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Feature Article: Google, how big can it get?

Paul Durman and Dominic Rushe in New York question how the search engine group can justify a valuation of $80 billion.

Clive Cooke, chief executive of the financial spread-betting firm City Index, had a large cheque to write out last week.

His company has lost £20,000 to a canny housewife who backed a view widely disparaged by many market professionals: that shares in Google would keep on rising.

Last Tuesday, as Cooke was preparing to pay up, Google’s stock price hit another new high, just shy of $300 (£165). That is more than three times the $85 price set last August when the American search- engine company joined the Nasdaq stock market after a difficult and controversial flotation.

That was only 10 months ago. But those troubles seem more like 10 years away. Google now looks set to join the S&P 500 index of America’s biggest companies, which includes Coca-Cola and General Electric.

In its short, public life, Google has repeatedly beaten expectations for its performance — and not modestly, but by a country mile. Riding the booming market in pay-per-click advertising, the Internet’s big, friendly giant has grown much faster than even its most fervent fans thought possible.

The latest share surge followed results showing quarter-on-quarter growth in revenues of 22%. Its fast accelerating profits have already hit $443m a quarter, and Google is only just getting started in Europe and much of the rest of the world.

With so much potential for Internet advertising, and with so many new services to drive more searching — and therefore more ads and revenue — the opportunities for Google seem almost endless. At least, that’s what the share price is saying.

It is this prospect that has so excited investors. And last week the company’s market value reached $80 billion, surpassing Time Warner and making it the most valuable media company in the world.

That’s right. Bigger than Disney. Bigger than Viacom, the owner of MTV, CBS and Paramount Pictures. Bigger than News Corporation, the ultimate owner of The Sunday Times. Bigger too, incidentally, than deeply troubled “old economy” businesses such as General Motors.

It would hardly be surprising to find Larry Page, 32, and Sergey Brin, 31, the Stanford University PhD students who founded Google, rubbing their eyes in disbelief. Google is only seven years old.

Any lingering scepticism left over from last year’s float is rapidly dissipating. Last week analysts at Smith Barney, part of Citigroup, placed a $360 target on Google’s shares. That would give the company a market value of $100 billion — or about 20 times the revenues Wall Street expects the business to generate this year.

Amid the euphoria, some of the calmest heads are to be found at Google. The founders are sceptical of Wall Street and its tendency to hype, then dump, companies. A look at their financial statements shows them to be far more cautious than many analysts. There are clear warnings that Google’s golden age may not last.

The company admits it faces “formidable competition in every aspect of our business”, particularly from Microsoft and Yahoo. New technology could block its ads, wiping out its revenues. “Our inexperience in the operation of our business outside the US increases the risk that our international expansion efforts will not be successful,” the company said.

But there are more immediate concerns. Google is spending so heavily trying to recruit the staff it needs to support its breakneck growth that costs are spiralling upwards — by almost two-thirds in the past year. Google is renowned as a fun place to work, but all that free food and free childcare is expensive.

“Our operating margin may experience downward pressure in the future as we build the necessary employee and systems infrastructures,” it conceded recently. “We expect that the growth rate of our costs and expenses may exceed the growth rate of our revenues during 2005 and beyond.”

This is the strange world of Google. The $100 billion business with declining profit margins, and where the biggest sceptics come from inside the business.

When Google began trading, it still hadn’t figured out how it was going to make money from its brilliant insight: that Web pages could be ranked according to how often they were referenced (or found useful) by other Websites.

Google initially planned to license its search technology to other Websites. It was not until 2000 that it began charging for text-based ads alongside unpaid search results. Two years later Google moved over to pay-per-click advertising — charging advertisers only when a potential customer clicks on an ad.

“Paid search” was not Google’s innovation, but it was superbly applicable to what was fast becoming the world’s leading search engine. With pay-per-click, advertisers can see exactly what they are paying for. They can measure how much it costs to generate each new sales lead, and which search terms work and which ones don’t.

Choosing the right search terms — finding the right mix of general and specific “adwords” — has become a science in its own right. Advertisers bid for the search terms they think will help customers find their business. The more they pay, the higher they will appear in the paid listings.

The measurability of paid search, and the ability to turn the flow of customers on and off, has made it enormously popular, particularly for travel and financial-services companies.

Last week Ian Carrington, Google’s head of vertical markets, confided to a London travel conference that Easyjet spends £18,000 a day on Google ads. One can start to see how Google’s revenues are set to pass $5 billion this year.

The UK has been quick to embrace pay-per-click advertising, and British firms provided almost 15% of Google’s entire revenues in the first three months of this year. But 60% of its revenue still comes from America. There is huge scope for further expansion.

To drive this process, Google recently hired Nikesh Arora, formerly chief marketing officer of T-Mobile, as vice-president of European operations. Until relatively recently, Google had only 30 or so people in its offices in London’s West End. Now it has more than 100.

To grow, Google has to attract more advertisers, expand into more countries and, most of all, generate more search. This is why it created a litany of new services — Google News, Google Local, Gmail, Froogle — to encourage computer users to look for more information, thus creating more advertising “real estate”. (See below).

These new ideas may or may not pay off. Google’s rivals at Yahoo and Microsoft already have, or are developing, similar projects. Google News, for example, attracts about 7m viewers a month, Yahoo News gets 25m.

Gillian Kent, director of MSN UK, Microsoft’s portal, said: “Google has had a big impact and it started with a better product. But it’s still early days.”

Some 62% of people in Britain visit MSN each month and Kent said its newly revamped search facility was now giving Google a run for its money.

“Search has low loyalty. Google has been a great phenomenon, but the company that delivers the best search will be the company that wins. There is everything still to play for.”

Google faces other challenges., the online arm of the company that owns Britain’s Yellow Pages, is working with Google to provide the listings information behind Google Local.

Eddie Cheng, president of, said this was a way of putting his advertisers before Google’s audience.

Cheng said that while Google was very good for larger, more sophisticated advertisers who were happy working online, its model was less well suited for the thousands of smaller firms who provide the bread-and- butter of local advertising.

Cheng said there were other limitations: “Google is a company that is run from America. They’re thousands of miles away and there’s an eight-hour time difference. They’re good at publicity and promotion (in the UK), but their engineers and core development people are based in the US and they think US. They will have a lot of problems trying to get established in all these other countries.”

On Wall Street they call it “the whisper number” — an estimate of how a company is going to perform based on analysts’ forecasts, with some market rumour and tittle-tattle thrown in for added spice. Google’s whisper number is now running 15% to 20% ahead of the market consensus.

David Edwards, an analyst at American Technology Research, said companies usually gave enough guidance to keep that number reasonably accurate. But Google, disdainful of Wall Street, doesn’t “do” guidance.

“We’re guessing more than we usually do,” said Edwards, who has a price target of $290, far below those of his more bullish rivals.

For a company that prides itself on giving easy access to information, Google is notably tight with its financials. So far it has surprised Wall Street with good news.

“At some point you would expect that expectations will get ahead of actual performance,” said Edwards. “It happens to most major companies.”

If and when it does, Google’s shareholders may pay a high price. But as City Index will testify, betting against Google has so far been a mug’s game.

At the company’s Silicon Valley headquarters, a cover of Fortune magazine has been pasted to a wall outside one of the cafes. The December 2004 issue asks: Google — is this company worth $165 a share? Try putting that in Google and making sense of the answer.

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