Finally Something Positive About Radio - They Beat Internet Display Ads

A study by Harris Interactive states that one-third of Americans find TV advertising to be more helpful in making purchase decisions than any other medium. According to the study, 37% favor TV ads, 17% favor newspaper ads, and 14% favor Internet search engine ads, while just 3% favor radio ads in making purchase decisions. Here is where radio gets competitive. In a response to the question, which type of ad do you tend to ignore the most, 46% said Internet banner ads are ignored while just 9% ignore radio ads.

Radio finally beats the Internet at something, even though most of radio's ad dollars have found their way online and the stock prices of the radio companies have been decimated as a result. Not sure what this means for the radio companies and I doubt that ad dollars will make their way back to radio.

The study also stated that 17% of Americans ignore Internet search ads, which strikes me as odd given that in most instances, with contextual ads being the exception, both paid and non-paid search ads are only displayed as a result of a query by someone. So it puzzles me why someone would intentionally ask for an ad to be displayed then ignore it. They would look at the ad, see whether it is relevant, and if it is they would click on it, and if not, they would ask for another ad to be displayed through a second search. No where in this process is the ad being ignored by the consumer. I doubt the owners of the survey would be savvy enough to differentiate between traditional online search ads and contextual online search ads, hence, their results are somewhat questionable.

Nonetheless, kudos to the declining radio industry for this win. I continue to be a big fan of radio and listen to it in both my car and at home and often find the ads helpful. The industry has staying power and will be with us for decades and probably for the next century. The same can't be said for the stocks of these companies as most will surely be taken private, voluntarily or involuntarily.

I chose to have nothing to do with the stocks but if you are inclined here is a list of the radio stocks:

Radio One (ROIAK) - $0.70
Cumulus Media (CMLS) - $0.73
Salem Communications (SALM) - $0.899
Entercom Communications (ETM) - $1.45
Sega Communications (SGA) - $5.80
Sirius XM (SIRI) - $0.46
Beasley Broadcast Group (BBGI) - $2.17 Read More!

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Update on 2009 Predictions

In early January I listed 12 items that I thought will or will not happen in 2009 in my post 12 Predictions for 2009. Half way through I take at look at those predictions to evaluate where we are.

Here goes!

1. I'll start off with something that I think is not likely to happen. Microsoft will not make a move for Yahoo! in any capacity. [So far dead-on with this prediction.]

2. Expedia and Priceline will attempt to merge but there maybe anti-trust issues raised. [This is looking like a long-shot but I am sticking with it.]

3. Yahoo! and eBay will explore ways to cooperate or work together. Could lead to a merger down the road. [This is also looking like a long-shot but I think Bartz and Donahoe should consider. Lets see what happens in the next six months.]

4. The U.S. dollar will crash mid-year. [That has started and given the BRIC's call for a new reserve currency, the dollar could spiral downwards as we progress through year- end.]

5. Inflation will become an issue once again. [Haven't seen clear signs of this in the economic numbers but economic theory is on the side of this prediction. I am sticking with it for the next six months.]

6. The market will run-up into the Obama stimulus package but will then correct by 20%. [Dead-on. That occurred from January to mid-March.]

7. AOL remains independent, i.e., no buyer surfaces. [They are going public so I am dead-on here.]

8. Bankrate will be purchased by a traditional media company. Tom - get out while the going is good. [They should have listened to me. Make it happen in the next six months.]

9. Several large retailers will file for bankruptcy as well as a few major financial institutions. [At last count, 52 financial institutions told us peace-out in 2009. Don't have the number of retailers handy.]

10. Google may look to buy what's left of Sun Microsystems. [Right on Sun being acquired, but wrong on the acquirer. IBM was the suitor. Still a pat on the back for calling the acquisition.]

11. There will be several major oil field discoveries around the globe, particularly Eastern Europe and Asia. [Dead-on with this one. Now I am hearing of one near New Orleans.]

12. The New York Knicks makes a play for Lebron James. [Being a fan of all sport teams in NYC and a big fan of Lebron, this was wishful thinking on my part. Plus, I erroneously thought Lebron was a free agent this year; however, he has one year left on his contract with the Cavaliers. This will be No.1 on my list of predictions for 2010.]



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Traditional Media Playing Defense. Time to Short the Sector?

"There is little the media companies can do to stop the havoc that the Internet is wreaking on their traditional business. They can slow the drain of profits for a while. But eventually, the companies will have to come up with new business models a little more adventurous than what was unveiled on Wednesday." - Wall Street Journal, Heard on The Street.

That to me was the most insightful section of the Wall Street Journal article discussing the Time Warner / Comcast TV Anywhere proposal announced on Wednesday. However, it was insightful not for only what it said but for what it left out. That is, the havoc the Internet is having on business models of what I refer to as the "traditional Internet companies" - Google, Yahoo, eBay, Amazon, MSN, AOL, and IAC. Of the group of seven, Amazon's business model is the most exposed to massive disruption. That's a tease to an upcoming write up on what I foresee as a head-to-head competition by the Internet's two most stable companies with one coming up on the losing end.

But first, Time Warner and Comcast announced plans to test TV Everywhere with 5,000 customers starting in July. Comcast video subscribers will be able to access shows from TBS and TNT, with more added later, for free over the Internet or on demand. Time Warner has been testing authenticated online access to HBO shows in Wisconsin for the past year.

The offer of cable shows online without charge to existing cable subscribers is an obvious defensive move to stem what I see, and as the article points out, as a huge consumer shift from cable/satellite pay TV in favor of content delivered online. I believe that the current recession/depression has permanently changed consumer consumption patterns with many trading down to less costly retail and media purchases. Add to that the 10-15 million unemployed, and we have a scenario where many consumers will strongly evaluate their needs versus their wants and chose to alternate from convenient luxuries such as pay TV towards free alternatives on the Web.

My write-up and graph several months ago about an economic reset captures this scenario.

Clearly that scenario is not showing up in the subscriber numbers today. DirecTV delivered 1.2 million subscriber gross addition and 460K net additions in the first quarter of 2009, the most gross ads since the third quarter of 2004 and the most net ads since the first quarter of 2005. Rival DISH Network, delivered 653K gross additions but netted a loss of 94K subscribers, however most went to DirecTV due to DISH's challenges such as customer service, technical, marketing, and lost AT&T subs. On the cable front, Cablevision lost 6K basic subscribers but added 9K digital subscribers in the first quarter of 2009; Comcast lost 78K basic subs but added 289K digital subs; and Time Warner Cable bucked the trend by adding 36K basic subs and 121K digital subs. Verizon FiOS netted 299K video subs in the first quarter.

Solid as these numbers appear today, there is trouble ahead for all within the pay TV chain, including the cable/satellite operators, the cable programmers, and to a lesser extent, content owners. As the article points out, there is a plethora of free content options on the web today such as Hulu, YouTube, TV.com, the broadcast networks owned websites where they post free content, and Apple iTunes where consumers can purchase individual episodes. The article left out options like Netflix and Amazon VOD which offer cheaper viewing alternatives to pay TV. Piracy is also lurking in the background and is very prevalent but very much ignored by the press and the media companies.

What will occur in the coming years is the disruptive power of the Internet reducing the economics of the traditional media players. Cash flows will start to diminish. Pay TV operators will slowly bleed subscribers as these subscribers access the web through their television sets and see no reason to, in essence, pay for TV, i.e, eliminate in-home cable connections. I believe that Americans will access the Internet through their TVs, which will connect through Wi-Fi, Wi-Max, DSL, or through a broadband connection. Viewers will be able to surf the web options mentioned above from a remote control device while sitting on a couch in their living rooms, at their desktop at work, or on a mobile device while traveling. Cable programmers will in turn see their distribution/affiliate fees paid to them by the pay TV operators shrink. For the cable programmers (&content owners) there won't be enough online advertising dollars from the move online to offset lost advertising and subscription fees. Even DVRs will be unnecessary as one will be able to quickly find replays of content by surfing the web from their TVs, putting TiVo's business model at risk. The 45-day DVD-to-VOD window will eventually collapse.

You will see cable operators, who are the most at risk, step up their campaigns to push usage caps on Internet video usage to curtail the defections. However, their efforts will ultimately be in vain due to public opposition and the competitive threat from DSL and WiMax.

What happens now? I am not advocating blanket short position on all media stocks because the disruption will take time to play out. In the meantime, media businesses are likely to chug along largely un-phased.

The writer suggested that "Time Warner and Comcast should offer an online-only option for consumers, so channels won't automatically lose viewers among people cutting off their video subscriptions." That can work.

What I see more is massive consolidation in the media space. The satellite operators will likely disappear into the arms of the telecom companies like Verizon. If government permits (a big if under the anti-trust focused Obama administration) cable operators will see the need to merge. The big content guys like Viacom, Walt Disney, Time Warner, and NewsCorp, who are already reeling from the pain of Internet disruption on their hugely profitable DVD businesses, will feel more pain. The good news in media is that out-of-home entertainment such as movie theaters is defensive to the secular threat from the Internet's disruptive impact, because of the need for people to leave their homes and offices. Further, the 72 foot wide and 53 foot tall IMAX screen experience is difficult to replicate in the home.

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Yahoo!'s New Home Page Revealed

Yahoo! released its new homepage and it is clean and appealing.

Thumbs up to Yahoo and Bartz. Plus it is fitting that my screen shots captured Michael Jackson.


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$30 EPS is Possible for Google in 2010

Google should report 2Q09 earnings sometime in the second week of July, and although I would not aggressively chase the stock at these levels, the bar versus consensus, once again, appears easy to beat. I aggressively accumulated shares in the stock around the $250-$275 levels late last year, when all was doom and gloom for the stock, but have taken profits along the way as the market rebounded and Google’s stock rebounded along with it. However, my work shows that the model has upside and we could see another 20%-plus appreciation in the shares from current trading levels. Further, if under the new cost conscious CFO, margins improve meaningfully, then we could see a clean $30 Adj. EPS figure in 2010, which would imply a $600 share price.

Consensus has Google delivering $4.031 billion in revenues in 2Q09, up 3.5% YoY but down 1% QoQ, $2.48 billion in EBITDA (61.7% margin), and $5.03 in Adjusted EPS.

My own model has Google reporting $3.993 billion in revenues (+3% YoY, -2% QoQ), $2.485 billion in EBITDA (62.2% margin), and $4.99 in Adjusted EPS. My revenue numbers are based on 15% YoY growth in paid leads and a 13% YoY decline in CPCs, with modest support from YouTube, CPM based revenues, and Licensing/Other revenues. The model assumes a less negative $375 million YoY FX impact and that Google is able to hedge $135 million of that figure for a net $241 million negative FX impact. The wildcard is the actual cost of the hedge, which shows up below operating income, and is difficult to predict. Another is the bonus accrual which is also difficult to predict. Both could lead to variability in the EPS report. Excluding those items, I believe Google’s new found cost disciple under the new CFO Patrick Pichette, should lead to significant margin improvement that is likely to start showing up this quarter. Supporting my thinking is a reduction in the growth rate of employee expenses due to the slowed hiring rate, less depreciation and some operating costs due to lower capex spending, removal of FX headwinds if the dollar goes into a tailspin due to the heavy stimulus spending (see my 2009 predictions), and tempering of the discretionary costs in the model.

Another positive is that commentary from several search engine marketers are suggesting that search ad spending is starting to pick up again.

Google continued to gain market share in online search in the first two months of the quarter but I am keeping an eye on the market share numbers for June and what it shows for the impact of Bing. Google has an enormous lead at 65% share in the U.S. but it is quite possible for them to lose some share if Bing’s recent gains are sustainable. Most pundits like Bing but think the share gains are temporary, with some pointing to the quick share gains after cashback was announced. Microsoft gave back the share gains after the hype from cashback abated.

Others are thinking that the share gains from Bing will come at the expense of Yahoo rather than Google. In my own experience, I used Bing for a few days aggressively after the launch but I am now back to Google. I consider myself an average search user so my experience could be telling. Nonetheless, I am refusing to write-off the beast from Redmond and I am taking a wait and see approach.

The shares are currently trading at 20x 2009 EPS compared to Yahoo!, which is trading at 40x 09, Amazon at 50x 09, eBay at 12x 09, and IAC at 40x 09. Thus relative to peers, the shares are attractive. I have Google generating $24.13 in Adjusted EPS in 2010 based off 10% growth in paid leads and 1.5% growth in CPC. If the economy recovers in 2010 and the non-FX component of the CPC declines experience over the past quarters proves cyclical rather than secular, then my CPC estimate will increase and my EPS estimate will likely shoot past $25. If I use Google’s current trading multiple and apply it to the 2010 EPS estimate, then I am looking at a stock worth $500 for another 20% upside. My DCF values the shares at $508 based on a WACC of 9.5% and a 3% terminal growth rate (16x terminal multiple). If the margin benefits discussed above are realized then it is not unrealistic to see a $30 Adj. EPS number in 2010, which would imply a $600 share price.

A quick note on YouTube. My work shows that the online video site is on track to generate $185 million in revenues in 2009 and grow to $250 million in 2010. While I believe the site is unprofitable, recent loss estimates by Wall Street analysts are too aggressive principally because they are missing the fact that YouTube’s costs are spread across Google’s operating infrastructure.
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Bing Paid Clicks Up 8%. Are Ad Budget Shifts Next?

Much has been said about Bing getting a bump in search and impression usage since its launch. But Efficient Frontier has taken it further, claiming that paid clicks on Bing is up 8.1% since its launch versus the previous week.

Importantly, the company believes that if the paid clicks growth holds, then advertisers are likely to shift ad budgets to Microsoft, the ultimate desired outcome.

Has Microsoft finally cracked the search nut? Let’s all wait and see, but if this holds, then both Google and Yahoo!’s multiple has to contract.

In a post several months ago I listed a number of items Microsoft should do to build their search business. See it here Closing the 3 to 65% Gap. Bing, in my view, has addressed a few of my suggestions.


Here is part of the post
"There are a few organic strategies Microsoft could employ that would help it grow share:

1. Change the mindset about search. The focus has been too much on generating revenues when the goal should be on improving the user experience and providing a differentiated product. MSFT’s number one problem is volume. If they improve the user experience then users will come. If users come then advertisers will come. If both users and advertisers come then monetization improves and revenues and profits grow. It is that simple.

Stated differently, to make headway in online advertising, then MSFT will need to significantly penetrate online search. To do so, they will need a steadfast commitment to online search from the CEO on down.

2. More Effective Marketing Strategy Centered on Search. This should be done to convince users that the online search experience and relevance is on par with Google’s. No cute ads like Ask.com which was ineffective and confusing. Just a plain ad that has the aim that search relevancy is on par with Google (provided the claim is true). Several ways to do this: 1) through word of mouth – this can be filtered through the press by attending more search related industry trade functions; 2) through a viral outlet like YouTube; 3) through banner ads on Facebook and other web properties; 4) go straight to MSFT users, which already has the number 2 web property in the world. The aim is to convince users that they do not need to jump off the MSFT pages to Google to conduct searches. In a nutshell, change user behavior through knowledge that their search engine is as relevant to Google and that the user experience is as compelling.

3. Need To Focus On Search Innovation. For the past 4 quarters, Google released 100 search monetization improvements each quarter. Point is they are constantly improving the search product and is letting the world know that or shows it to the world. MSFT should do the same.

4. Change the Brand. “Live” confuses everyone and is difficult to find. Plus the marketing effort behind Live Search was ineffective. Change the Live name to something else. Use either MSN or Microsoft Search as the brand. No need to deviate from the solid brands of those two.

5. Develop More Relationships But Be Careful Not To Overspend. Agreements with Sun, Dell and HP to include the Live Search Toolbar on new PCs, and the much-ballyhooed Live Search Cashback, which gives Web users rebates for purchasing products from participating Microsoft vendor partners through the Live Search site, are good examples. Others like Verizon and Facebook are important in that they create brand recognition. Management should go after MySpace if Google drops it. But management must be careful not to overspend or enter into deals that are uneconomical.

In all, if Microsoft buys Yahoo and in addition follows the recommendations above to grow organically, they will develop meaningful share in online search and as consequence develop a meaningful presence in online advertising.

This is the first in a series of discussions on Microsoft’s Online Services Business (OSB). In subsequent posts, I will discuss strategies for the company in branded advertising/ad agency/ad networks or what they describe as their online advertising platform or the newly created PubCenter, portal and information content products, communications and social networking, and cloud computing efforts.

My reasoning for focusing on Microsoft is because I believe they do have a competitive presence in the Internet space and it needs to be documented, given that it is largely ignored by Wall Street analysts in favor of other parts of the business model."

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DOJ probes possible tech hiring pact by Google, Yahoo, Apple

The The Deal Pipeline (www.thedeal.com) reports that according to Washington antitrust lawyers, the Department of Justice has sent letters to at least a dozen major computer hardware and software companies, such as Google, Yahoo! and Apple. The letters suggest that antitrust division lawyers suspect that some of the targeted companies have agreed not to poach each others' employees, which is in violation of the nation's oldest antitrust law, the Sherman Act of 1890.

Here is the letter courtesy of Marielena Santana at TheDeal.com:

DOJ probes possible tech hiring pact
by Cecile Kohrs Lindell In Washington
Updated 06:13 PM EDT, May-29-2009

New Assistant Attorney General Christine Varney has launched an investigation into hiring practices among high-tech companies.

According to Washington antitrust lawyers, the Department of Justice antitrust division's networks and technology section, led by chief James Tierney, has sent letters to at least a dozen major computer hardware and software companies. Google Inc., Yahoo! Inc. and Apple Inc. are believed to be among the recipients, as is at least biotechnology firm, Genetech Inc.

A DOJ spokeswoman did not respond to a request for comment.

Google spokesman Adam Kovacevich declined to comment on the matter.

The letters suggest that antitrust division lawyers suspect that some of the targeted companies have agreed not to poach each others' employees. Such an agreement, if DOJ lawyers can prove it exists, could be a violation of the nation's oldest antitrust law, the Sherman Act of 1890, which prohibits agreements among competitors that result in restraint of trade.

Although a potential violation of antitrust law, if confirmed the suspicions may not rise to a criminal violation. Sources said the letters appear to be in the form of a Civil Investigative Demand.

The DOJ's staff has been increasingly active since the arrival of Varney and her deputies, who include two top antitrust litigators, Molly Boast and Bill Cavanaugh, and a well-regarded economist, Carl Shapiro, who held the post during the Clinton administration. Another marquee staffer, Phil Weiser, is yet to arrive from his teaching post at the University of Colorado Law School.

An antitrust lawyer said that the DOJ's staff has been authorized to investigate matters that would not have been given serious reviews under prior Assistant Attorney General Tom Barnett.

Varney promised a departure from previous practice quickly after arriving at her post. Barnett, an experienced antitrust lawyer who has returned to private practice at Covington & Burling LLP, the former firm of Attorney General Eric Holder, was criticized by a vocal contingent of the antitrust bar for approving some controversial mergers, including Whirlpool Inc.'s purchase of Maytag and the combination of XM and Sirius Satellite Radio Holdings Inc.

In recent speeches, Varney has invoked the foresight and commitment to antitrust demonstrated by Thurman Arnold, President Franklin D. Roosevelt's pick to head the antitrust division.

Arnold tripled the number of cases the division files, and has drawn praise for helping restore competition to troubled Depression-era markets




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CashBurnBook, I Mean FaceBook

I was listening to NewsCorp's dismal earnings report last week, in which operating income declined 47% YoY due to weakness at all divisions except Cable, and in which CEO Rupert Murdoch declared that the worst of the economic decline is over. FIM revenues, where MySpace's numbers are reported, declined 11% YoY due to 16% lower advertising revenues, due to a reduction of branded and performance based advertising at MySpace.

I have long held that social networking sites will be a challenge to monetize and then a greater challenge to drive to significant profitability. In my NewsCorp model, I have MySpace generating about $630 million in revenues for the year, about half of that comes from Google's disappointing search deal. Most reports have FaceBook generating about $300 million in revenues in 2008. My quick slight of hand calculations, so to speak, has FaceBook's revenues growing about 50% in 2009 to about $440 million.

According to the Compete data graphed below, FaceBook's domestic unique visitor traffic has been on a tier, jumping 250% in April 2009, while MySpace's domestic traffic declined 9% YoY and has declined every month for the past year. My guess is that MySpace's enormous traffic is shifting to FaceBook.



That's all good news for FaceBook. As shown by the following graph, FaceBook's page views have grown enormously, as everyone and their daddy, is now on FaceBook. My 70 year old dad recently requested that I add him as a friend.



But all that glitter isn't necessarily gold. My back of the envelope analysis shows that those billions of page views are digging FaceBook into a big hole and they will likely have to raise a significant amount of capital this year. My calculations show that FaceBook will burn through approximately $250 million in cash in 2009.



Good luck to FaceBook, but those numbers will make it difficult for them to go public in 2010 and they will have to sell out to Microsoft, in my less than humble view.
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YouTube Will Lead hulu in Online Video Indefinitely

With all the talk about hulu edging towards Google, I decided to take a look at the traffic stats, courtesy of Compete, to determine what's conjecture and what's reality.

In my analysis of the unique visitor data, I went back two years on a monthly basis. Instead of comparing growth rates, which are in the high tripple digits for hulu, I decided to look at hulu's (and Crackle) YouTube penetration, meaning hulu's traffic divided into YouTube's traffic.

In August 2007, hulu's traffic was 0.1% of YouTube's traffic. By April 2009, hulu's YouTube penetration grew to 8.9%, a meaningful and envious jump in two years. [All domestic data.]

In April 2009, hulu's unique visitor traffic grew 630% YoY compared to YouTube's 25% YoY growth rate. I decided to extrapolate the growth rates for as long as I could. My analysis showed that in three years, hulu will reach about 30% of YouTube's traffic in three years, and will likely stall at those levels.

Thirty percent will be an enormous traffic level given that YouTube owns the user generated content eyeballs while hulu is only professional content. Yet still, YouTube should feel safe from a competitive position. Now all they have to do if figure out how to make money.

My bet is that hulu's owners spins it out into a public company in about two years.

hulu: Founded in March 2007, Hulu is co-owned by NBC Universal, News Corp. and Providence Equity Partners. It is operated independently by a dedicated management team with offices in Los Angeles, New York, Chicago and Beijing.

Crackle, Inc., a Sony Pictures Entertainment Company, is a multi-platform next-generation video entertainment network that distributes digital content including original short form series and full-length traditional programming from Sony Pictures’ vast library of television series and feature films. Crackle is one of the fastest growing entertainment destinations on the Internet today, offering audiences quality programming in a variety of genres, including comedy, action, sci-fi, horror, music and reality. Crackle reaches a global audience through its impressive online and mobile distribution network.

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Implications of Google's 14% Y/Y Decline in CPC Pricing

Google revealed in its 10K that CPC pricing declined 14% YoY compared to Street back of the envelope estimates of a 10% YoY decline. Google attributed the decline to FX impacts as well as advertisers lowering bids on keywords due to the economy.

It is difficult to quantify which of the two had a greater impact on the CPC growth rate, however, the latter of the two is more important and has a direct impact on Google’s business model.

From Google: “ we believe advertisers managed their advertising costs in response to the general economic downturn….Specifically, we believe that as a result of the general economic downturn, advertisers, in aggregate, have lowered their bids for keywords in response to a decrease in the sales they are able to make per paid click”

Key here is whether this is a cyclical or secular change. If it is cyclical, then this is a positive for Google as advertisers will likely adjust pricing upward as/if the economy recovers. If this is a secular change then this adjustment to Google’s model is a negative and will impact Google’s growth multiple leading to a decline in the stock’s valuation.

Initially, I was inclined to write-off the 14% YoY decline as a cyclical event and nothing more. Supporting this is commentary coming out of Time Warner and New York Times’ (About Group) earnings conference calls that CPC pricing on their respective search businesses actually increased YoY. This was surprising to me given that both Google and Yahoo! reported CPC declines in 1Q09.

Nonetheless, what gives me pause is the precedent secular decline in other ad mediums, namely radio and newspapers. Pricing for those two mediums will likely never recover.

In Google’s case, a permanent deflationary scenario in pricing cannot be ruled out, I believe. My Google model and several other Google models on Wall Street have CPC pricing rebounding in 2010. That assumption, I admit, can turn out to be wrong. Given that volume (search queries) has turned out to be relatively resilient in this recession and that Google owns the volume game now, pricing is the one metric I believe should get more scrutiny.
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Google Should Again Outperform Street Estimates

Google is scheduled to report 1Q09 earnings after the market close on April 16, 2009 and the Street is expecting revenues of $4.117bn (+11% YoY, -2.5% QoQ), EBITDA of $2.409bn (58.5% margin), and Adj. EPS of $4.89.

Given the spate of negative headlines in the quarter, both from Google (product closings, layoffs) and commentary from SEMs that their search business has deteriorated in the quarter, sentiment for the 1Q09 report is subdued, with many expecting a negative sequential decline of 5%-plus for net revenues and a decline in margins.

Despite the negative headlines, the stock has rallied over the past month (March 9th), but that was in lock-step with the resurgence in the overall stock market – the shares are up 28% over the past month compared to a 26% uptick in the S&P500. Thus, the shares haven’t meaningfully outperformed the market.

So what do the key metrics imply for the quarter?

Search share. According to Hitwise, “Google’s market share rose from 72.11% in February to 72.39% in March, while both Yahoo and Live Search saw declines. Year-over-year numbers are also in Google’s favor: It’s up 8% over March 2008, while Yahoo and Live Search are down 19% and 17%, respectively.”

These numbers are domestic but it shows that Google continues to gain share at the expense of rivals. So that’s a positive.

Ad Coverage. This metric ticked down a bit both YoY and sequentially to 45% for both January and February, according to comScore, but still shows a high level of ad monetization existed in the quarter. Another positive.

Paid Clicks. comScore reported that paid clicks increased 22% YoY in January and February of this year, but down 4% QoQ. While that number is domestic and excludes searches on the network, my calculations for international and network suggests that global paid clicks should come in at around 18% YoY, which should represent flat growth from YoY growth trends in 4Q08; QoQ growth should come in at negative 2%. The negative sequential growth suggests that seasonal trends are becoming more visible in the model, rather than just cyclical pressures.

Pricing. Cost-per-click, the second most important metric in the model, should continue to show some level of weakness as commentary from advertisers suggests that they have traded down to less pricey terms. In addition, advertisers are exploring terms in the long-tail, which cost pennies, but at the same time, are more targeted and deliver higher ROIs. While this may appear to be a negative secular trend that may hurt Google’s monetization and revenue growth, the nature of the search model is such that as more advertisers explore long-tail terms, the cost of those terms will increase. This will go on until the term “long-tail” no longer has meaning and will represent the current level of terms, given that a finite level of commercial search terms exists. Thus, Google and the other search engines should not have concerns about the longer-term secular direction of pricing.

In 4Q08, CPCs on an FX neutral basis, decreased 2% YoY and 7% QoQ. Admittedly, this metric is harder to read than the others but data from advertisers have suggested continued negative trends. Further, there has to be less finance companies bidding on terms, and there is chatter that travel companies have pulled back spend on top-level travel terms – both should put pressure on the metric. Nonetheless, I do not anticipate a huge negative number in 1Q and I am modeling in a 4% YoY decline in CPCs for the quarter.

Revenue, Margins, EPS. Taken together, the 18% YoY growth rate in paid clicks and the 4% YoY decline in pricing should lead to search revenue growth of 14% YoY. Contribution from the other buckets (DoubleClick, YouTube, licensing, Postini, etc.), will not be meaningful enough to have an impact on the overall growth rate, so I am estimating 1Q09 YoY revenue growth of 13-14%, which is ahead of consensus growth of 11%. QoQ, my YoY estimate suggests a revenue decline of 1%.

On EBITDA, I am expecting a margin of 59% for the quarter, down 100bps from 4Q08 but up 50bps from 1Q08. My Adjusted EPS estimate is $5.00.

Valuation. The shares are trading at 17x ’09 Adj. EPS and 15x ’10 Adj. EPS, multiples that are below Google’s historical forward EPS multiples and below the long-term EPS growth rate. So despite the 28% run-up in the share price, the shares are still cheap on an absolute basis. On a relative basis, the shares are significantly cheaper compared to Google’s Internet brethren such as Yahoo!, Blue Nile, Amazon, Netflix, etc., all of which are trading at multiples north of 30x ’09.

My DCF produces a fair value of between $450-$500, depending on assumptions. Wall Street is forecasting a $24-$25 earnings per share figure in 2010. Lets say a $25.00 EPS. If we apply the current multiple to that figure (the most conservative method), we get a $425 fair value, which is still a 15% upside potential. Bump that target multiple up to 20x, which is reasonable and implies a PEG of only 1.25x, we get to a fair value of $500, which is a 35% potential upside. Hence, I am looking at a 15-35% potential upside in Google’s share price over the next 12 months. I’ll take that and will hold onto my shares.


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The Math On Software Maintenance Revenues

I noted previously that maintenance software revenues are supporting software profits and valuations, a view shared by JPMorgan analyst John Difucci. In his last published report, he walked though the math on how software maintenance revenues supports that thesis.

Again, I thought his report was excellent and well thought out and his graph and write up brings home the point as to why I believe that software stocks are one of the best investment tech sectors next to Internet stocks.

Here is a snapshot of his view:

"The power of the typical perpetual software model can be demonstrated with an example. In Table 2, we look at a typical enterprise software company, with about $200 million in total revenue in 2008, of which 50% is license and 50% is maintenance. Ignore any professional services at this point for simplicity’s sake.

Note that professional services have lower margins than maintenance and are likely driven by previous license sales. Professional services may provide a lagging component of the software segment, but from an accounting perspective, they often have little impact on the change in the bottom lines (and sometimes even the top lines) of most software companies. In addition, we provide a spreadsheet for investors to examine this model on the Morgan Markets website.

That said, consider the following development of our example:

• Dramatic license decline of 25% in 2009, then less declines for a couple of years before some growth returns.

• Normalized maintenance renewal rates of 95%, which decline to 90% in 2009, slightly improving to 92% in 2010, before returning to normalized rates thereafter.

• Initial average pricing pressure of 3% on maintenance starting in 2009 and lasting for a couple of years, before declining to 2% pricing pressure, and then is eliminated.

• Maintenance Margins of 85%

• License Margins fluctuate based on License Sales



Even for the above scenario, after license declines in three consecutive years (the first of which it declines by 25%), coupled with pricing pressure and reduced renewal rates, maintenance still never declines. In addition, since the overwhelming majority of profit is derived from maintenance revenue (not license revenue), total profit only declines in 2009, and increases every other year.

Note that in this example, we assumed license came in evenly throughout the year (which is typically not the case, it’s usually back end loaded). Given the ratable recognition of maintenance, only half of the annual maintenance signed is recognized in the year it is signed, with the remainder recognized in the subsequent year."


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