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Summary:

A funny thing is happening to Google on the way to near-certain immortality. Its stock, it seems, is as fallible as any other. Consider the year-by-year appreciation of Google’s stock price: 2004: Up 126.8%, from the offering price of $85 to $192.79. 2005: Up 115.2% to […]

A funny thing is happening to Google on the way to near-certain immortality. Its stock, it seems, is as fallible as any other.

Consider the year-by-year appreciation of Google’s stock price:

  • 2004: Up 126.8%, from the offering price of $85 to $192.79.
  • 2005: Up 115.2% to $414.86.
  • 2006: Up 11.0% to $460.48.
  • 2007: Up 1.5%, as of April 12.

Google, which joined the S&P 500 a little more than a year ago, has since failed to outperform that index: The S&P 500 returned 16.5% in 2006 and is up 2.1% this year. So after two years of glorious gains, Google has since lived a life less ordinary.

What’s going on here? It’s well known that Google’s revenue growth rate is slowing, as it does with any company that is getting larger. But it’s not as simple as that. Google’s profit margins are rising. And investors can be awfully forgiving about slowing revenue growth if margins are getting fatter.

Whether or not you factor in traffic acquisition costs, Google’s revenue percentage growth has slowed from three digits to two in recent years. But its operating margin has risen to 33% in 2006 from 20% in 2004 (the year of its IPO), while its net profit margin has risen to 29% from 13%.

But as any investor knows, there are other factors besides profit growth at play in stock performance: things like financial transparency, speculative trading and liquidity. All of these have buffeted Google’s stock at one time or another since it went public, but liquidity – that is, the balance or imbalance of supply and demand for its shares – is right now the determining factor.

One event that is having an underappreciated impact on Google’s stock is the secondary stock offering in September 2005, which added 14.2 million shares to the 19.6 million already in the market. That offering began a gradual tilting of the balance-o-meter of Google stock in favor of supply over demand.

Demand for Google remained high in 2005 as the company blew away earnings in the third quarter ($1.51 a share vs. the Street’s estimate of $1.36) and Net stocks in general rallied toward the end of the year. But think about this: Google ended the first week of 2006 at $465.66. If you bought it 15 months ago, you haven’t made money.

The supply caught up with demand. If anyone was hot on Google, thinking it might fulfill the orgiastic fantasies of analysts who had a $2,000 price target on the stock, there was always someone more than happy to sell shares to them.

Google added to the supply of shares when it bought YouTube for $1.65 billion in a stock acquisition. Google’s 10-K says it issued another 3.2 million shares for that. Since those stocks were issued on Nov. 13, the stock has traded flat to down.

Then there are all those stock options that are starting to trickle into the total number of Google outstanding shares as they are vested and exercised. In a thoughtful article Wednesday, the San Jose Mercury News asked whether employees who are receiving the last of their four-year allotments of Google’s pre-IPO options will bolt.

The story pointed to the obvious cultural and HR questions that such events raise: will Google’s valued veterans move on to create startups that could steal Google’s thunder? Will a class-system emerge where wealthier employees are resented by the newly hired? Google, as you’d expect, is making intelligent moves to stave off these problems.

But from a liquidity standpoint, there remain problems. On the one hand, exercised options add to the number of stocks outstanding, further dampening demand. On the other, a stagnant stock price – like Google has seen for five quarters – could deter new hires who are motivated by the lure of options gains.

Google could solve this problem the way most tech companies do: by buying back its stock in the open markets. At nearly $500 a share, that’s a pricey proposition. And it would betray the company’s oft-declared intention to invest only in future growth, not its stock.

In the now legendary “Owners Manual” that Larry and Sergey penned for shareholders, Google swore that it wouldn’t care about capital gains as much as “doing no evil” and “making the world a better place.”

Now, like so many tech giants before it, Google is faced with the unsavory reality of taking cash that could be spent on its future and instead spending it on the unglamorous reality of stock buybacks. Whether it makes this move or not will have, in time, an increasingly bigger weight on investors and employees, past and future.

Kevin Kelleher is a writer living in the San Francisco Bay Area. He has a regular stock column at TheStreet.com and is a contributor to Wired, Business 2.0 and Popular Science. He has previously worked at Bloomberg News, Wired News and The Industry Standard magazine.

  1. Likely because its Friday, this prompts me to take a financial markets view of things :) Great article that touches on several stakeholders and their considerations at play.

    General Issue employee options are seen as absurd in most industries. They make sense as compensation to those that are situated in roles where they ought to be held accountable for stock performance. Google is no exception and frankly the stock market always and rightly approached Google as just another stock always.

    I would be inclined to think that the lack of ‘upward annualized volatility’ in the stock-price reflects the keen foresight of Google’s underwriters. In a way they correctly anticipated non-normal performance of the stock. That is what the better financial market makers do best. In addition the slackness indicates, as you have alluded in your note, that there exist equally, if not more, attractive investment opportunities for investors. The question thus still remains one of capital structure for Google’s executive and how they view equity markets within that structure.

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  2. Brad Gerstner Friday, April 13, 2007

    Kevin,

    Nice analysis. However, given the trillions of potential $$ for this or any other company that is deemed a “good investment” I have a difficult time buying into some abstract argument about “too much supply.” There is a lack of demand for Google’s stock for a reason – investors do not believe the risk-adjusted expectations for future cash flows (aka profits) are the highest and best use of their capital.

    What is fascinating about this from my perspective is that notwithstanding the company’s impressive market position and market out-performance, it current trades at roughly 19.5 X ’07 and 14.5 X ’08 EBITDA. This is significantly less than recent private sales in the space (Digitas @ 17X ’08); public internet stocks (Bidu, Ctrp, Akam) and no where close to where Amzn, Yhoo, and eBay were trading at this stage in their life cycles.

    For Google, the multiple compression (the amount somebody is willing to pay for a $1000 of profits) has occurred much faster than for their peers – which is an interesting topic for discussion. But ultimately all investments are governed by cash flows and profits. If Google’s profits which grew an astounding 100% in 2006 continue to grow as expected and the stock price stays where it is, this simply means that the company is becoming more of a bargain.

    And as we all know, bargains (especially in the stock market) rarely last long…

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  3. “the company blew away earnings in the third quarter ($1.51 a share” – “Google ended the first week of 2006 at $465.66″.

    Maybe I’m missing something here, but you seem to be saying that the P/E is something like 77 on an annualised basis but the reason capital appreciation is reduced is oversupply?

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  4. Good article. I agree with you that the increasing supply of Google stock has caused their price to stagnate. However, I do not agree that they need to repurchase shares to increase that price. I think they’ll be fine if they just stop issuing new shares. Because of Google’s growth, and because of the company’s popularity, I think demand for their stock continues to grow. If they just keep the share count the same, eventually demand will exceed supply and the share price will go up. Actually, I find it amazing that the share price has not gone down after the significant increases in supply. To me, that shows that demand continues to increase significantly.

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  5. Kevin Kelleher Friday, April 13, 2007

    Heath: On a historical basis, Google was always absurdly valued – its profits were more than tripling annually at that time. As Brad pointed out, its current valuation based on future earnings expectations are much more reasonable.

    Mark: My post didn’t get into insider selling, especially by executives, which adds a constant stream of supply to the stock. As much as Google would like to ignore what its stock price is doing, it has to be becoming more and more a HR concern.

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  6. Personally, I think the slowdown really has nothing to do with Google. Nothing has changed at Google, they suddenly didn’t forget how to make money, their profits are actually increasing.

    People look at the high price of their stock and begin to wonder if it is overvalued. Throw in a few institutional investors and hedge fund guys that feel like getting froggy with Google stock and you could have a very rocky situation if you are a Google stock owner.

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  7. Executive liquidation and uncertainty in future cash flows.

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  8. [...] writer at Gigaom puts forward an analysis of Google stock price stagnation in terms of oversupply of Google share from the 2005 stock offering and the YouTube stock swao [...]

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  9. Kevin:

    This is a really thoughtful article.

    Here’s an entirely different take: Google’s revenue growth has been powered by two revolutionary products: Adwords and AdSense.

    The Company continues to churn out some really great innovations, such as Google News and Google Maps, but at this point the revenue contribution of these, and other new services, is (I believe) insignificant.

    The major growth in Adwords and Adsense use has occurred. Now, the Company is optimizing their performance.

    It seems to me your question is not whether Google is a great company or even fairly valued but why it’s value does not keep increasing astronomically. All of the above may cause investors to wonder whether — without any new revolutionary products — Google merits a continuing torrid increase in it’s overall valuation.

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  10. I think the easy answer is that the stock was over priced to begin with and by not sliding, you could almost say that it going up by just the right amount. Afterall all the eggs at Google are in one basket which has to make at least some inventors weary.

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