Google’s Growth Strategy Comes Under Criticism

Michael Liedtke, the technology writer for the Associated Press, recently wrote an article discussing the effects of the unorthodox Google stock split designed to keep the majority voting control in the hands of founders Larry Page and Sergey Brin. The issue is that Google may have to pay out $500 million to shareholders of the non-voting stock because Page and Brin promised that the non-voting stock that its stock would trade within 1% of the voting stock. Because the non-voting shares lagged by almost 2% in the first year, Google may be on the hook for half a billion dollars in payments. All those criticism are fine and fair.

The problem with Liedtke’s analysis is this passage: “Yet many investors have become frustrated with Page’s unwavering belief that Google should be spending billions on far-flung projects ranging from driverless cars to diabetes-controlling contact lenses that may take years to pay off and have little to do with the company’s main business of search and digital advertising. The big spending is one reason Google’s stock price is 3 percent below where it stood at the end of 2013, while the Standard & Poor’s 500 index has climbed 12 percent.” The source of this passage can be clicked here: “Stock Split Could Cost Google Over $500 Million.”

I don’t think someone can nod their head in agreement with Liedtke’s passage and call himself a long-term investor. He criticized Google’s stock performance since 2013 without recognizing that: (1) Google’s profits have grown from $18.03 per share at the end of 2013 to $20.82 at the end of 2014 for a gain of 15%. It’s hard to criticize a $300 billion company for growing profits 15% in a given year. And (2) the selection of 2013 for the stock price comparison gives a skewed picture. You could easily choose 2011 as your reference point, and you would see that the price of the stock has increased from $236 to $535 in under four years, for a cumulative gain of 126%.

But really, the greater issue is the criticism that investors are upset with Google’s investments into driverless cars and other “far-flung projects.” Almost every investor agrees in the abstract that they would rather see their business invest into long-term growth projects rather than pursue short-term profits. Yet, when companies actually engage in growth projects with delayed and uncertain payoffs, members of the media in conjunction with some high-profile investor issue criticism. There are plenty of companies that engage in buybacks at questionable valuations to prop up earnings per share or neglect to invest in the long-term health of the business to appease the short-term interests of Wall Street. Google is a company that pursues old-fashioned revenue growth through product development to grow earnings per share, and this way seems preferable to financial engineering.

Anyone with knowledge and appreciation of Google’s own corporate history ought to endorse Page’s approach. After all, it was a “far-flung project” that led to Google becoming the billion-dollar juggernaut of the internet. When Google was getting started in the 1990s, its search engine found success through its PageRank system. The PageRank was successful because it not only found relevant search engine terms but also adjusted for quality. This is what made Google superior to its competitor Overture. Back then, Overture had little ability to deliver search engine results that came from trusted sources.

If you wanted to search for Bank of America mortgages, how would a search engine know to take you to The Charlotte Observer instead of, say, a guy’s website that was an angry screed blaming Bank of America for foreclosing on his cat? You couldn’t just take the easy way out and give newspapers higher search engine placements than privately run blogs. What if someone truly runs an excellent blog that is of higher quality than the local newspaper on a particular topic?

To remedy this issue, Google developed a back-link system that ranked search engine results based on the amount of referrals from other sites. The logic is that people generally link to high-quality articles, and leave low-quality articles alone. This system was so groundbreaking that Larry Page originally wanted to call the company Backrub because the search engine results consisted of websites “rubbing each other’s backs” every time they linked to each other and increased their search position. The Bank of America mortgage article with 50 referrals would receive better placement than the Bank of America mortgage article with 2 referrals.

But despite this organic breakthrough, Google still had an issue—they had a search engine, but they could not make it nearly as profitable as they desired. That’s because they had no way to connect online advertising to the text of an article. If I ran a blog on investing, the St. Louis Cardinals, and Bruce Springsteen, how would you know which ads to put on each page?

The answer came from an unexpected place. Google purchased Applied Semantics in 2003 for $102 million, and that changed the company forever. Applied Semantics was able to trace pictures and texts on the screen and connect it to third-party media. Eventually, Google turned Applied Semantics into its Adsense Division, and it was soon able to place ads on websites that matched the text of the article. If you searched vacations in Guatemala, you would receive advertising to hotels, plane tickets, resorts, and passports. We take that all for granted now, but it was the obscure acquisition of Applied Semantics that eventually become responsible for a third of Google’s nearly $70 billion in annual revenues.

If Google had a culture of repurchasing stock or pursuing short-term profits, things like the Applied Semantics acquisition would never happen. The rich collection of side projects is what makes Google so compelling because it is like a high-quality pharmaceutical company with a well-funded research and development budget. If nothing materializes from the side projects, the company could still perform satisfactorily. And only one breakthrough from the side projects can take the company to a new era of prosperity. When the investor community is surrounded by layoffs, cost-cutting, and stock buybacks, it seems foolish to criticize one of the few companies still trying to achieve profit growth by investing in new products that may one day become lucrative. Not only is this approach intuitively attractive, but it is in the DNA of Google’s corporate success story.



Originally posted 2015-04-03 05:58:19.

Like this general content? Join The Conservative Income Investor on Patreon for discussion of specific stocks!