Why Google Isn't About to Slow Down

Google grew revenues 24 fold over the past four years. ($440 million in 2002 to $10.6 billion in 2006.) There are two reasons for this. 1) Google started small and dislodged existing large search providers, and 2) search is by far the fastest growing segment of the Internet advertising industry, which grew 34% last year.

But by the end of 2005, Google had captured nearly 2/3 of the search market. It then ran out of market share to easily take from competitors relative to its new larger size. This is why in 2006, Google increased its market share of searches by only 5.6%, which accounted for perhaps only 9% of 2006 revenues.

One way to view this trend is that the 90%+ revenue growth days are probably over for Google. Another way is to understand that poached market share was only 9% of Google's earnings — and its winding down can't affect growth much anymore.

In other words, almost all of Google's revenue growth is now internally generated. It comes from the broader demographic shift towards Internet advertising and search. These demographic rates have been stable over the past couple years (and have even been accelerating a bit). Therefore, Google's revenue growth now looks like it should at hold firm around the 60% range for the coming few quarters and possibly beyond.

There is also the possibility of revenue upside. Google's growth will enter a whole new phase if any of the company's new initiatives like IP video, or G-radio stop being accounting liabilities under development and instead become income-producing assets. Just bear in mind that combined radio and television advertising revenues are about 8 times the size of Internet advertising globally. Even a small inroad here will have a big effect.

One more thing. I have previously used the word "revenue," 9 times to emphasize that I am talking about top line growth. I want to point out that Google increased revenue by 2,415% over the past 4 years, while it only increased operating income by 1,904%. This deserves comment because fast growing companies tend to grow profit quite a bit faster than revenues — That is, unless they are ramping up capacity.

And ramping capacity/expenses is exactly what Google warned about last summer. That is when the company announced that operating income would not grow by 2005 levels (215%) because the company would be increasing spending on new business. They warned that 2006 spending growth might even exceed revenue growth in a push to develop new initiatives.

In a quarter where revenues were up 73%, Research and development was up 105% from $600 million to $1.228 billion. Sales and marketing was up 81%. General expenses were up 94%. Meanwhile the costs that are entirely marginal were still moderating. The cost of revenue was up only 64% and traffic acquisition cost was up only 56.4%.

My point is that all of these items were trending towards being a smaller percentage until 2006 (as should be expected). But in 2006, some costs abruptly reversed trend. I argue that any increases in these expenses over the 73% revenue growth rate for 2006 certainly deserves to be considered captial in nature. Not doing so results in a de facto understating of Google's earnings that exceeds $310 billion/year.

So Google is growing revenues with no end in sight and investing aggressively, and Mr. Market could not care less. As a long term Google shareholder this did not bother me. On the contrary, it made me happy that I could increase my position in Google cheaply. You see, I know that: 1) Google will continue to grow revenues in the 60% range because its growth is based on a demographic shift. 2) Earnings are effectively understated because Google's high level of investment in future growth is not broken down or clearly presented. 3) Google's true PE ratio is lower than everyone thinks. 4) Google's true 2006 growth rate is higher than everyone else thinks, and. 5) This high level of investment will eventually have an high level of payoff.

I know what the guys at Google can do with a few billion dollars — They can (and did) build a Google. With all the new and promising add-ons now under development, at least one of these initiatives is bound to be another hit.

Disclosure: Author has a long position in GOOG.

Comments

[debrarobinson-hinkle]

i appreciate your comments on google,they make really good sense, thank you, debbie robinson hinkle---webwoman52@ya...