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| The MidCo Hall of Fame |
In my previous post, I outlined the broad parameters that I use to determine whether a company qualifies as a MidCo. As a reminder, MidCos matter because it is my contention that they tend to be great businesses and as such are a a great place to pan for investment gold. As a close friend pointed out, Barry Diller made a career out of buying and selling them (see IAC). In this post, I will induct the first ever member to my MidCo Hall of Fame. First up is the king of all private sector MidCos - Google.
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| "In Google We Trust" |
Based on Google's recent 10-Q, one may suspect that the Googolplex actually houses the 3rd U.S. dollar printing facility (besides the two facilities in TX & DC). First, a few of Google's stats:
- LTM EBITDA margin of 46%
- Return on Invested Capital of 80%
- YTD operating cash flow of almost $5bn
1) AdWords: The AdWords franchise allows advertisers to display paid-for listings next to the Company's organic, unpaid search results. The advertisers pay a fee every time a user clicks on its paid-for link with the price per click varying by keyword (note: you can have some fun by going to KeywordSpy which allows you to search for the going rate of any keyword; most expensive keyword? Let's just say an alien might think asbestos is the mana of our civilization based on related keyword prices). In this way, Google is acting like an infrastructure provider that owns both free for use as well as toll roads. The Company has 65% market share in domestic search, well ahead of the Yahoo/Bing partnership of desperation.
2) AdSense: The AdSense franchise effectively allows a website to outsource its advertising function to Google (note: I would gladly use this if I had more than 8 pageviews per day). Google basically serves as the middleman between the content providers (i.e., websites) and advertisers and places contextually relevant display or search adds on its clients' websites. For this, Google takes a ~30% to ~50% cut of the action.
So Google is clearly serving as an intermediary in both its AdWords and AdSense business models (also in YouTube as well but that's not a material contributor to profitability yet). Turning to the four criteria I laid in my last post, let's see how Google ranks:
1) Free cash flow potential - ~$30bn of cash & cash equivalents and $5bn of operating cash flow YTD? Enough said. However, I would not quite consider Google a virtual (i.e., asset light) business. There is a tremendous amount of computer infrastructure (think data centers) underpinning the company's search franchise as it must scan and catalog the ever expanding Internet on a regular basis. However, because the Company's core AdWords & AdSense franchises are so profitable, the amount of capital investment required to maintain this infrastructure is small relative to the Company's ongoing profit generation. The scary thing about Google's financial metrics is that they are clearly diluted by the Company's engineering and research oriented culture which urges employees to invent cool stuff irrespective of profit motive or apparent business model. I suspect there's at least a few hundred basis points of margin to be had if the Company focused exclusively on driving profitability within their core Adwords and AdSense franchises.
2) Operating leverage - Adwords and Adsense have phenomenal operating leverage as additional revenue requires very little marginal cost (note: this is less true for AdSense as the Company must give its content providing websites a substantial cut of the advertising revenue). AdWords click traffic growth is the Company's most profitable type of growth as every incremental click on an existing client's advertisement flows almost fully to the bottom line. Some may counter that the Company must continually invest in R&D, sales functions and computer infrastructure but I view these costs as semi-fixed relative to the Company's top line. The bottomline is that Google's core advertising franchises have a tremendous ability to scale with expanding profit margins and the numbers prove this out.
3) Principal risk - Like every good MidCo, Google's business model bears no principal risk as the foundation of its business model is connecting web surfers with their advertising clients' websites. Now some may argue that the Company's pay per click (PPC) business model adds a level of contingency to the advertising business model. While this is true, I do not consider this as a form of principal risk and if anything, this accountability is one reason advertisers find the PPC, pay for performance pricing model, so attractive.
4) Network Effect - Google's Adwords and AdSense franchises enjoy the NE as do some of the Company's newer businesses. Google's dominant market share in basic search provides the Company with an ever growing database of search histories with which to tweak its underlying PageRank algorithm and presumably improve its search experience (and thus its market share). The scaling of AdSense creates a NE as advertisers increasingly turn to the Company as its client base of partnering websites grows while websites increasingly choose Google to outsource their advertising function as its bench of advertising clients broadens. YouTube also enjoys the NE as increasing popularity enhances the website's value as both a destination for viewers and a medium for video distribution by content creators. Google's smartphone operating system also exhibits the NE as increasing scale makes the platform more desirable for App creators which leads to more App creation which in turn enhances the value of the platform to users.
At some point in the future, I will post on why I like Google equity as an investment (note: I own some personally). The point of this post is to simply highlight the strength of the Company's core business model and to discuss its MidCo nature. It is a phenomenal brand, service and MidCo. Plus it can find you a French wife:
Kudos to King Google!
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