Business Analysis: Can these guys be for real as Google's share price doubles?

The hype hides a sound business with strong growth prospects, many investors believe
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The Independent Online

When Google floated on the stock market in August there were plenty of doubters that its shares would fly and almost no one predicted its value would double in barely four months. Yet that is what Google's stock has done. Now the doomsayers are out again, warning Google may have created a new internet bubble whose shares have only on way to go: down.

Google has achieved a breathtaking amount since it was created by two Stanford computer geeks, Larry Page and Sergey Brin, six years ago. It is used for almost 45 per cent of all internet searches in the United States.

The company, now worth about $45bn (£23bn), has been swift to establish itself in other countries around the world, with this part of the business now growing more quickly than its US arm.

Google has also had the self-confidence to be able to dictate its own terms to Wall Street. Its initial public offering was conducted as an unconventional "Dutch auction", which boosted the number of shares open to retail investors and squeezed the fees of its financial advisers. And the company, based in Mountain View, California, has left investors tearing their hair out with its refusal to give financial guidance.

Yet its shares are highly rated and, according to many at the investment banks who follow the stock, its prospects for growth are through the roof.

Some analysts, such as the internet guru Mary Meeker at Morgan Stanley, believe Google is capable of average revenue growth of 25 per cent not just for the next few years, but for a decade. This would push it into the category of the biggest companies in the world, alongside GE, Wal-Mart and Citigroup.

According to sceptics, this story has been played out before. In the late 1990s, internet companies saw their shares rocket into the stratosphere, only to come crashing down when investors woke up to the fact that their underlying business did not justify such hugely inflated price tags.

The roller-coaster ride happened not only to flimsy businesses which have subsequently disappeared, but also to mighty players such as Amazon. The online book and music seller saw its shares peak at more than $100 in December 1999. Five years later, they are trading at about $38, despite a market-leading position and continued investment and innovation.

Another victim of the bursting of the hi-tech bubble was America Online. At the height of its popularity, AOL was valued at $163bn and was able to buy Time Warner in the most ambitious deal of the internet age. But with the deal barely agreed, AOL's value began to crumble and Time Warner has since had to write off billions of dollars. It has also dropped "AOL" from its name.

Is Google different? One of the key issues which analysts have been wrestling with is how to value Google. Most judge the company according to Ebitda (earnings before interest, taxes, depreciation and amortisation), a measure commonly used by Wall Street as a proxy for operating income.

Google's Ebitda totalled $321m last quarter, compared with $322m at eBay and $260m at Yahoo!. Lanny Baker, an analyst at Citigroup, estimates total Ebitda of $1.5bn in 2005 and $2bn in 2006 for Google.

According to Mr Baker, a fair price for the company is $130 a share, making its current level of about $170 pricey. While most of its larger internet peers are trading at 31 times Ebitda, the Citigroup team believe Google ought to trade at a maximum of 25 times, because it is less good than other companies in its sector at converting Ebitda into cash flow.

Mr Baker says: "Google's growth rates and margins are impressive, though heavy capital expenditures sap the company's free cash flows".

Benjamin Schachter at UBS agrees that the company - whose reputation is for hiring the brightest graduates through a gruelling interview process - shells out comparatively much more on capex (capital expenditure) than Yahoo! and other big internet companies.

The spending is, however, close to levels at Microsoft and Oracle in their early years. This could help Google maintain its lead in technology that is the key to it staying ahead of competitors, which are busy improving their own internet search engines in order to compete.

At the moment, advertising revenues from Google's search business account for 95 per cent of its earnings. Fans of the company argue that putting so much emphasis on investment is not just about keeping this part of the business in its first-class position, but also thinking of different ways to use the technology.

One major project at Google's headquarters is to take its relationship with advertisers further. If a company has a backlog of a particular product and wants to do a sales blitz on in certain geographical areas and to certain types of customers, Google is working on a system whereby retailers could alert it. This would trigger ads on relevant people's computer screens when they use the search site.

Google has also recently widened its proposition by adding email news alerts which can be sent to customers' in-boxes and, as of this summer, a service called Picassa which allows people to send pictures electronically.

Yet there are clearly risks. Google remains highly exposed to the health of the advertising market, which is cyclical. It is also paid by advertisers only when people actually click on their online banners, making the revenue stream precarious if consumers suffer a crisis in confidence and want to cut back on spending.

The foreign market for advertising to accompany searches is projected to have considerably further to grow, but Google is vulnerable to possible problems with political and business environments. Underlining how precarious expansion abroad can be, Google has had problems with the rollout of its online news service in China, which some attribute to the possibility that the country's governing regime cut off access to links deemed to be overly critical.

While Google is beginning to offer other services, critics also point out that it is far less diversified than Yahoo!, which is seen as more of a "portal" bringing together a range of businesses.

Another area of concern is over the corporate governance of Google, with onlookers fearing that its rapid growth is outpacing its ability to create a proper infrastructure. Some investors also do not like Google's dual class voting structure or its three-person executive team, made up of its two founders and its chief executive, Eric Schmidt. Some argue that there are not enough directors with media or advertising experience in a company that seems to cherish computer wizardry over and above most other skills.

Google's senior people themselves have also not helped to shore up confidence in the company's share price. Its three most senior people recently said they would sell about 16.6 million shares over 18 months. That will net Mr Page and Mr Brin about $1bn each, while Mr Schmidt will take home in the region of $370m.

While almost no one doubts Google's business is one of the very best to have come out of the technology boom of the past decade, now might not be the time to buy into its remarkable story.

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