. Unlike the text-only ads that accompany Google's search results, these snazzier ads entice large advertisers that are as concerned with building brand as they are with driving traffic to their sites. It's big business, worth about $4.5 billion in the U.S. this year, according to Forrester, vs. $2.8 billion for search ads.

Google, however, is a long way from proving itself a player in branded marketing. Sure, the six-year-old company is tinkering with a trial program that delivers targeted image ads from its roster of 150,000 advertising customers to other online content providers. But Google has not hinted at near-term plans to open up its own prime real estate for branded ads. Such a risky move would run contrary to Google's long-established mission of providing a sleek, simple page that favors speed over sizzle.

Even if Google does pull the trigger, it would desperately trail such rivals as Yahoo, Microsoft's (MSFT ) MSN, and AOL (TWX ), which have spent years building their salesforces and relationships with traditional marketers. Although Google points to its 150,000-plus advertisers, buyers of search ads often aren't the same people who buy branded ads. "The people who control these budgets are very different," says Wenda H. Millard, chief sales officer at Yahoo.

Google's management structure could also be a concern. The company prides itself on an organization that is nearly devoid of middle management and values freedom for engineers and their work. But Google's headcount is growing faster today than at any other time in its young life -- adding 3.6 employees each day so far this year, vs. 1.1 a day in 2002. Back then, Google's vice-president for engineering, Wayne Rosing, fretted about the risks facing Google as it raced past 500 employees. Google will be hard-pressed to balance innovation and order as it approaches 3,000 employees later this year.

Google will no doubt lure plenty of interest when it sells shares, likely in August. But given all the challenges ahead, smart investors will proceed with caution.

By Ben Elgin

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