Corporation

Strategic Report

Matthew P. Lubman Douglas J. Leavitt Shimon Jacobs April 20, 2005

SageGroup, LLP 1 Google Corporation

Table of Contents

Executive Summary ...... 3

Company History ...... 4

Competitive Analysis ...... 6

Financial Analysis ...... 8

Strategic Question...... 15

Conclusions ...... 27

SageGroup, LLP 2 Google Corporation

Executive Summary

Google is in an excellent position as the 2nd quarter of 2005 begins, with strong products, strong revenue growth, and excellent strength in internet advertising markets. Yet the company’s total dependence on advertising (the source of 98% of Google’s revenue) is somewhat problematic. To reduce its risk profile, Google needs to do something to diversify its revenue streams. The most sensible way for Google to do this is to become an “internet conglomerate” and enter businesses like internet telephony and the operation of non-search based websites.

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Company History

Google was founded by two Stanford University computer science graduate students, and , who began working in 1996 on a better way to do internet searches. The technology that drives Google today was completed in

1998, and Larry and Sergey attempted to license it for to the portal companies, as they were not interested in starting a business themselves. When all of the portals turned them down, they decided to go at it alone. www.google.com went live on

September 7, 1998 and, fuelled by word of mouth and some good press clippings, it grew astronomically. Less than a year later, Google received $25 million in funding from some of the top venture capital firms in Silicon Valley, showing that they had really arrived on the internet scene.

This was only the beginning for Google, however. The portals that had spurned Larry and Sergey only a few years earlier suddenly realized that they needed Google’s superior search technologies. In June of 2000, Yahoo! and Google announced a partnership where Yahoo! licensed Google’s search technology to use on their own portal. In the same year Google introduced AdWords, the paid-search product that now accounts for the vast bulk of the company’s revenue.

Over the past four years Google has introduced a variety of new products and features, including , , Google Image Search, and “Google In A

Box,” which allows corporate or academic intranets to use Google technology to search their own networks. Google’s R&D arm, Google Labs, continues to churn out new products on a fairly regular basis.

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Needing more cash to grow the business, Google made the momentous decision to go public in the summer of 2004. Eschewing the conventional IPO process, Google decided to retain the boutique investment bank W.R. Hambrecht to underwrite an auction-style IPO, where the price of Google shares would be determined by what the market would tolerate. This effort to maximize the amount of cash raised in the IPO backfired, however, when a hailstorm of negative publicity around the IPO resulted in an auction price lower than Google’s management had hoped for. Since the completion of the IPO, however, Google’s NASDAQ-traded stock (NASD: GOOG) has skyrocketed, having more than doubled its value in less than 9 months. With Google Labs humming and the paid-search market showing exceptional strength, Google looks to be in great shape as 2005 begins.

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Competitive Analysis

Internal Rivalry Google right now is in a dominant position within the search business. While Yahoo! competes with Google as a full-service portal, Google holds a major edge within its specialty of search (44% share versus Yahoo’s 31%), and is slowly offering new services (such as and Froogle) to compete with Yahoo. In contrast, Yahoo has not moved aggressively to change the perception that its search features are inferior to Google’s, nor has it invested heavily in developing new search technology to match that of Google. Yahoo seems to view search as more of a side- component of a full portal strategy as opposed to being the centerpiece of the website. Similarly, Microsoft (the #3 player in search) does not have particularly robust search technology but benefits from the popularity of its MSN portal site to generate some searches.

The #4 player in search, Ask Jeeves, seemed like a non-issue for Google’s future until it was purchased by IAC/InterActive Corp, media mogul Barry Diller’s internet conglomerate. While nobody knows if being connected to Diller’s internet empire will help revive Ask Jeeves’ moribund market share (a distant 4th behind Google, Yahoo and MSN at 5.1%), it makes Ask Jeeves a competitor to Google worth thinking about.

The Google Network product features no serious competitors at this time.

Supplier Power No supplier of components holds any material power over Google.

Buyer Power Search-engine consumers do not pay Google directly and therefore have no power over Google. There is no evidence of buyer power for Google Network customers, though it is theoretically possible.

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Threat of Entry This is a very major issue for all of Google’s products. Google was a small tech startup that stole share from Yahoo! and the other portals in a very brief period of time because it had better technology. Similarly, an unexpected startup with a great new technology could arise at any time and surpass Google’s search technology.

This is not the scenario that keeps big Google investors up at night, however. That distinction belongs to the scenario where one of the most competitively successful firms of the past 25 years, Microsoft, opens up its wallet and throws money around to design a dominant internet search technology that is integrated into the new version of Windows (codenamed Longhorn and currently scheduled for release in 2007, though that date keeps getting pushed back) While Google bulls rightly point to Microsoft’s repeated failure to develop a dominant presence on the internet as evidence that the threat of entry from Microsoft is not catastrophic, the reality is that a robust search engine built into Windows is a serious threat to Google. It is also possible that Google will be bailed out by antitrust law, as a court might see this as illegal bundling by Microsoft in violation of the restrictions set on the company by its antitrust defeat at the hands of the government a few years ago. In the opinion of the SageGroup internet team, any robust internet search product bundled with Windows would constitute a violation of Microsoft’s antitrust settlement, so we will not spend much more time discussing the threat of entry by Microsoft.

Entry is an even larger problem for the Google Network. While the Google Network currently competes with a wide variety of banner and pop-up advertisers, it holds a near-monopoly on clickable text ads despite a total lack of barriers to entry in the business. Anybody from a Silicon Valley garage-start up to a conglomerate like IAC/InterActive could enter this business on a moment’s notice and potentially take share from Google.

Threat of Substitutes Internet search faces no real threat from substitutes.

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Financial Analysis

Business Model

Google has a simple corporate structure with two major lines of business.

One is Paid Search, where business purchase text advertisements called AdWords that appear when a consumer uses Google to search for a specific keyword. In this business, Google charges the business that purchases the advertisement a fee every time a link is clicked. The fee is called the “click-through rate” and is a critical statistic in measuring the profitability of Google. This number is unfortunately not disclosed by the firm. The other major line of business is the Google Network, where independent website operators place Google text-based ads (called AdSense here) on their website. When a consumer clicks on a Google Network advertisement, the business who purchased the ad pays a fee to Google, who then shares a portion of this fee with the website operator who hosted the ad. These two businesses together form 98% of Google’s revenue. The remainder comes from tertiary products such as Google in a Box, Gmail, , Blogger, and other products and services.

Company Analysis

Google’s current share price is $194 per share, giving the company a market capitalization of $55 billion. Google went public through an auction-based initial public offering at a price of $85 per share last August, meaning that investors who purchased shares at the IPO have realized an impressive 128% return in less than

9 months. In the company’s Prospectus filing, upper management made it clear that they intend to avoid traditional Wall Street practices like stock splits, the use of accrual accounts for “smoothing” earnings, and providing quarterly earnings

SageGroup, LLP 8 Google Corporation guidance to Wall Street analysts and shareholders. All of these steps are an imitation of Berkshire Hathaway, the insurance and investing giant run by legendary billionaire Warren Buffet; Google management has made it clear that their goal is to replicate the successes of Buffet in the digital world.

Looking at Google’s financial performance over time, it becomes immediately apparent that Google is currently in the middle of its “hyper-growth phase.” Gross revenue growth at Google has declined from 409% in 2002 to 234% in 2003 and

118% in 2004, but these are still exceptionally strong numbers, especially for a company with over $3 billion in sales (a mark achieved by Google in 2004). Google first became profitable in 2001, when they earned almost $7 million ($.04/share), and profitability has grown quickly alongside revenue, as EPS rose to $1.46/share in 2004. For full details on this, including SageGroup’s forecast/wild guess at

Google’s future financial performance, please refer to the included earnings model.

Ratio analysis only provides a little bit of insight into a company like Google, which is very young and growing at an extremely fast rate. After all, Google’s product mix in 2002 was extremely different from its mix in 2004 (as the Google

Network, for example, did not even exist in 2002), so looking at trends in the decomposition of ROE can only provide us a limited amount of insight into business trends at Google. Having offered this qualification, here is the decomposition of ROE for Google over the past 3 years (note that net revenues are used instead of gross revenues in all relevant ratios):

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Table 1:

Year Profit Margin Asset Turnover Leverage ROE 2004 20.35% 59.16% 1.13 13.62% 2003 11.24% 107.80% 1.48 17.93%

2002 28.89% 120.27% 1.65 57.31%

The wild fluctuations in Google’s ROE (and, indeed, in all of the components of its ROE) are indicative of the fact that Google has been growing extremely rapidly and has been changing both its capital structure and the sources of its revenues over the three year period we have looked at here. Now that the IPO is complete we can expect Google’s capital structure to become more stable, so it seems reasonable to expect that DuPont analysis will become a more useful tool for understanding Google’s operations in future periods. At this point, however, it says little beyond telling us that Google is an asset-light business with high profit margins and a fairly conservative capital structure as of 2004.

Competitive Environment

The paid-search market is dominated by three players: Google, Yahoo!, and

Microsoft’s MSN. Ask Jeeves, recently acquired by IAC/Interactive Corp, is a distant

4th. A look at comparable statistics for the Big 3 internet search players can be found in Table 2.

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Table 2:

GOOG MSFT YHOO Industry Market Cap: 52.54B 267.98B 46.08B 79.95M Employees: 3,021 57,000 7,600 234 Rev. Growth (ttm): 117.60% 14.40% 120.00% 15.20% Revenue (ttm): 3.19B 38.47B 3.57B 53.93M Gross Margin (ttm): 54.29% 83.67% 63.67% 48.08% EBITDA (ttm): 788.67M 13.44B 834.28M 1.37M Oper. Margins (ttm): 20.07% 32.73% 19.26% 6.84% Net Income (ttm): 399.12M 10.00B 839.55M N/A EPS (ttm): 1.442 0.917 0.576 N/A PE (ttm): 132.73 26.86 57.67 22.83 PEG (ttm): 1.58 1.76 2.09 1.17

PS (ttm): 16.09 6.97 12.63 1.86

MSFT = Microsoft Corp YHOO = Yahoo! Inc Industry = Computer Services

Once company clearly stands out from the competitors, and that company is

Microsoft. Known as one of the most dogged competitors in the technology industry, Microsoft’s combination of deep pockets and control of the Windows operating system makes it a very serious threat to Google in the long run. Rumors that Microsoft will build an extremely powerful search engine into Longhorn, the oft- delayed newest version of Windows, are considered by some industry observers to be one of the most important risk factors associated with owning Google shares.

SageGroup’s analysts believe that antitrust concerns would likely prevent Microsoft from integrating a competitor to Google into Windows to any greater extent than

MSN is already integrated into Windows, which is why we are not overly concerned about the threat of increased competition from Microsoft.

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It is also important to note that the internet search business has extremely low barriers to entry, as we note in our Porter’s Forces analysis of the industry. This suggests that a startup firm with a superior search algorithm could appear out of nowhere at any time and take significant market share away from Google, much in the way that Google rapidly took share away from Yahoo! when it first appeared on the internet. While there is little that Google can do to minimize this risk beyond continually tweaking their search algorithm in hopes of keeping it at the cutting edge of technology, it is something that Google shareholders and management will have to remain vigilant about at all times.

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Revenue Build

Advertising Revenues 2001 2002 2003 2004 2005 2006 2007 2008 2009 Google web sites $66,932 $306,978 $792,063 $1,588,674 $3,018,481 $5,131,417 $7,697,126 $10,006,263 $12,007,516 Growth Rate n/a 459% 258% 201% 90% 70% 50% 30% 20% Google Network ---- $103,973 $628,600 $1,554,278 $2,953,128 $5,020,318 $7,530,477 $9,789,620 $11,747,544 Growth Rate n/a n/a 605% 247% 90% 70% 50% 30% 20% Gross Ad Revenues $66,932 $410,951 $1,420,663 $3,142,952 $5,971,609 $10,151,735 $15,227,602 $19,795,883 $23,755,060 Traffic Acquisition Cost $94,500 $526,500 $1,228,900 $2,362,503 $4,016,254 $6,024,382 $7,831,696 $9,398,035 as % of Network Revs 91% 84% 79% 80% 80% 80% 80% 80% as % of Total Revs 23% 37% 39% 40% 40% 40% 40% 40% Net Ad Revenues $66,932 $316,451 $894,163 $1,914,052 $3,609,106 $6,135,481 $9,203,221 $11,964,187 $14,357,025 Licensing/Other Revs $19,494 $28,593 $45,271 $46,048 $87,491 $153,110 $252,631 $341,052 $409,262 Growth Rate n/a 147% 158% 102% 90% 75% 65% 35% 20% Gross Revenues $86,426 $439,544 $1,465,934 $3,189,000 $6,059,100 $10,304,845 $15,480,233 $20,136,935 $24,164,322 Net Revenues $86,426 $345,044 $939,434 $1,960,100 $3,696,597 $6,288,590 $9,455,852 $12,305,239 $14,766,287

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Earnings Model

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Gross Revenues $19,108 $86,426 $439,544 $1,465,934 $3,189,000 $6,059,100 $10,304,845 $15,480,233 $20,136,935 $24,164,322 Gross Revenue Growth n/a 352% 409% 234% 118% 90% 70% 50% 30% 20% Traffic Acquisition Cost $94,500 $526,500 $1,228,900 $2,362,503 $4,016,254 $6,024,382 $7,831,696 $9,398,035 Net Revenues $19,108 $86,426 $345,044 $939,434 $1,960,100 $3,696,597 $6,288,590 $9,455,852 $12,305,239 $14,766,287 Cost of Revenues $6,081 $14,228 $37,010 $99,354 $228,753 $434,631 $739,186 $1,110,426 $1,444,460 $1,733,352 R&D $10,516 $16,500 $31,748 $91,288 $225,632 $428,701 $729,101 $1,095,276 $1,424,753 $1,709,703 Sales/Marketing $10,385 $20,076 $43,849 $120,328 $246,300 $467,970 $795,887 $1,195,604 $1,555,261 $1,866,313 General/Administrative $4,357 $12,275 $24,300 $56,699 $139,700 $265,430 $451,423 $678,140 $882,135 $1,058,562 Stock Comp. Expense $2,506 $12,383 $21,635 $229,361 $278,746 $529,617 $900,732 $1,353,105 $1,760,141 $2,112,169 Non-Recurring Items $0 $0 $0 $0 $201,000 $0 $0 $0 $0 $0 Total Costs/Expenses $33,845 $75,462 $158,542 $597,030 $1,320,131 $2,126,349 $3,616,328 $5,432,552 $7,066,751 $8,480,101 EBIT ($14,737) $10,964 $186,502 $342,404 $639,969 $1,570,249 $2,672,262 $4,023,300 $5,238,488 $6,286,186 Interest/Other Income $47 ($896) ($1,551) $4,190 $10,042 $0 $0 $0 $0 $0 EBT ($14,690) $10,068 $184,951 $346,594 $650,011 $1,570,249 $2,672,262 $4,023,300 $5,238,488 $6,286,186 Income Taxes $0 $3,083 $85,259 $241,006 $251,115 $549,587 $935,292 $1,408,155 $1,833,471 $2,200,165 Tax Rate n/a 30.6% 46.1% 69.5% 38.6% 35.0% 35.0% 35.0% 35.0% 35.0% Net Income ($14,690) $6,985 $99,692 $105,588 $398,896 $1,020,662 $1,736,970 $2,615,145 $3,405,017 $4,086,021 Diluted Sharecount 67,032 186,776 220,633 256,638 272,781 272,781 272,781 272,781 272,781 272,781 Earnings Per Share ($0.22) $0.04 $0.45 $0.41 $1.46 $3.74 $6.37 $9.59 $12.48 $14.98

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Strategic Question

While Google is growing at a breakneck pace, at this point 98% of the company’s revenue comes from paid search. This extreme dependence on one product is a bit disconcerting for a company valued by Wall Street at $50 billion.

This is all the more unsettling because paid search is not a business that we can even be 100% sure will exist in 5 years. Unfortunately, Google can’t do much to mitigate the risk of a decline in the paid search market. The other main uncertainty related to paid-search is that Google has thusfar been able to raise its click-through rates rapidly and consistently without encountering a decline in demand from advertisers. While Google investors don’t know what prices will create a balance between supply and demand, Google management doesn’t have much more of a clue than the investors do. Therefore, the two biggest risks inherent in buying shares of Google have little relevance to the strategic direction the company needs to take.

To get to the biggest strategic question facing Google, we need to go back to the root of the two major risks (the future and maximum size of the paid search market) facing Google shareholders: the fact that Google currently generates 98% of its revenue from paid search. While Google management cannot change the dynamics of the paid-search market or predict the future of internet advertising, they can attempt to diversify their revenue streams to mitigate this risk.

Diversification of revenue streams seems particularly promising because Google is an extremely valuable brand name (named as the most valuable brand in the world by BrandChannel in 2003 and still in the top 10 today). Unsurprisingly, Google has been attempting to leverage its brand across products other than internet search. SageGroup, LLP 15 Google Corporation

Services like the Google Network, GMail, Froogle, and Google News are the result of these efforts. While the products are there, it is much harder to find a real connection between many of the products. Furthermore, it is hard to figure out how many of the products can become profitable additions to the Google franchise.

What Google needs is a clearly articulated strategy that helps them diversify their revenue streams without damaging the core internet search business. This report will outline and evaluate some of the options Google has to pursue this goal.

Option 1 – Become a full-service portal

What it is:

If Google was to pursue this strategy, it would presumably attempt to ape

Yahoo!, which is currently the internet’s dominant portal service. Portals are the marriage of search and content aggregation, with the overall goal of being a one- stop shop for the bulk of your internet needs. Yahoo!, for example, has subsidiary sites that provide content in news, sports, weather, and many other areas. These subsidiary sites are very comparable to traditional media; they serve both as content aggregators (running stories from the AP, Reuters, etc) and content providers (with original columns and other proprietary content). While paid search has become an important part of Yahoo’s earnings, search itself is in many ways a secondary feature for Yahoo as a product. If you need information, Yahoo’s own sites should be able to provide what you’re looking for. Using their general internet search service essentially means that the internal content aggregators failed to answer your question, which forces you to go outside the Yahoo network to find what you are looking for.

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Why It Could Work:

Google already has the most important components of a portal service, with the robust search engine, Google News for news, Froogle for shopping, and GMail for e-mail. Even more importantly, it already has an extremely valuable brand name, which is the most important factor in a portal’s success. A simple redesign of www.google.com that put more emphasis on Google’s proprietary content could turn it into a basic portal, which could be expanded as more products were developed. Finally, the portal model is a proven business model, making this a seemingly low-risk option for Google to pursue.

How It Could Fail:

Turning Google into a portal is problematic for two critical reasons. First of all, one of the main reason people go to www.google.com is because it is an uncluttered and effective search site. While good design would likely nip this problem in the bud, turning Google into a portal could potentially drive away search customers and therefore damage the core business, which would be catastrophic.

More importantly, however, the mission of a portal is fundamentally at odds with the Google’s vision of the world. Google’s PageRank technology, which judges the importance of a web site by the number of other sites that link to it, essentially outsources the task of determining which pages are most important for the searcher to see to the broader market of internet users. Google has made it clear that the company’s vision is to apply this model of depending on the aggregate decisions of the market (as implied by the links they write in to pages) rather than the decisions of well-placed individuals like news editors. This vision is incompatible with the idea of operating a portal, which, as described earlier, is largely in the business of content aggregation. Therefore, while the idea of turning Google into a SageGroup, LLP 17 Google Corporation full-service portal seems like a good idea on a spreadsheet, it is simply not a realistic possibility given the company’s overall vision.

Will It Happen?

Not a chance. While becoming a portal would seem to be a logical move for

Google to make from a purely financial standpoint, the portal business model does not match Google’s strategic vision, as described above. The chance that the founders would approve a move like this seems infinitesimally small.

Option 2: Become an Internet Conglomerate

What It Is:

The current model for an internet conglomerate is IAC/Interactive Group, the internet conglomerate run by media mogul Barry Diller that features properties like

Expedia, Evite, and HSN.com, as well as the recently acquired Ask Jeeves search engine. IACI’s businesses are largely disaggregated, unlike in the Yahoo! portal model. IACI has traditionally been pitched to investors as a safe way to bet on the

Internet, with a particular emphasis on the past successes of Diller and the implicit indication that he can turn IACI into the internet equivalent of Fox, the network that he helped build from the ground up.

IACI would seem to be an odd firm to imitate in light of the fact that the company is currently weighing a proposal to spin off its travel segment in order to increase what it deems to be a depressed valuation. If Google was to pursue the conglomerate strategy, however, the model would not be IACI but rather Berkshire

Hathaway, the insurance-based conglomerate run by legendary investor Warren

Buffet. Google co-founders Larry Page and Sergey Brin have repeatedly expressed SageGroup, LLP 18 Google Corporation their admiration for Buffet’s management style and have emulated such Buffet trademarks as the “Owner’s Manual for Berkshire Shareholders” in the few months since the IPO.

While many of Buffet’s strategies (most notably his refusal to invest in high technology businesses) cannot be adapted for use at Google, there are material differences between the Berkshire model and the IACI model. Berkshire’s operating units are run with little to no interference from Buffet and Charlie Munger at headquarters, whereas Diller has his hands in the day to day operations of many parts of IACI. Berkshire is also noted as being a risk taker in the insurance business; they are famous for offering insurance products in illiquid markets where other companies refuse to tread for fear of making a major mistake in the event of a catastrophe. These are both traits that Google can emulate if it chooses to pursue a conglomerate strategy.

If Google was to pursue a conglomerate strategy, it would also have to decide whether it should limit itself to simply owning websites or expand into other facets of e-business. Rumors that Google will try to enter the internet telephony business and Google’s admiration of the Berkshire model of owning profitable businesses that are unrelated to the core business suggest that the company would choose the latter course of action, and the rest of this report will operate under the assumption that Google would not limit itself to simply owning websites.

Why It Could Work:

The main allure of the conglomerate strategy for Google is the opportunity to leverage its valuable brand name across a variety of businesses. It seems plausible SageGroup, LLP 19 Google Corporation that economies of scope could be created by tacking the highly recognizable Google brand on to other internet-related businesses. A good example of how this might work comes from the rumors that Google will enter the internet telephony business.

If these turn out to be true, a consumer who wants to switch to voice over IP might be choosing between Skype, Vonage and Google Telephony. As it is nearly impossible to distinguish one of these services from the others, a consumer might choose to sign up with Google Telephony on the theory that Google is an established company and therefore a less risky company to do business with than their startup competitors. This same process could presumably be applied to other novel technologies that appear on the internet with similar results.

Some marketing professionals have outlined plans for Google that are much more ambitious than simply leveraging the Google brand onto other internet startup businesses. A blogger named Robin Sloan outlined a scenario (available here) where Google acquires Tivo and merges with Amazon to form a company

(“Googlezon”) that dominates mass media in the 21st Century. It’s an ambitious proposal to say the least, and the odds of it actually happening seem very slim from this observer’s perspective. Having offered that qualification, some of the points brought up in this article are worth thinking about when we consider the possibility of Google expanding into relatively mature businesses.

First of all, the ultimate goal of “Googlezon” is to provide relevant and personalized content (and, of course, advertising) to end users. This fits in perfectly with Google’s strategic vision of eliminating the human middlemen between the end users of information and the sources of information and replacing them with unbiased machines. Secondly, the way it allows the machines to know what content SageGroup, LLP 20 Google Corporation they want to filter through involves the erosion of traditional privacy practices. This is a practice that Google began to experiment with in Gmail, where the service’s computers read your emails and generate ads based on the text contained within.

For Google to achieve its vision and use computers to customize content for users, the computers need to have access to everything, even when this compromises privacy. While we may be uncomfortable with this right now, it is entirely possible that it will become commonplace within 10 years. After all, the Internet already allows more information about individuals to be publicly available than ever before, so this is only another step along a path we are already following.

While the SageGroup team is unwilling to formulate a plan as detailed as the one put forward by Robin Sloan on the grounds that it involves too many moving parts that might not happen to have any real likelihood of being accurate, we are willing to consider the possibility that Google has unleashed a truly revolutionary concept by eliminating the middlemen in the information business. We are also quite sure that scenarios like the one proposed by Mr. Sloan are prominently featured in the most pleasant dreams of Larry Page and Sergey Brin. Where we disagree with Mr. Sloan is the role of blockbuster mergers in the evolution of

Google. While Larry and Sergey may have grandiose plans to make Google becomes the centerpiece of 21st Century mass media, CEO is a practical man who will tell his big-picture oriented partners to focus on setting the stage for this revolution by acquiring inexpensive startups (like they have done in the past with products like Blogger) rather than purchasing mature firms like Tivo or Amazon. He will not allow them to risk destroying their $50 billion company by squandering its resources on a long-shot attempt to become the most important firm in the world. SageGroup, LLP 21 Google Corporation

How It Could Fail:

The less ambitious portion of the conglomerate plan could still fail if the economies of scope that we have forecasted do not actually exist in the real world.

This scenario is certainly a realistic possibility, as any student of the history of failed mergers can quickly see that economies of scope often look better on paper than they do in real life. Those people who are uninterested in a full rundown of the pitfalls of counting on economies of scope need only ask long-term shareholders of

AOL/Time Warner how their portfolio has performed over the past 5 years. The look of anguish on their faces should be enough to foster a healthy skepticism about the miracles of creating a media conglomerate with economies of scope.

Another potential problem with the economies of scope scenario is that

Google has traditionally avoided putting its brand name on products it has not developed internally. Blogger and Picasa are the two most obvious examples of this. While many people know that these are Google products, they are largely independent of the Google brand. This suggests that Google management may prefer to run an internet conglomerate where each brand is independent, much as

Warren Buffet has done at Berkshire Hathaway.

It almost goes without saying that the more ambitious scenario could fail for more reasons than any of us can even imagine. In the interest of time, we will focus on one critical flaw that could undermine the entire concept of the decentralized media world of the future. Throughout the course of human history, we have been able to increase our total output as a species by specializing as individuals and then trading based on our comparative advantages. One result of this specialization is that some people have specialized in acquiring and distributing SageGroup, LLP 22 Google Corporation information to others who are focused in other areas. We call them journalists, and they appreciate the stability that comes from having a paycheck delivered to them by their employer every two weeks. In Google’s disaggregated model, the traditional journalist is replaced by information supplied by people who either a) aren’t journalists and simply post information on the web as a side job or b) are freelance journalists who get paid by Google and its advertisements rather than by a salary. The first option implies that Google’s disaggregated media model will reverse the hitherto constant process of increasing specialization and division of labor by humans. The second option seems farfetched when you realize that talented journalists will almost always choose the stability of a paycheck written by a major media company over the uncertainty and danger of being a freelance writer who depends on advertising revenue from Google to feed his family. Unless people’s historical preference for a steady job is another casualty of the internet revolution, it seems unlikely that the major media companies will lose too much sleep over the threat of disaggregated media taking over the world.

Will It Happen?

If “it” means “Google becomes an internet conglomerate,” then the answer is probably yes. Even if economies of scope on the internet prove to be nothing more than a pipe dream, Google would benefit from simply diversifying its revenue streams even if they are unconnected to the core internet search business. As you may recall, SageGroup has identified revenue diversification as the main strategic problem that Google faces today. By entering growing businesses like internet telephony, Google would reduce the volatility of its earnings and its dependence on paid search and therefore make its stock more valuable to investors by decreasing risk. SageGroup, LLP 23 Google Corporation

As for “it” meaning “Google becomes the center of a new disaggregated media world,” the SageGroup team is very skeptical. There is good reason to believe that media will not become a disaggregated business, yet even if that comes to pass there is no guarantee that Google will be in the driver’s seat when the dust settles. Robin Sloan suggests that Microsoft will be Google’s main competitor in the world of disaggregated online media, but in reality that role could be played by anybody from the old-line media companies (who are not nearly as asleep at the wheel as Mr. Sloan would want you to believe) to Wal-Mart to a startup that is currently nothing more than a gleam in the eye of a pair of computer science majors at Harvey Mudd. Given the enormous potential gains of actually achieving the dreams of Mr. Sloan (and presumably the dreams of Larry and Sergey as well), Google should not simply write off the possibility of becoming the hub of a disaggregated media world. That being said, investments aimed at making this happen should remain small and peripheral while the bulk of the company’s resources are spent on more achievable goals.

Option 3: Merge with another major internet business

What It Is:

In this scenario Google would merge with another established player on the internet with the aim of decreasing the risk level of the combined entity. The two most obvious partners would be Amazon.com or EBay, neither of whom are dependent on advertising or search as a source of revenue.

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Why It Could Work:

Both Amazon or EBay bring something unique to the table as partners for

Google. As Robin Sloan observed in his article on “Googlezon,” the marriage of

Amazon’s ability to track a consumer’s past purchases with Google’s targeted advertising systems could greatly improve the efficacy of targeted advertising.

What he fails to mention is that merging Google and Amazon could increase sales at the latter by including direct links to buying products at Amazon on GMail and

Google Network advertisements. EBay brings similar things to the table, as both new and used items are sold in EBay auctions. The additional allure of EBay over

Amazon is that its disaggregated model of directly matching sellers and buyers fits in nicely with Google’s vision of decentralized decision making.

How It Could Fail:

First of all, Amazon and EBay are major customers of both paid search and the Google Network, so merging with one would bring up the potential for favoritism in ad placement and could potentially violate another one of the guiding principles of Google, “don’t be evil.” Secondly, consumers who only buy a small fraction of their products online might not get a real increase in the relevance of the ads targeted at them by Google. Finally, none of these companies is particularly interested in selling their businesses, so a merger would likely result in a power struggle at the combined entity that could prove devastating to the firm.

Will It Happen?

No. None of these managements are willing to sell the company, and a hostile bid seems unlikely given the valuations attached to all of the potential

SageGroup, LLP 25 Google Corporation players (and, in the case of Google being the target, the fact that Larry and Sergey have super-voting shares that allow them to block any deal.)

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Conclusions

In the opinion of the SageGroup team, Google needs to do something to diversify its revenue streams in order to reduce its exposure to a potential decline in the paid search market. Turning into a traditional portal is not a viable option for Google to pursue, while a merger with an established player on the internet seems equally unlikely. The only viable option for Google, therefore, is to turn itself into an internet conglomerate. While the SageGroup team has its doubts that the process of turning itself into an internet conglomerate will involve Google becoming the center of a new disaggregated media system, it would be in the company’s best interests to continue to work towards that goal without putting a significant amount of the firm’s capital at risk in the process. In the meantime, however, it should focus on entering into businesses where it can leverage the Google brand to gain a competitive advantage while generating non-advertising revenue if at all possible. If Google was to follow this strategy, it would hopefully be able to accelerate its growth even further while reducing its vulnerability to a potential decline in the paid search market. That would only improve the fortunes of a company whose future already looks bright.

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