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September 18, 2004

Is Google Froogle?

As Google (GOOG) hits its all time high today, of over $117 a share, the updraft is likely to suck a number of punters sitting on the sidelines into the game. For many of these investors, there is no rational argument; for them its enough that Google emerged from nowhere to become one of the world's most recognizable brands in a few short years, to become everybody's favorite search tool and that it has now established market "momentum". If you bet this way, you will be tempted to jump in now and ride it up to say 150, picking up your profits along the way. Good Luck!

Hidebound value investors will see the activity at GOOG as the kind of bubble folly that brought billions of losses to investors in AOL, Yahoo, Amazon, Nokia, etc. who jumped in for a ride in irrational exuberance. No company, they argue, can sustain a P/E of 160 or a market capitalization 33% higher than venerable General Motors. Folks who poohed-poohed that kind of sage advice in the past, will listen with one ear, as they might when getting admonished by a rich and comfortable uncle, all the time looking forward to visions of laughing all the way to the bank.

From where we stand, Google has proved itself an amazing company and certainly deserves the success it has received so far. Unlike, EBAY, perhaps the greatest Web success story, GOOG relies strictly on intellectual property, or sheer brainpower. This is the source of our great respect but can you make an economic case for a company that makes its living by weaving its presence into what is actually a dynamic cloud, the great information pool that is the World Wide Web?

So first, the economic arguments: does Google meet the fundamental economic criteria, a marketplace big enough to sustain huge profits over a long period of time and a sustainable position of dominance within that market? To the first question, we can respond, unequivocally, yes. Here's why Google's potential market towers over that of EBAY and even Amazon, two companies that have also both successfully multiplied their presence across Cyberspace. But EBAY's and Amazon's limitations, to a certain point, are mainly physical. Certain items, like Pez boxes, lend themselves to shipment purchases. Other larger items, and big ticket items bring much greater hurdles to an EBAY transaction. What do you do with the 500 lb. home gym set you just bought on EBAY if it turns out defective? So the dealer agrees to take it back. You're still stuck with repacking, shipping and the hassles involved in any returned transaction. Of course, you can tarnish the vendor's reputation and thereby protect future folks like yourself but still. So, EBAY, as great as it is, has some limitations.

Amazon is also terrific at what they do. By teaming with used and rare book sellers, home reviewers, etc. they provide a powerful service and for a lot of items, Amazon beats going to the local bookstore. Amazon has also been quick to take advantage of the dynamic Web in profound ways that range from sophisticated software that makes recommendations based on purchases by other people who match your eclectic tastes to affiliate programs on various special interest web sites to services like Alexa which attempts to determine interest movement as it pulses through the dynamic web and, oh, by the way, match that interest with items that can be purchased on Amazon.

The power of Google is different, and in our estimation, degrees above that of the two successful companies that emerged from the last wave, should Google dominate. That's because Google has inserted itself into wired peoples' lives in a more profound way. Because of the absolute simplicity of its user interface --often just a point on a bar at the top of your browser-- Google takes almost no effort to access. It has become as simple as turning to somebody, perhaps a bit opaque but amazingly wide-read standing next to you and asking whatever it is that you need to know for that moment.

"Okay," some of you ask: "I see the power and reach but where's the economic model?" The answer, of course, is apparent: much of what people want to know determines how and where they will spend their money. In other words, if you can ask Google where you and your friend might find a restaurant that serves traditional Iranian food and that is located within 10 blocks of the SoHo bar you are sitting in, and it gives you via survey result, a review and some pleased customer comments something that sounds reasonable, your mind just might get made up. Along with the results, which may or may not be satisfactory (since, often the information you looked for, may not exist in a way that GOOG can understand it) you will get advertisements by restaurants that match the profile of your search. Google will pass those paid advertisements along with the list of hits.

We will, sooner rather than later, all carry around cell phones that allow web browsing. It's already part of the Cybersphere and will only get more ubiquitous. Meanwhile, those of us at our desk tops will use that time to do our research though a few degrees away from real time. We'll continue to want to know as much as we can about what we plan to consume. Is it any wonder that companies like Verizon are quietly selling off their still extremely profitable Yellow Pages businesses?

Google's power, as we said, is purely in the algorithms buried in its software. GOOG can take what were once called natural language queries and turn them into sophisticated results. To be accurate the software needs to be constantly crawling the web looking for updated information. The real magic at Google occurs in it's evaluating the relevancy of the site information it points you to. For this, the engineers at GOOG constantly fiddle with algorithms designed to measure that relevancy. Roughly speaking, Google software measures, for instance, the value of a particular source using its knowledge of how many sites point in and out of a particular Website, thereby calculating the relevancy and topicality of those sites as part of the weighting. The evolving thinking that goes into these measurements represents, of course, the crown jewels, of the company.

In other words, that's the great caveat emptor of this equation. With so much at stake and with GOOG so clearly ahead in a multibillion dollar advertising business where the sky is the limit, will somebody cut it off at the pass?

That's why companies like MSFT, YHOO, and AMZN et al. will put huge resources into this space. The real question for the long run is whether Google can keep its lead. The history in high tech is that when a company reaches a certain dominant position it becomes nearly impossible to dislodge it. When it comes to search, has Google crossed that threshold? That's a question only time will tell.

Posted by dymaxion at 12:58 PM

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June 25, 2004

The IPO Revival?

In the wishful thinking department there's no grease like easy money when it comes to the skids. So what's the deal? Are we likely to see a revival of IPO's as is being promised by a number of financial journals since Google decided to take the plunge? The answer, of course, is an unequivocal no! It takes the absolute height of a boom for new public companies to appear out of whole cloth.

So that's not the question we are going to deal with here. Let's, instead, examine what it is that makes the IPO market so attractive to ordinary investors and what they really ought to expect. The first thing to understand is that in IPO there are actually two broad markets, one pre-IPO and the other after the event. Needless to say, nearly all the big money is made in the "pre " market and most of the big money lost occurs in the "post" market.

So, what is it good for? Let's start with the positive: in investing high risk needs to be rewarded by high reward. In other words, if the kid down the street invites you over to his garage and gives you a demo of her latest hot idea and then asks you to throw some of your hard earned bucks behind it, well, your real chances of a payback are, let's say, infinitesimal. You're an "angel " in the vernacular and chances are your only reward will occur somewhere in the hereafter. VC's are supposed to be a little smarter, having been around the block a few times, and although they stick their own necks out, often they are mostly playing with other peoples' money.

Still, without them, most start-ups wouldn't ever get off the ground and the most dynamic part of our economy would probably end up like the hairy mammoth. In Europe, where VC's tend to play a much smaller role, it's the government through grants and subsidies that helps float new businesses. Whatever you think of politicians, and perhaps you have a higher opinion than we do, that's no way to seed an economy. A raffle would probably work better. And so, for all their warts and the distortions they often bring into play, let's grant that VC's take big risks and thus, on balance, deserve the rewards they pull out of the system, even if it comes out of the hide of the ordinary investor and often that of the founder(s) and early employees.

Because VC money is often crucial at an early stage and through the long voyage across the chasm, they wield enormous bargaining power. Founders often find themselves giving away much of their stake in order to keep the ship afloat. The VC's understand the game; lousy and mediocre ones often so distort the navigation system and ballast that long odds become impossible. Founders, of course, deserve the big payoff if it ever comes. They often spend years in the desert, scrape and claw, overcome enormous odds even before they have their first employee. Early employees also deserve major payoffs if the company does overcome the odds, and going public is one way this happens. Most start-ups rely heavily on stock option plans to hook and retain technical and managerial talent. There are a lot of problems associated with these plans but even here, on balance, the potential payoff does help early stage companies make it across that difficult period that Geoffrey Moore described as the "chasm ". Without them, it would get a lot harder to succeed.

But even here it's important to note that most employee stock option plans are written by the VC's and law firms who understand the process a lot clearer than your average guy, even in Silicon Valley. Plans commonly tie employees' hands at critical points by requiring long vesting periods and locks on when option holders can finally sell the vested shares they think they own. There are also cash flow, timing issues and tax traps, namely the AMT, that can turn paper profits into humongous tax liabilities. When it comes to stock option plans, they ought to be stamped like cigarette packs with a big caveat emptor.

Most companies never make it to the IPO stage and this may be a good thing for everyone involved. That's because IPO's are extremely expensive and time consuming. A company's management, often at a very critical moment (are there ever any non-critical moments for a new company in a hot, emerging market? you might fairly ask) becomes practically a prisoner of the IPO process for a period that can easily cover a year's time. Instead of worrying about competitors, business, critical research and development, they are thrown into a world of lawyers and bankers whose demands are all consuming. The founder and his chief managers get sucked into every facet, including the authoring of the prospectus. What's sometime worse, is the demands that the underwriters make on the company. Lean companies are required to beef
up their management rolls, often throwing delicately balanced team relationships into turmoil. Where everything was held to together by sweat and blood, now appears a new force, the suit with a resume. What's worse, these resume guys come straight out of central casting and have hefty demands that include big chunks of stock options further throwing delicate internal relations out of whack.

Then there's always the temptation to start the PR wars. Companies that once bargained hard for business cash flow considerations now abort the process so they can announce another deal, another strategic partner that looks good on paper. There is, in fact, nothing more contorting to the workings of a young company than the IPO process, as glamorous as it sounds.

Another longer term downer is the transparency that being traded publiclybrings to a company. Aftermarket stockholders have been given unrealistic expectations, and, as we will get to see, have almost by definition, terribly overpaid for those expectations. Now the company is expected to show its results for all to see on a quarterly basis. This usually means goodbye to strategic thinking, long term planning and hello to the world of gimmicks and skirting the law.

Let's remember that all of the pre-market players up to the underwriters and their friends do not require an IPO to get their rewards, a buyer with a good offer can come along and often do. Big companies are usually failures at creating really new business units and the smart ones know it. What they have is market power, management skills and resources. For them, the equation is a simple one. Sit around, wait and see who emerges and then scoop up the tiny percentage of winners at what seems like a premium price. Investors and unromantic prospective employees should be aware that companies where the founder is a major stockholder are not likely to get sold until it's too late and the premium has long been taken off the table. It's a matter of ego. This gal or guy has come up with the idea and pushed it along against all odds. Now, just when things are finally starting to take off the chances are that this same personality is going to imagine him or herself to be the next Bill Gates. Sell?, lose control?, not likely no matter how sweet the offer.

So who really benefits, the post market guy who buys the shares in the public market? Not likely. The sweet spot occurs right at the intersection
with Wall Street with the investment bankers. These guys get paid just for showing up and doing the work of launching the IPO. Further, they are the only ones to get to buy a lot of "unrestricted shares " still at the pre-market price, which, even in a hot market is equal to having the keys to the government printing presses. They get to reward friends and punish enemies and leverage this sure money to establish their power over the market. So, it's no accident that this is where all the shenanigans occurred in the late lamented last hot IPO market. A few companies like Morgan Stanley and CSFB got the lion's share of the market and they are, by the way, the same ones that are still in negotiations with the government as what the fines they are going to pay are going to amount to.

So if you are one of these investors who can't wait for the next IPO, take the word "laddering " and role it around the cobwebs of your brain. One of the things these companies are being fined for is the practice of "laddering ". What this means is that in order for a pre-public market investor to get his quota of shares, he had to promise to come into the public market on the first day and make a purchase at post market prices. Now why, you might ask, would anyone who got his shares at, say $15, want to buy more at say, $30. Well imagine what it does to the market to have a whole bunch of people coming in and boosting up the price right at this critical market when Mr. ordinary investor is beginning to lick his chops. Prices soar the first day, the headlines scream and lo and behold here come a whole other bunch of suckers in the second day. Now you got a Ponzi scheme.

Now if you've also got the megaphone of the press and the cheerleading of supposed analysts into the mix, you've got a bubble, baby! Are we anywhere close to an IPO revival? We don't think so. First, there's no next big thing. But that's a story for another day.

Posted by dymaxion at 06:16 PM

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June 07, 2004

A Wealthy Dose of Skepticism

Yes, you guessed it. That really does look like a leathery Alfred Hitchcock.

In fact, it's his death mask. Hitchcock was a man of many talents and always had that bemused air of a man who knew just how foolish the human drama can be, particularly when the actors begin to imagine they somehow know what the author has in mind for them. Hitchcock actually had a knack for building up the suspense; by layering in quick cuts, focusing the audiences attention on seemingly key details and fogging things with a trail of red herrings, the master of suspense was able to lead us towards the climax without letting on to the real secret, his secret.... things were not going to turn out quite the way we thought.

Hitchcock created a kind of Daliesque clockwork universe. He used to say that the actual shooting of the film was a kind of bore. He had already imagined every scene in his mind's storyboard-eye.

At the dymaxionweb we have the habit of following the news every day. It rolls past us hourly like the pieces of a mosaic settling back into the atmosphere after having been scattered by an immense cataclysm. The suspense builds: deficits grow, people starve or get killed, the money printing presses roll at an ever quicker pace (M3 in the US up 20% in the last three months) jobs are created, oil prices go up and down, house prices bubble, stocks dip, the dollar bumps up.....

This past week we were "entertained" by tapes of Enron energy traders joyfully manipulating millions of Californians as they worked the levers that drove the prices of energy to obscene heights. The rolling blackouts they caused resulted in accidents, deaths, company shutdowns and millions of hours and dollars wasted for the benefit of a few inside pockets. So much the worse, we say, and move on to the next scene projected by the news machine.

Some people will pretend they have it all figured out. They'll gladly sell you their formula. Instead, we think of folks like Ivan Boesky, the highly successful arbitrageur. No seasoned trader would need to rely on illegally obtained inside information if the markets worked in predictable ways nor would all those same experts with fool-proof investing schemes sell their secrets so cheaply if those secrets really could beat the markets like clockwork. No, dear reader, it doesn't work that way. So the next time you get a hankering about a sure thing and decide to roll the whole wad, think about our Hitch perhaps sitting not too far from the shoulder of the market Gods.

And for all those investors who are planning on a long-term income of 20% a year from the stock market (don't laugh, a recent poll of ordinary investors revealed that as their reasonable expectation), or from any other market they are not manipulating, we acknowledge our admiration and wish them the best of luck.

Posted by dymaxion at 02:07 PM

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