• Jeff Matthews

Down and Out in Mountain View

In its latest communication fumble, Google Inc. accidentally revealed an internal financial target for 2006 on its Web site but said it didn’t constitute financial guidance. —Wall Street Journal, Wednesday

Google Inc. said it agreed to pay as much as $90 million in legal fees and advertising credits to settle a lawsuit filed against it and other Internet companies last year alleging that the companies knowingly overcharged for online advertisements and conspired to continue doing so. —Wall Street Journal, Thursday

The Cover Story Curse still holds: just three weeks after Time Magazine featured “The Google Guys” on its cover, those same Google Guys appear no more adept at running a public company than my dog Lucy.

Funny how perceptions change, and change quickly.

During the IPO process two short years ago, The Mainstream Press could not have been more dismissive of The Google Guys, their “Do No Evil” ethics, and the ad-driven search-engine business they had created.

A year later, after that same ad-driven search-engine business model had blown through pre-IPO earnings forecasts on the heals of some terrific new products—including Google Maps and Google Mail—and the stock had tripled, The Mainstream Press jumped on board the Mountain View Express.

Even CNBC, chastised into sobriety after its Bubble-Era cheerleading had come to grief, finally joined the caboose, giving full exposure to an analyst expounding a Bubble-Era, $2,000-a-share theoretical future Google stock price in the first days of 2006—which coincided precisely with the peak in Google’s stock.

Then came a disappointing quarter, and now comes word of two more Google Gaffes, straight on the heals of last week’s miscue by CFO George Reyes, a straight-arrow guy if ever there was one, who triggered panic-selling in the stock by making very rational comments about the likely diminution of Google’s growth rate.

Reyes’ comments should have surprised nobody who has been paying attention to the public comments of Google customers such as Blue Nile and FTD Group regarding the diminishing value of Google search—but Wall Street’s Finest, no doubt feel embarrassed to have finally embraced the Googlephoria at the moment it was about to evaporate, have not been mollified.

Somewhat obscured by the Google miscues was Tuesday’s excellent Wall Street Journal piece by Mylene Mangalindan regarding the heavy investment spending required by internet-based companies: As the big survivors among Internet companies mature, they are learning a painful — and unexpected — lesson: Staying in the online game requires heavy, constant spending. That is something Amazon.com has been dealing with for some time, and it triggered an excellent question on that company’s last conference call, when Mark Rowen of Prudential asked what I thought was very interesting question, foreshadowing the Wall Street Journal story:

“Jeff [Bezos, Amazon CEO], you have said for a long time that your model is more efficient that the traditional retail model because you don’t have to invest in real estate, which always goes up. Instead you can invest in technology, which goes down.

“But if I add up all of your expenses as a percent of revenue, and add in free shipping…I think in 2005 it was a little over 20% in the fourth quarter…which is 200 or 300 basis points higher than a company like Wal-Mart.

“So could you just sort of give us an idea…why is it that we are not seeing more efficiency, if, in fact, the model is more efficient?” Mr. Rowen was not making his numbers up.

In calendar 2005, both Amazon and Wal-Mart generated roughly the same gross margin (24% and 23%, respectively) while Wal-Mart’s pre-tax margin came in half a basis-point above Amazon’s 5.04% pre-tax margin.

The difference between gross margin and pre-tax margin is cost-structure, and since Wal-Mart starts out with a lower markup to consumers but ends up with a higher piece of the gross profit dollars, it would appear that Wal-Mart—stodgy old brick-and-mortar Wal-Mart—is more efficient than technology-savvy Amazon.com.

To Rowen’s perceptive question, Jeff Bezos gave a bland answer:

“Well, I think one thing to keep in mind is that if we were not investing in some of these new initiatives such as digital and Web Services, our cost structure would be different today. So if we were totally optimizing our cost structure for a kind of steady-state business, you would see a different cost structure…”

“If you look at the return on invested capital, the dynamics between our business and traditional retail are very different in large part because of the efficiency of our capital model, high inventory turns, low PP&E.”

All of which is very true but ignores the fact that Wal-Mart is always investing heavily in “new initiatives” and does not operate “a kind of steady-state business,” despite the fact that Wal-Mart came public back in 1970.

What does this have to do with Google? Well, Google management highlighted big capital expenditure plans at last week’s analyst meeting—which at a minimum would equal 19% of net sales.

Just for comparison’s sake, Caterpillar Tractor’s capital spending amounted to roughly 8% of sales last year.

How could a search-engine company dealing in bytes be spending more heavily, relative to its sales, than a brick-and-mortar manufacturer of earth-moving equipment?

When I first started using Gmail, which encourages users to never delete an email (see “Plastics” from January 9), I could literally watch the storage space available in my Gmail account rise, like a population count in Times Square, as Google added the servers and storage to accommodate all the data piling up from Gmail accounts around the world.

Then, about two months ago, that storage counter slowed to a crawl, and now increases modestly only every few days.

As a result, my use of the Gmail storage space allocated to my account has ballooned from 1% of my storage capacity to 24%.

24% is not sustainable: at the rate I’m going, it’ll be at 50% by summer and 100% by December.

Sure, I can revert to MSN methods of deleting all the emails I don’t especially need—and I’ll do it if I have to. But that wastes time.

Could it be the dot-coms have underestimated the long-term capital required to maintain, let alone grow, in the online world? I don’t know the answer to that question: but having trained its customers to expect “limitless storage,” Google needs to deliver precisely that, otherwise, it will start losing customers.

And if it starts losing customers, the “Do No Evil” Google Guys will not be able to do much good, for themselves or their fellow shareholders.

Jeff Matthews I Am Not Making This Up © 2005 Jeff Matthews

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations.

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The content contained in this blog represents only the opinions of Mr. Matthews. This commentary in no way constitutes investment advice. It should never be relied on in making an investment decision, ever. The content herein is intended solely for the entertainment of the reader, and the author.

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