Google - A Ben Graham-type Value Play?

Note: this post was
carried today on Wallstrip

Overview

I know, I know. I am going to catch a ton of crap from “true
believers” in value investing for using such a comparison. I may even
be labeled a heretic. But just wait a minute - before the deep value
guys burn me at the stake, please read the thought process below. In
short, the way it looks to me is that Google has created a platform for
my most favorite word - arbitrage. Buy customers
cheap, use the platform to catalyze a revenue transformation, and get
rewarded for it (effectively, “selling” them) in the public market. I
might even make the argument that there is a built-in “Margin of
Safety” to the model Google has created and the strategy it is
pursuing, further blurring the distinction between its classification
as a rapid growth company and one of the principal tenets of value
investing (are you hearing this, Warren?). This is a beautiful thing,
made massively scalable by Google’s unsurpassed back-end architecture
and massively profitable by its advertising revenue-generating machine.
After looking at the numbers, doing a little thoughtful analysis and
gauging the data across the blogosphere, it appears that our friends in
Mountain Valley might, in fact, be a true value play. Let the arguments
begin.

Getting a Grip on Google

1. YouTube - Boon or Bane?

In the late 1990s we heard a lot of talk about business model and
revenue - but not a whole lot about profits. The philosophy was land
grab, plain and simple. There are several looking at YouTube the same
way, thinking that Google got taken (or, perhaps, suffering from a
little “Irrational Exuberance” in Schiller-speak). I’m not so sure. For
a moment let’s take a step back and think of a metaphor to help us
understand Google’s thought process. These are clearly not stupid
people and must have some logical basis for laying out $1.65 billion
for this nice little company. Using the Jeet Kun Do model, clearing our mind and thinking outside the box, I’d like to offer one possibility: Think Advertising.
Using this model, a company’s valuation is based solely on audience,
and getting other people to pay money for access to this audience.
Market capitalization should, therefore, be directly related to the
population of people you can attract to whom you can display ads (for
which you can get paid). So, the thinking goes that a useful, yet
simple-headed metric for customer valuation could be market
capitalization divided by unique users. Let’s try this out and see
where we get.



For those of you who have been living under a rock for the past eight
years, Google makes a LOT of money from advertising and keywords. Real
money. Big, big money. Monetization is not Google’s problem. Eyeballs
targeted => Ads => MONEY. People pay to advertise and get
priority access to keywords on the Internet, and Google is all about
directing traffic and making money. They are like the ultimate traffic
cop on the take (sorry, Ray Kelly).

2. YouTube - By the Numbers

“The Tube” spends most of its dollars on technology to route, upload, access and search videos, based on user requests. Google paid
$1.6 billion for 72 million unique monthly viewers. That equates to an
acquistion cost per customer of $22. You can argue over the 72 million
users, so if we cut that in half (to forestall any arguments) to 36
million, that’s a cost per customer of $44. So to Google, a YouTube
customer cost somewhere in the $22-$44 range.

3. Other Media Outlets - By the Numbers

TV

Fox’s American Idol has 21.1 million viewers. At $660,000 for a 30 second spot,
a 1-hour show would have close to 15 minutes of commercials yielding a
revenue of $950 million a year (30 spots a show X 4 shows a month X 12
months), or an implied value of $45 per user.

NY Times

The New York Times Company,
has seen better days. In the last 2 years the stock has gone from the
low 40s to the low 20s. Imagine that - 50% of its market cap erased in
2 years - a direct result of online media taking its toll on MSM. NYT
currently has a market cap of $3.3 billion, Net Income of $259 Million,
and a 5% profit margin. They have 1.7 million print subscribers and 37.7 million
unique web viewers per month, which includes About.com. For arguments
sake we’ll put them together for a total of about 40 million viewers.
Using our admittedly rough methodology a NYT customer appears to be
worth approximately $82.

The Googleplex

With a market cap of a stunning $144 billion, Net Income of $1.4
billion and 25% Profit Margin, what is a customer worth to The Beast?
In the strictest sense Google is all about advertising, and it has
rapproximately 380 million unique monthly users according to Neilsen/NetRatings - spending an average of 22 minutes on the site. The market cap divided by the number of unique users per month nets a per customer value of $380. Zowie.

4. YouTube - the Verdict

With YouTube valued at $22-$44 dollars a user, Google must see this
and be licking its chops. Or, to me, “This is a grand arbitrage
opporunity.” Google knows what it can squeeze from a user, how it can
scale users and how much it should pay to acquire users. I’d say that
$380 in vs. $22-$44 out represents the kind of margin of safety value
investors can get their arms around. Even if the ad market gets
increasingly competitive (say, if Yahoo! can ever post a credible
challenge), and they can monetize even at the levels of the NYTimes,
that’s a YouTube valuation of $2.8 billion ($82 X low-end 34 million
customers). In short, this represents a pretty nice IRR given the
likely monetization time horizon. Even a little exposure to the
Googleplex can go a long, long way.

Getting a Grip on the Risks

With a margin of safety like that where are the risks? Well…

YouTube - This Isn’t a Game

YouTube isn’t simply a place to go to upload/download video content.
Why did YouTube prevail over Google Video despite the significantly
faster bandwidth and fewer restrictions? It has created an expansive
yet tightly-knit user base – in short, a culture and a community all
its own. With these entanglements comes risk. A user-base sensitive to
changes, especially one that could fundamentally impact the user
experience, will not hestitate to speak out - and do so with great
force. Mark Zuckerberg of Facebook found this out the hard way.

Generation Facebook is taking action — against Facebook.
On Tuesday morning the popular social networking site unveiled a new
feature dubbed the “News Feed,” that allows users to track their
friends’ Facebook movements by the minute. For many of Facebook’s 8
million-plus student users, it was too much. Within 24 hours, hundreds
of thousands of students nationwide organized themselves to protest the
new feature. Ironically, they’re using Facebook to do it.

Since Tuesday, a handful of anti-News Feed groups have
sprung up on Facebook. The largest has 284,000 members and is called
“Students Against Facebook News Feed (Official Petition to Facebook).”

This is a user base that is all about open discourse, free exchange (copyrighted material), pushing boundaries.  Check out my post on the Michelle Malkin controversy, in addition to the latest controversy
over a restricted political ad which drew a firestorm in the
blogosphere. In short, the integration of YouTube is not simply A+B=C^2
(with the exponent due to Google’s ability to turbocharge per-user
revenue). In fact, the equation could end up being A+(B-D)x2=C, where
the D is disruption and conflict arising from integration, and the x2
reflects the drain on management time required to deal with a troubled
acquisition.

Being Big and Successful - It can Really Suck

Google is quickly becoming and established, BIG Corporation – with
all the restraints and controls that come with it. The Boston Herald
carried a great piece
on the backlash of some users. It was just one of many visceral
reactions YouTube members had to the news. Many comments and videos
posted on the site were congratulatory. But many people expressed
concern that Google’s acquisition could tame the Wild West culture
YouTube has fostered.

“Anytime a huge corporation takes over another one, the fact of the
matter is, things change,” a YouTube user, who goes by Mykal100, said
in a video post. “Google, hands off. Don’t change a thing.” One only
has to look at the responses to the now- famous “Kings” video, featuring founders Chad and Steve to feel the hesitation and fear amongst their loyal fans:

fuck this place seriously its just going to go to hell.
once google gets their hands on it its just going to have a bunch of
restrictions. all you stupidasses can congratulate them for selling out
but i think they sold us off to the slaughter.

nothing good lasts. youtube is gonna go down hill from now since its
in googles hands, get ready for comercials or having to pay to put a
video on. i would of sold out too but i wouldnt of made a stupid video
about it…

Well, they have now taken the you out of youtube. The whole point of
youtube was to allow a bunch of nobodys, teens, adults, elderly people,
and let them broadcast themselves. From what I’ve heard you will now
have to pay to watch. Who in their right mind will pay to watch Mr.
Pregnant?

The biggest risk in the YouTube deal is something so old economy -
Integration Risk. Google needs to leverage YouTube without destroying
the ultimate value of YouTube, the community. Google will need to
balance open, edgy world of YouTube and the emerging corporate safeness
and conformity of Google. Already we can see chinks in the armor. A few
months ago I had written a post
on creative destruction, and specifically referenced Google. I think it
is some of the things I mentioned in that post which pose the greatest
risks to the Company as it continues to grow and evolve:

So, what about Google, the glamour gal of the moment?
Still pulling in great people, losing few top performers, innovating
like crazy, focused on organic growth. So where are the chinks in the
armor? As noted in a previous post, Google is really great at general
search but pretty crappy at targeted, vertical search. Domain expertise
is not their forte, and a massive industry has been born and is being
nurtured around this idea of domain-specific vertical search. Depending
upon how robust and specialized these search engines get, one can
imagine that advertisers would be willing to pay more for eyeballs that
have essentially self-selected by living on a particular vertical
search tool versus surfing a generalized search tool. This could suck
ad dollars away from Google and render their general search model a
highly profitable but less rapidly growing enterprise.

This would not be good and would readily translate into a
manifestation of creative destruction. While they have clearly created
an innovation culture around Google Labs and fostered big-thinking by
their employees, they need to turn some of this potential energy into
kinetic energy if they are to maintain their growth trajectory, drive
stock price and keep employees pumped and excited.

While it is hard to get to the top, time (and our friend J. Schumpeter) has shown that it is even harder to stay there.

Conclusion

Bottom line: an investment in Google entails risks, and serious
risks to be sure. That said, the margin of safety for investing in the
Company - given its dominance in online advertising, an unparalleled
infrastructure and some of the brightest minds on the planet -means a
lot of bad things can happen before its model begins to weaken. And as
it becomes more acquisitive, its opportunity for turbocharging its
value creation just grows. I see Google as a legitimate value play. May
Ben Graham’s ghost not strike me dead for uttering these words. But
we’re talking Google, baby. I’m not sure I see the analogy in the Ben
Graham era.

Thank you, Rob Passarella and Rick Calmon.  Excellent job researching this post.

The author does not have a position in the securities of Google.