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Worried about Google? Story Stronger for Long Term

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Google announced disappointing earnings Thursday with the two headlines being lower click rates (ad rates) and more losses at Motorola.    The news immediately took the stock down 9% before it was halted.   To put this in context, Google stock had run up 37% in the last four months, so it is likely that some new investors looking for a quick momentum decided to take their gains.  However, companies competing in this new mobile-ecosystem world need to be evaluated long term, not on a quarterly basis, because new product introductions and investments in long-term strategies can have big impacts on quarterly results.  And long term, Google is only getting stronger.

Advertising is Google’s core business, and Google is the market leader.  Google has dominated online search advertising with 79% market share most recent data by IgntionOne.  Google also leads in mobile display ad revenue with 25% according to e-Marketer and dominates in mobile advertising overall with 51% market share because Apple and others have not yet entered the mobile search space.

Mobile introduces unique challenges to Google…and everybody else.  The challenge: advertising does not work the same on mobile devices as it does on desktops.  The screens are smaller making the ads harder to read and it difficult to place very many ads on that screen.  As a result, marketers are not sure how to monetize mobile ads or not sure of their effectiveness.  And during this period while marketers are trying to figure mobile ads out, ad rates for mobile are falling.  Google has faced this problem for three quarters, Pandora announced similar results in September, and Facebook has admitted to the challenges of around mobile advertising.

But, don’t despair, there is good news.  First, the mobile ad market is nascent.  In 2012, the market for mobile ad spending is expected to be $2.61B this year, and that will grow over four-fold over four years .  Second, the format for effective mobile ads has yet to be figured out.  For example, video ads have proven to be extremely effective given the captive audience of a mobile device and the engaging nature of video.  Third, the screen sizes on mobile devices are growing.  The latest introductions of smartphones all boast larger screens than previous generations.  Moreover, tablets are proliferating with the most popular, the iPad, sporting a 9” screen, almost as big as a laptop.  Lastly, the challenges of mobile advertising are facing the entire industry – and it is a very smart and well-capitalized industry.  Google has $48B, Apple has $117B, and Facebook has $10B in their bank accounts and armies of talented, creative employees that have brought to market game-changing innovations including online search, smartphones and social networking.  It is a certainty that they will figure out mobile advertising.  Or someone else will and they use their war chests of cash to copy it.

Investors need to look at the bigger picture, or the secular trends.  Advertising is affected by economic cycles, which are easy to analyze and follow. However, mobile advertising is a secular, growth market and it is harder to analyze while it is underway.   Consider a previous trend:  Apple embarked on a new business strategy for a technology company.  Before then, technology companies focused on one thing:  hardware (IBM) or software (Microsoft).  These companies focused on the enterprise sector and Wall Street wrote research on these companies in “silos” or verticals of companies in the same business with the same type of end customers.  Then Apple came along, and analysts thought it was a hardware company, but it was really a software company, luring customers to its products through the elegance and ease of use created by its user interface (software).  Apple combined software, hardware and services in a closed ecosystem.  “Closed” was considered blasphemy in tech circles, because tech was always considered for the enterprise, which required open systems their IT departments could customize.  But technology for the consumer had to be to “plug and play” – end-to-end systems that delivered services consumers wanted, like music.  Apple proved hardware, software and services had to be put together to be a valuable offering to consumers.  And, by doing so, Apple revolutionized the music, cellphone and laptop (now tablet) businesses.  The new "trend" or paradigm for consumer technology companies is to create systems around hardware, software and services.

To be competitive, hardware, software and services have to be rolled together.  Two years ago, Apple’s strongest competitor on the cellphone side was Samsung.  And Samsung continues to nip at Apple’s heels, now in tablets.  It looked like an Apple-Samsung-Sony war because each had an ecosystem of sorts, while Google was focused on search ads and Amazon was focused on e-commerce.  Fast-forward to today when Google and Amazon have woken up.  Google and Amazon are manufacturing their own tablets, Google bought Motorola for smartphones and it is rumored that Amazon is on its way to smartphone production, particularly given recent rumors of acquiring Texas Instruments mobile semiconductor group.  Both Google and Amazon have figured out they have to be involved in all three aspects of consumer technology:  hardware, software and services.  There are legitimate criticisms of Google and Amazon pursuing this strategy in the short term.  First, some say (on CNBC) that the strategy is unfocused.  Second, the margins are thin to negative on the hardware side.  Google’s Motorola unit is losing money, the Google Nexus margin is estimated to be 20-30% and Amazon is estimated to lose money on the manufacture of its Kindle Fires.  The contrast to Apple’s overall 40+% gross margins and 50+% iPad margins is stark, of course.  However, the long-term justification for Google and Amazon is that this is necessary to stay in the game with Apple.

Google is in very early stages of this strategy.  The Motorola acquisition was just competed in May.  The short-term implications of the acquisition are negative:  bloated employee numbers, cash flow drain, and delays of its new Motorola Droid RAZR phones.  But the long-term assets are substantial:  17,000 patents which Google can use to defend against and negotiate with Apple, arguably some of the most popular cellphone designs and legacies in history (StarTAC), and deep-rooted cell phone institutional knowledge.  The Google Nexus 7 was just released in June and Google adeptly entered the tablet market in a category that it did not have to go head-to-head against Apple straight out of the gate. Google compares favorably against others well in terms of app store, number of apps, number of app developers.

There are threats to this strategy, but these are not foregone conclusions either.  What Google is doing is creating as much real estate as possible for proliferation of its search engine.  Through that engine, it can sell ads.  There are three threats to this business.  First, if people use apps to get the information they want, they will search less.  Google is protecting itself here.  Google offers Android free to OEMs and to developers, and most apps built on Android are free.  Thus, if people use apps rather than search on an Android device, Google can deliver ads through its own apps.  Second, if Apple continues its purging of Google from its default settings on iOS devices, that could substantially affect Google’s business.  It is reported that Google pays Apple $1B to be its default search, and earns about $1.3B from searches on Apple mobile devices.  For the near term, at least, it seems unlikely that Apple will remove Google search because of the flack over maps, the dollar amounts involved and Apple’s strategy of promoting apps over search.  The last and potentially biggest threat to text search is voice search, or users asking rather than typing questions.  Then the opportunity to serve a display ad goes away.  Again, voice commands are early stages as well, and asking a question (search) still leads to wanting an answer (click through opportunity.)

All in all, Google appears to be doing all the right things to pursue an effective and profitable long-term strategy in consumer technology.  It is just very early.  Google’s foray into hardware is only just beginning but their first steps appear to be headed in the right direction.  The Google Nexus 7 was well received, and it is anticipated that the new Motorola Droid RAZRs will be attractive to consumers if they can get out before the holiday shopping season.  Google has momentum in mobile advertising, with an $8B annual run rate.  It is outpacing every other mobile ad player.  As Android continues to proliferate, it will have more real estate from which to deliver ads or to test ways to deliver ads.  Google is as well positioned as any company to compete in this new consumer technology paradigm.   Today, it appears the long-term horse race is between Apple, Google and Amazon.

It is a challenge for investors, because these are long-term opportunities in a stock market that is very short-term oriented.  Investors need to analyze which companies are well positioned for the long-term and take opportunities to buy the stock on short-term reactions.  Those investors in long-term secular growth companies have been rewarded.  Investors who believed in the ad model for online search and invested in Google on its IPO at $85, had a bumpy, albeit rewarding, ride to $714 over the ensuing three years.  The new world is mobile, and investors again are challenged to look at the longer term.  Google traded up 37% over the last four months on sentiment, and it traded down on the earnings news on sentiment.  With the stock at $681 today, a P/E multiple of 16x compared to expected growth of 16%, and consensus price targets dropping to a respectable $765 to $800, the stock is priced to provide a 12-17% return over the next year.  Longer term, the prospects could be even better if Google’s strategy plays out.