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05/06/2004

Will Google be Worth More Than Yahoo?

Looking through Google’s S1 filing for its upcoming IPO is an awe inspiring experience. Such impressive financials make it highly probable that Google’s market cap will exceed Yahoo’s when Google goes public later this year. That Google may soon surpass the $35BN market value of Yahoo is especially ironic given that Google has Yahoo to thank for a large part of its tremendous success.

Simply Stunning
In Q1 2004, Google generated operating income of $155M on revenues of $389M which equates to stunning operating margin of 39.9%. Even Microsoft, high-tech’s perennial profitability poster-child, only had an operating margin of 35% in Q1. In contrast, Yahoo generated operating income of $132M on revenues of $758M which equates to only a 17% operating margin. From a cash flow perspective, Google had $204M in operating cash flow for a mind numbing 52.4% cash flow margin. Yahoo generated slightly more operating cash flow of $236M, but its cash flow margin was only 31.1% thanks to its higher revenues.

From a top line growth perspective, Google’s $389M in Q1 revenues represented a 118% increase from last year’s $178.9M. Yahoo’s Q1 revenues grew at a seemingly faster 168% pace from $283M to $758M, but this does not account for Yahoo’s acquisition of Overture. If you add in Overture’s Q1 2003 revenues of $225M, then Yahoo’s growth rate was only about 49%, less than half that of Google’s.

So in summary, Google’s growth rates and operating margins are double those of Yahoo’s and despite having revenues that are just over half the size of Yahoo’s it was still able to generate more operating income and almost as much operating cash flow thanks to its amazing margins. Given the premium that Wall Street puts on high growth and high margins, you don’t have to have be an expert in valuation analysis to know that these numbers almost pre-ordain that Google will have a higher valuation than Yahoo.

A Few Potential Pitfalls
That said, there are a few factors that could conceivably hurt Google’s valuation enough to prevent it from surpassing Yahoo. First and foremost, investors may be highly skeptical that Google can sustain its torrid growth rates and lofty margins, especially in light of increased competition from folks like Microsoft. Second, Google’s business model and revenue streams are highly concentrated on its core business. Any major disruption in the paid-search market will hit Google particularly hard, while many of its competitors will have other revenue streams and business lines to fall back on. In addition, Google’s core search market is unlikely to be able to provide the kind of growth that Google will ultimately need to justify such a lofty valuation. Third, Google’s relative immaturity as a public company combined with its strange IPO process, avowed prohibition on earnings guidance, and shareholder unfriendly governance structure may encourage investors to more heavily discount their future earnings expectations for the company than they might otherwise.

The open question then is whether or not these factors will be significant enough to offset Google’s superior financial performance. To some extent, this question will be resolved by how well Google conducts its IPO road show, but it will also depend on what, if any, competitive developments take place in the near term, as well as Google’s Q2 financial report (which may come shortly before the IPO pricing if the SEC drags its feet). My personal belief after looking through the numbers is that with a reasonable execution of the IPO there’s a very good chance that Google will be worth more than Yahoo. However, if it’s not I suspect that a Google/Yahoo, long/short paired trade is likely to become a staple a most hedge funds overnight.

A Trip Down Memory Lane
Of course, you may be wondering, what’s the big deal? So what if Google is worth more than Yahoo? In the grand scheme of things, isn’t this situation nothing more than a piece of financial trivia? It might have been except for the fact that in many ways Google really has Yahoo to thank for a large part of its success.

Yahoo, as you may recall, started out its life as a simple search engine. As the Internet grew and new opportunities for expansion opened up, Yahoo gradually moved from being just a search engine to being a full fledged portal with all kinds of content and services. The more services Yahoo added, the less important its core search product appeared to become. So much so, that as search evolved from manually compiled site directories to farms of automatic “crawlers” doing full text indexing, Yahoo didn’t even bother to invest substantial resources in developing its own full text search capabilities, despite the fact that this was clearly where the search business was headed. Yahoo’s reluctance to invest in search was likely driven by the popular conception that search was a “loss leader”. It was simply a free service you offered to get people to your site in the hopes of selling them something else. Given that Yahoo already had millions of people coming to its site for things other than search, such as mail and news, it naturally felt that it didn’t have to invest a lot in search because it already had tons of traffic.

This abdication of the search leader crown through underinvestment and corporate neglect created an opening for new start-ups to stake their own claims in the rapidly developing full text search space, one of which was a little known start-up called Google. As it happened, Google’s search algorithms were clearly superior and it soon developed a cult following on the Internet.

Rather than be alarmed by Google’s rapid rise, Yahoo actually decided to outsource their full text search to the young start-up. After all, why spend their own time, effort, and money on something destined to remain an Internet backwater? While Google had been growing quickly prior to Yahoo’s decision, when Yahoo selected Google as its default search engine Google’s growth really started to take off. This can be seen by anyone taking a tour of Google’s corporate headquarters for there is a famous graph on one of the walls there that charts the volume of search traffic on Google's site. Two of the most obvious upward inflection points are when Google became the default search engine on Yahoo’s US site and when it became the default on most of Yahoo's international sites. So not only did Yahoo direct huge amounts of new traffic to Google but it provided Google with a tremendous new credibility in the eyes of the average Internet user.

Creating a Monster
While Yahoo concentrated on supposedly larger opportunities, Google quietly indoctrinated Yahoo’s entire user base in the joys of searching with Google. Even at that point though, all was not lost for Yahoo surely could have purchased Google, but rumor has it that despite Google letting it be known that would seriously consider an offer from Yahoo, no serious offer materialized.

Slowly but surely, many Yahoo users started going directly to Google. As a result, Google’s traffic was growing exponentially and its user base was starting to look like it might even rival Yahoo’s at some point in the near future. But by the time that Yahoo realized it had created a monster it was too late for it to do anything about it. Whereas early on their partnership Yahoo held tremendous influence over Google because it accounted for such a large part of its traffic and growth, just a few years later, Yahoo was a relatively small part Google’s traffic. Worse yet, thanks to the full-on embrace of electronic commerce by businesses around the world and the massive increase in websites, search was rapidly going from being a loss leader to a major cash cow.

Yahoo’s belated realization of search’s importance came far too late for them to have any bargaining power over Google, which now believed that it could not only easily go public but that it’s own business model and focus was likely superior to that of Yahoo’s . Unable to purchase Google at any price, Yahoo ultimately decided to purchase Overture Services, Google’s main competitor in the paid placement market. The rest, as they say, is history.

To Have A Winner You Need A Loser
Given this history, Google really owes a great big “Thank You!” to Yahoo for making three major strategic blunders. The first was Yahoo’s decision to de-prioritize search, the second was Yahoo’s decision to outsource its search to Google, and the third was Yahoo’s failure to use their initial leverage to buy Google early on at an attractive price.

In light of these blunders, the fact that Google may now be worth more than Yahoo must certainly be a bitter to swallow for Yahoo’s shareholders. Not only did they miss out on an opportunity to double the value of their shares, but Yahoo’s own decisions helped created a major competitor which will likely be a thorn in their side for years to come. To add insult to injury, Yahoo’s shareholders can only imagine how valuable their company would be if the management team had not only acquired Google when it was still a start-up but had followed through on their almost completed merger with EBay (which fell apart over trivial management issues). Together these two non-acquisitions may well indeed constitute the biggest strategic failures in the history of the Internet industry.

Perhaps the only Yahoo investor that won’t be disappointed on the day of the Google IPO is Sequoia Capital. Sequoia’s Mike Moritz made his firm’s original investment in Yahoo and he also made his firm’s investment in Google. Given these family ties, it is likely that Sequoia played no small role in getting Google the Yahoo distribution deal. When one realizes that Sequoia has already distributed its Yahoo shares back to its investors, the sheer beauty of their finesse play becomes readily apparent. Having gotten a great return out of Yahoo, they then parlayed their influence at Yahoo into helping Google break-out. It’s as if they hit the jackpot twice playing the same lottery number.

However for the Yahoo’s remaining shareholders, the day that Google’s IPO prices is likely to prove bittersweet at best. What many will remember as one of the biggest technology IPOs in history will, for some, painfully and publicly quantify one of the biggest missed opportunities in Silicon Valley. In this way, the fact that Google will even be worth close to what Yahoo is, let alone more than it, will transcend financial trivia and become a lasting lesson in consequences of strategic miscalculation.

May 6, 2004 in Stocks | Permalink

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The thoughts and opinions on this blog are mine and mine alone and not affiliated in any way with Inductive Capital LP, San Andreas Capital LLC, or any other company I am involved with. Nothing written in this blog should be considered investment, tax, legal,financial or any other kind of advice. These writings, misinformed as they may be, are just my personal opinions.