Google @ $165
Are These Guys For Real?

Four months after the IPO, Google's stock has soared, the company is selling scads of online ads—and its bosses realize it has to grow up fast.

By Fred Vogelstein

November 29, 2004

Jon Gales loves Google, but not for the reason you might think. It's a terrific search engine, sure, but what Gales really likes is that Google is making him money. Gales's website, Mobiletracker.net, is a compendium of news and reviews about cellphones that after a year and a half attracts about 200,000 users a month. Google supplies the ads for the site, visitors click on the ads, and because of the site's popularity, Google sends Gales monthly checks of $5,000 or more. That's a decent chunk of change for any sole proprietor. But for Gales, the numbers are eye-popping. He's only 19 and lives expense-free at home with his parents in Tampa, posting four or five items in the course of the day while parked on the living room couch with his laptop. Says Gales: "If things keep going the way they are going, I'll be making more money than my dad next year."

Google is making money for lots of people these days, whether they're tiny website entrepreneurs, giant corporations like the New York Times Co., or the legions of shareholders who have seen Google's stock price roughly double in less than four months. (It was trading around $175 [in mid-November], but $165 is a round number many analysts have used in valuation models—and a level the volatile shares have yet to dip below in recent weeks.) From its humble beginnings in Larry Page's and Sergey Brin's Stanford dorm rooms six years ago, the company has become the latest mecca for clever engineers and a $2-billion-a-year growth machine.

Last quarter Google's Ebitda, Wall Street's proxy for operating income, totaled $321 million, vs. $322 million for nine-year-old eBay, $260 million for ten-year-old Yahoo, and $114 million for nine-year-old Amazon. Google is much smaller than those fellow dot-coms but is growing faster. Its sales and Ebitda each doubled last year and the year before that. Google's operating profit margin, at more than 60%, is bigger even than Microsoft's at its peak. Such virtues, revealed for the first time during Google's public offering, made the August IPO one of Wall Street's most eagerly awaited births ever. And sure enough, Google has emerged as a robust baby. By happily continuing to buy the stock despite a P/E ratio on estimated 2004 earnings of 65, investors are betting that this newborn is destined for a long, lusty life of fat profits and fast growth.

But the doubters—and there are many—point to shadows in the nursery: questions about Google's geeky, dot-com-era management style and the possibility that it can't cope with growth; recent sales of stock by insiders and other major stakeholders (including Time Warner, FORTUNE's parent and owner of AOL, which lately unloaded $188 million worth); and increasing pressure from Microsoft, Yahoo, and other formidable rivals that would like to crush this infant in its crib. Far from hailing Google as the next eBay or even the next Microsoft (search the web on that phrase and Google's name does come up), the skeptics see Google as just the latest dot-com-bubble stock. Who is right?

FORTUNE recently spent weeks interviewing current and former employees—CEO Eric Schmidt was the only current employee who spoke on the record—as well as analysts, customers, and rivals, and this much is clear: While the company is still extremely young and the valuation question is ticklish (we'll come back to that), Google is shaping up as a real Internet powerhouse. It's doing so by staying ahead of its rivals in its core search technology, installing a grown-up management team, and becoming a dominant force in online advertising. Seth Godin, a well-known online advertising consultant and former Yahoo employee, used to be dubious about Google's prospects. Not anymore. "They were right, and I was wrong," he says. "They've created the first new and effective ad medium in 50 years. It's brilliant."

Even if Google isn't the next Microsoft, it won't be the next Netscape either. The odds are, whether you believe in the recent run-up in the stock or not, Google will be a player. Mary Meeker, Morgan Stanley's Internet analyst, has been calling Google the "eBay of information" for three years. She may be right.

For starters, take a look at how rapidly the company innovates to stay ahead of its rivals. Back in the day, Wal-Mart figured out among other things that constant improvement of inventory-control systems would get merchandise on and off the shelves faster—and result in lower prices. (Everyone sold the same dog food and batteries, after all.) Intel constantly improved its processor speed; Dell innovated by, for instance, constantly improving its efficient manufacturing and distribution systems. Google works in a similar way by constantly tweaking its signature search product and all its offshoots at a rapid rate. It might not have the impregnable wall against competitors that its blue-chip peers in tech have—digital auction house eBay with its network effect or Microsoft with its desktop monopoly—but it's trying to build something comparable through quick and easy-to-use innovations that keep surfers coming back.

In the past year the company has rolled out no fewer than a dozen tasty online search improvements designed to build traffic. Its Gmail service gives users an e-mail address plus a gigabyte of free online storage and the ability to easily save and find old messages and files. A new desktop search feature lets you locate information on your hard drive as easily as Google lets you find it on the web. Google SMS allows limited searches from your cellphone—whether it has web access or not. And it's not just the Western world that Google wants to win: This fall the company augmented its tool to allow translation back and forth of web pages written in eight languages, including Chinese.

The product parade isn't just about techies showing off—it's a matter of survival. Yahoo, Amazon, and Microsoft have all rolled out search products this year; each tries to outflank Google in a unique way. Yahoo now not only lets you search the web but also includes a "local search" function, enabling you to quickly zero in on, say, a nearby bar. Amazon lets you search inside books, affording free access to a world of copyrighted material that doesn't appear elsewhere on the web. Microsoft's MSN Search combines web searching with a function for everyday factual questions. ("What's the population of Iraq?") It draws on Microsoft's Encarta encyclopedia and other databases and reflects the hundreds of millions of R&D dollars the Redmond giant has invested in natural-language understanding. Microsoft makes no secret of its wish to unseat Google as the search king. Indeed, at Microsoft's annual shareholders' meeting in November, CEO Steve Ballmer insisted, "We will catch up, and we will surpass" Google.

So far, Google has fought off Ballmer and other challengers. A year ago some industry watchers speculated that Yahoo's new search engine would displace Google because Yahoo had 157 million registered users—and since Yahoo knew more about the people using its search engine, it could offer better-targeted advertising. Instead, Google gained ground against Yahoo in search this year, according to Safa Rashtchy, a Piper Jaffray analyst. "Just look at the growth of search revenues at each company," he says. And it is working hard to develop a more personalized relationship with its users. Take Gmail: With the e-mail service, not only does Google have a quick way to easily reach its millions of subscribers, but it also scans the contents of their e-mail box to send out targeted ads. Or perhaps you've signed up for Google news alerts—another innovation launched this year that lets you filter articles from Google News for automatic delivery to your e-mail address. Or you use Picassa, a desktop photo organizer Google acquired this summer, to send pictures to your family. Both let Google know where to find you.

Why Are They Afraid Of Google?

Knowing where to find you—and then learning more about you—isn't a small thing. It is, in fact, the Holy Grail of web commerce. The more Yahoo, Microsoft, and Google know about you, the more targeted and more valuable they can make their searches and ads. And if Google's Wall Street fans are right, advertising is what will power Google into eBay's league. Already every major financial services firm, airline, and automaker, as well as hundreds of thousands of other businesses, hawk their wares on Google. The formula is simple. When you search for information on your favorite Caribbean isle, Google makes sure you see travel-related ads, not ads for house paint. Advertisers are charged only when you click on their ads—something Google users prove remarkably willing to do. Google today captures a whopping $1.9 billion of an estimated $10 billion spent annually on online ads. It's also rocking the offline world of direct mail and Yellow Pages advertising, both of which have seen steep declines.

Google keeps the innovation machine chugging in its online-ad business as well. Ads are sold primarily in two ways. The ones that appear on all its search sites—which span the Internet in 104 languages—account for the bulk of its revenues, some $1.5 billion a year. But Google also licenses its search and targeted advertising setup to other sites. If you go to AOL, the New York Times, or the Washington Post websites and do a search, you are using Google technology and seeing Google-generated ads. It also places ads for much, much smaller media gurus like Matt Daimler, a 27-year-old networking engineer in Seattle. Two years ago Daimler got so frustrated with getting bad seats on long business flights that he started Seatguru.com, which collects and displays information about the best and worst seats on airplanes. The hobby became a business when he and his wife added Google ads to the site. Days after they had signed up for the service, Google began sending scads of travel-related ads their way. The company takes a cut of the ad revenues—it won't tell guys like Daimler (or us) how much—and sends the rest as a monthly check. The ads turned the site into a $120,000-a-year business.

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