In the fall of 2007, when Google stock was all the rage, we outlined a scenario in which the stock could go to $2,000 over a couple of decades.At the time, this seemed startling. Considering the time horizon, however, it was actually pretty mundane.
Basically, going to $2,000 from $700 over 10 20 years meant that Google’s stock would have to appreciate at an average annual rate of about 6% a year.* This didn’t come close to offsetting the risk of owning it. (In those days, you could get almost that much owning a US Treasury bond.)
When we laid out the $2,000 scenario, therefore, we suggested that anyone who did NOT think Google’s stock could go to $2,000 over 10-20 years should sell it immediately. We also said we hoped that the stock might plunge to, say, $200, in the interim, so that people who bought it “for the long term” could actually get a compelling return.
Well, now we’re about a quarter of the way through that front-end 10-year time horizon. So it’s worth checking in on where things stand.
First, here’s what has happened over the past 2.5 years:
- Google-the-company has VASTLY exceeded our expectations for free-cash flow production. Even with the revenue drop of the recession years, Google’s free-cash flow has plowed ahead, achieving an extraordinary $10+ billion annualized run rate.
- Google’s revenue growth has decelerated, as expected. This has caused the stock’s free-cash-flow multiple to compress from about 25X at the peak to about 15X today. If Google’s revenue growth continues to decelerate, the multiple will continue to compress.
- Google’s stock did drop to the $200s, giving everyone an opportunity to buy it and get a compelling return. (Alas, that opportunity is now mostly over).
- Google has abruptly withdrawn from what will likely become the largest Internet market on earth (China). This did not have a huge immediate revenue impact, but it has significantly reduced the company’s growth prospects.
- Google has continued to dominate search, but, importantly, it has NOT YET DEVELOPED A SECOND MAJOR GROWTH ENGINE. Add up everything Google is doing in addition to search and it’s still pretty much a rounding error.
This last point is critical. For Google to hit $2,000, it needs to develop a second major growth engine–an “Office” to accompany the search-business “Windows.” (People always talk about Microsoft’s Windows monopoly, but it was the company’s second major product suite, Office, that ended up driving half of the company’s revenue and profitability.)
Why won’t the search business alone take Google’s stock to $2,000?
Because the “search” product adoption cycle is already well past the halfway mark.
Google dominates search share in just about every major market on earth. The growth of this business from here on in, therefore, will come through incremental (small) market share gains and revenue optimization. The days in which Google could enter a huge new market and grow from 0% share to 60% share over five years are now over–especially after the China pullout.
But doesn’t “mobile” represent a huge new search market that Google is only beginning to tap?
Possibly, but in our opinion, mobile is a much smaller opportunity for Google than most people think. We think most of the commercial searching that is and will be done via mobile devices is substituting for searching that would be done on PCs. Yes, if Google (or someone else) can finally develop a compelling location-based local advertising product, this might open up a vast new advertising opportunity. But at this point, having listened for 15 years to breathless proselytizing about how huge the mobile ad market is going to be, we’re going to wait until we see it to believe it.
Google $2000: It’s All About Cash Flow
Google’s search business is now about a $20 billion global business (which, interestingly, is about the same size as Microsoft’s Windows business). The search business throws off substantially all (if not more than all) of the company’s $10 billion of free cash flow. Assuming the whole world doesn’t switch over to Apple apps, Google’s search business will probably double in size over the next 7.5 years, and the cash flow will likely double along with it. So that would give Google about $20 billion of free cash flow at the end of the original 10-year period.
For its stock to hit $2,000 a share, Google will need to have a market cap of about $700 billion. To achieve this market cap in a reasonable market environment, the company will probably need to generate at least $30 billion of free cash flow (20X free cash flow) and probably $40+ billion (15X free cash flow). To achieve those multiples, the company will also need to have strong growth prospects well beyond 2018.
So the search business alone seems unlikely to get Google to $2,000, at least not within the original 10-year timeframe. To get to $2,000, Google needs another huge growth engine to accompany the search business, one that is much earlier in its adoption cycle. This growth engine needs to be just as big and just as profitable as Google search business, the same way “Office” is to Microsoft’s “Windows.”
Still Awaiting The Other Google Growth Engine
But wait–doesn’t Google have all sorts of other growth engines percolating? Won’t one of them be as big as search?
Google has LOTS of other businesses percolating (too many, in all likelihood). But, collectively, these are a rounding error next to the search business, especially with respect to free cash flow.
Let’s take them one at a time:
- AdSense and search on third-party sites (Google Network). Google generates about $8 billion a year of revenue from running ads on other publishers’ sites. This seems like a big business–and, from a revenue perspective, it is. But in addition to being a much smaller business than the search business, it is a vastly less profitable. Google’s gross profit on Search revenue is at least 90%. Google’s gross profit on its Network revenue is only 25%-30% (subtract $1.44 billion of Traffic Acquisition Costs from the $2 billion of Network revenue in Q1). To generate the same free cash flow as the core search business, therefore, Google’s Network business would have to be 4X as big as the search business. Right now, it’s less than half the size of the search business.
- Display advertising. For the most part, Google’s display ad revenue is included in the Network revenue above. Google will likely continue to gain share of the display advertising it serves, but, again, this will not generate much free cash flow (because Google has to pay out the majority of this revenue to its partners). Now, if Google ever deigns to put display advertising on its own sites, this will drive several billion dollars of high-margin revenue and cash flow (because Google will keep the bulk of it.) Several billion is not $20+ billion, however. And Google still seems to regard itself as above display advertising.
- YouTube. YouTube’s (relatively puny) revenue is included in the Google Sites revenue above (which is otherwise almost all search). In the future, even if Google figures out an amazing YouTube revenue model, the business’s profitability is going to look a lot worse than that of the search business. Why? Because YouTube will always have to pay out a big share of the revenue to content partners, the way Google does with its “Network Sites” partners. To produce the same profitability as Google’s search business, therefore, YouTube would have to grow to 4X the size of the search business. Think YouTube will be an $80 billion business anytime soon?
- Android, Chrome, etc. Right now, these products are a cost centre, not a revenue driver. Over the long haul, they will likely help grow revenue from the search and display businesses. But they’re not, as yet, businesses unto themselves.
- Mobile. Mobile search revenue, in our opinion, is mostly likely to substitute for PC-based search revenue–unless Google can finally develop a compelling location-based product. The industry has had 15 years to develop this product, however, so we’re not holding our breath. Most likely, mobile will be nicely additive to the existing search and display business, but, again, we don’t see another $20 billion business emerging from it. Google is also dabbling with selling consumer gadgets–Nexus One–but at this point, this business is just that: dabbling (For more, see above.)
- Google Apps. Google Apps have the potential to be a big business, but, right now, they’re tiny. Again, right now, the point of the business is to lock people in to using Google so they’ll generate more ad revenue. Google’s efforts to build a major enterprise business to displace Microsoft Office are still in their infancy. And given that the whole point of switching to Google Docs is to same money, it’s hard to see how Google Apps will quickly grow into another wildly profitable $20 billion business (as big as Office is today).
So, take everything Google is doing today outside of search, and it doesn’t add up to much. It generates about $7 billion of revenue, but a relatively tiny amount of profit. Grow all of these products at a reasonable rate for the next 7.5 years, and you’re still going to be hard-pressed to get anywhere near the $20 billion of free cash flow Google will need in addition to the search business cash flow to get to $2,000 a share.
In other words, Google still needs another major growth engine.
What’s it going to be?
We don’t know. And we’re no closer to knowing than we were 2.5 years ago.
If the new growth engine does not emerge in the NEXT 2.5 years, Google $2,000 will seem increasingly unlikely, at least within 10 years.
What Google does have, of course, is a monster pile of cash and a highly valuable currency. This means that Google does not have to develop another $20 billion business by itself. The moment Google sees a potentially huge business (or businesses) that are complementary to its core business, it can buy it (them) and then turbocharge them with its vast global user base and cash flow. So we’re not ready to say that Google $2000 in 2018 is unlikely.
* Thanks to reader and Registered Financial Advisor Steve Jossi of Birch & Jossi for catching a major typo here–the 6% return covered 20 years, not 10.
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