The Valor Blog.
Investment News and Views, Direct from Our Team.

These are a few of our favourite things – Google (By our star recruit Marc Lerner)

Our newest recruit Marc Lerner has given an excellent summary on why we are very happy to hold a reasonable allocation of our client’s portfolios in Google:

Despite the seeming complexity of the various services it provides – Gmail,
Youtube, and a search engine that is synonymous with finding something on the
internet, in terms of revenue Google is, quite simply, an advertising company,
with advertising accounting for 96% of revenue in 2011. There are two primary
types of advertising businesses the company runs – advertising on Google
websites – for example, the plain text ads on Google search or Youtube ads
before a video, and advertising on Google Network Members’ sites – a network
of affiliate websites that hosts ads relevant to their content contracted through
Google. The former is a far more profitable business model than the latter, as in
the latter Google has to pay a large proportion of its revenue from advertisers
directly on to the Network Members, although interestingly the second model,
by tying the major cost directly to revenues in a variable manner (if advertising
revenue drops, so do the payments to Network Members), in the case of an
economic downturn could help in mitigating the severity of margin contraction,
which has some value in what is essentially a cyclical business. The ads on
Google sites are, however, a larger part of revenue and have been growing faster,
so the more profitable segment of the company is overtaking the less profitable
one.

In a world where the Internet as a source of information is fast taking over
traditional forms of media – newspapers, television and books – Google has
created a near-monopoly in its strongest generator of advertising revenue,
Google Search. The nearest competitor, Microsoft’s Bing, has a market share
that fluctuates around 14-16%, with Yahoo posting similar figures. Neither has
anything like Google’s – a high of 66.8% of the market in June 2012. Nor is either
likely to increase to any extent that rivals Google – at most, possibly taking share
from each other is all these two can reasonably hope for. After all, when you
need to find something online, what do you do? You Google it.

A current challenge that Google is facing is drawing advertising revenue from the
increasing use of smart phones and tablets, rather than traditional computers, to
access the internet. Because of the physical and technological limitations of such
products, this is a difficult task – for example on a mobile screen there are no text
ads on a Google search, presumably simply because there is not enough space.
The extent to which Google can innovate new ways to generate revenue from
this technological space will have a significant impact on the growth it can attain
in future years. However, even if such innovation, which Google is pursuing
aggressively, provides only disappointing results, the core business will likely
continue unaffected insofar as the convenience of using a computer or laptop
ensures that they will never be fully replaced by mobile devices.

Longer-term, there is some risk in online advertising that – legally or illegally –
ad blocking programs that block ads such as Google’s become very widely used.
These already exist – for example here is a free ad blocking extension to Google
Chrome, which claims to be the “world’s most popular browser extension” and
“used by millions of users worldwide”. Most of Google’s advertising revenues
only get paid on a cost-per-click basis, so if this became truly popular as the
general population becomes increasingly tech-savvy, the effect could be very
serious on Google and its Network Members’ revenue, or its costs insofar as
counteractive technology may need to be developed. Leaving this possibility
aside, however, the position that Google has as a search engine ensures it will
have a competitive “moat” around it for years to come.

Marc Lerner