The Most Significant Thing Google Did In 2005

I finally found some time to read the 2005 Google annual report.  I recommend any investor to get in the habbit of reading such documents (10-K's, 10-Q's), because they give you the real story behind a business, not to mention a birds eye view of what's going on that's not easy to see following day to day news.  If somebody had asked me, "what's the most significant thing Google did in 2005?" I would have said a whole bunch of things, all of which would have been wrong, but reading the annual report makes clear what the right thing is.  I'll get to what I think is the most important thing later, but first I want to mention a few things that caught my attention.

1) In 2005, Google bought 15 companies for a total of $85M.  That's less than $6M per company, and a scary number for VC's who are investing in Internet companies with hopes to sell them to Google.  They'd better be really, really capital efficient :-)

2) Top competition is Microsoft and Yahoo.  No surprise here.  But we know what Microsoft is doing about is, you may have seen Steve Ballmer's "advertisers, advertisers, advertisers" video.  They want to get a hold of all the advertisers and choke Google there.  Again no surprise.  What's surprising to me is that nobody know what Yahoo is doing?  Are they doing anything?

3) Google did $6.1B top line, $1.5B bottom line, but increased it's cash position from $2 to $8B.  They did that by raising $4B in the secondary offering.

4) They spent $483M on R&D but spent $1,417M on property and equipment, not counting depreciation.

Point #4, makes me conclude that point #3 is the most important thing Google did in 2005.  It's raising that $4B.  Why?  Because it gives them a war chest that Yahoo does not have.  In 2005, Yahoo generated $600M in cash, and Google generated $6B.  This could spell disaster for Yahoo, if Google starts to force them to spend capex at a rate that they can't keep up.  While Yahoo tries to keep up with Google coming up with products, they may lose the game if they can't bid for the data centers like Google can.  They may lose the war by losing the hardware battle, not the software. 

I have a lot of respect and admiration for the products Google is building, but if somebody asks me what's the most important thing Google did in 2005, the answer is the secondary.  Obvious as it sounds, I bet it wouldn't be the first thing most people say.

Comments

[Christian Cadeo]

Interesting point and same thing I was thinking when the secondary was annouced. It seems like this whole paradigm of lessing cap ex spending by internet companies was a fallacy.

Question, for you. Being an investor in yhoo, what do you recomend their strategy would be to counter the warchest of goog and msft? Obviously a secondary is out of the question with the low price. In addition, if we are in this new phase where these companies need a warchest, why in the world would yhoo continue to do share buyback? Wouldn't it of been more prudent to not do it or unless they are going to use the shares bought back as currrency?

[Dimitar Vesselinov]

"...what do you recomend their strategy would be to counter the warchest of goog and msft?"

You don't have to build this kind of infrastracture. Think P2P, BitTorrent...

"A peer-to-peer (or P2P) computer network is a network that relies primarily on the computing power and bandwidth of the participants in the network rather than concentrating it in a relatively low number of servers."
http://en.wikipedia.org/wiki/Peer-to-peer
http://en.wikipedia.org/wiki/BitTorrent

[Kevin Dewalt]

Great post and interesting point about Google spending less than $6M/company. Wow, maybe the SW industry really is dead for institutional investors.

On the "war chest"...two quick thoughts...

-First, on a Free Cash Flow basis the results between Google and Yahoo don't look as bad. Yahoo threw off $243M of FCF during the first quarter while Google threw off $480M. While the Google results are almost twice as high, the difference probably won't allow one company to massively outspend the other on CapEx over the long haul. These expenditures have a diminishing rate of return at some point. If Google starts dipping into its "war chest" so significantly to drive FCF lower or (*shudder*) negative for more than a quarter or two, the stock will get crushed.

-Second, if the search industry comes down to a capex game we already know the winner. There is a software company in Redmond that produced $2 Billion in FCF last quarter and is sitting on a $35B war chest. Fortunately for entrepreneurs, VCs, and consumers, the war seems to be waging over brand, service, talent, innovation and not capex.

Still, I definitely agree that Yahoo should be nervous about a tactical spend-war that might hurt both companies' valuations in the short-term while giving Google an uncatchable lead.

[baris]

Christian,
Don't have a good answer for you. They have change the rules of the game somehow and surprise Google. You can find a powerpoint of their strategy from their analyst day here.
http://www.aventureforth.com/2006/05/19/understanding-yahoos-grand-plan/

Dimitar,
Does Yahoo currently use any of this? They still need data centers and computers and bandwidth. It will have to be a big change for them.

Kevin,
On a quarterly basis, 2X more cash is still significant for Goog vs. Yahoo. Microsoft is the big question here, and you have a point. What are they doing sitting on the $35B in cash? I hope they have somebody there who can think big. My guess would be that they will give such a good deal to advertisers, and make them exclusive to them.

[Vladimir Miloushev]

Baris,

You are right - the game has become about capex. The problem is that today's online application companies like Google, Yahoo, eBay and Amazon, and even Salesforce.com, are vertically integrated. We have seen this before - there used to be a time when to make a chip you needed to build your own foundry, and the company that spent most on foundries usually won.

We all know how that ended. The fabless model came along, with a few specialized "foundry providers" like TSMC ready to manufacture chips for everyone. Without the need to spend their way up, hundreds of semiconductor startups got founded and funded, and some made it big. Most of the chips today are made by companies that don't own foundries. Owning a fab is no longer a competitive advantage - just a drag on the balance sheet.

Now, TSMC had to invest in a foundry in order to make this work. In the case of web applications, you don't even have to do this. The hard assets are already in place - they are operated by existing hosting providers. A large hosting provider like EV1 or The Planet today operates 20,000 to 30,000 servers, which is in the same ballpark as Google. The only problem is, there is no easy way to run a scalable web application on them.

At 3Tera, we have solved this problem and are enabling the fabless model for web companies. Take a look at our website for a sneak preview of what's coming. The next Google will likely grow to 100M users without owning a single server, just like Broadcom doesn't own foundries and Cisco outsources all of their manufacturing to Flextronix and Sanmina.

[Babak Azad]

Here is an interesting article about one big thing Google is up to - but it's apparently not very public just yet.

http://www.iht.com/articles/2006/06/13/business/search.php