Google is a quintessential American success. Two entrepreneurs set out to build a better internet search engine. Seven years later, Google is a $108bn market cap company with $6.14bn in revenue (up 93 per cent) and free cash flow of $1.62bn. Google’s ascent rightly gives one hope about America’s future.

Google’s stock, however, seems to carry a “hope premium” that may come under serious contraction. The surge that pushed the stock to $475 on January 11 from $85 at its August 2004 debut cannot be dismissed as irrational. But Google faces enormous headwinds in 2006. Even with the 22 per cent decline since fourth quarter earnings disappointed, the stock’s current $368.75 price tag suggests the company will be able to sail through them all with little diminution of growth – an unlikely scenario.

There is nothing new to say about Google; only differences about how one perceives its future. Scores of analysts cover the company, as do remarkably good reporters and bloggers. Based on the company’s regulatory disclosures, Google is well aware of the risks.

However, even if they successfully address them all, it will cost money and resources to do so. Besides, with virtually every great company that has grown big, Wall Street has found it impossible to not overshoot its expectations.

Google is a hotbed of innovation. In a recent profile in Time magazine, the founders noted that they kept a close watch on the 100 most promising new ideas within Google. One hundred! If any company could make half of them work, it would be Google.

For now, it makes money one way: 99 per cent of its revenue comes from advertising. But both Yahoo and Microsoft are launching revamped search initiatives that should introduce price competition.

Should Google focus on fending off the competition in search or on diversifying its revenue stream? It has wisely opted to try both. Nonetheless, the initiatives will probably hurt the bottom line.

Regarding search, going toe-to-toe with Microsoft and others costs money. The potential deal to pay Dell $1bn over three years to make Google the default setting on Dell PCs indicates just how costly even making the right moves may be. The battle will be more costly and less profitable for Google.

And its initiatives will cost lots of time and money. It would be a miracle if any new initiatives were as high margin and profitable as search. Meanwhile, as they push Google’s cost base up faster than revenue, the operating margins may slide below 50 per cent.

Google’s team has said they are trying to build a long-term viable business. This course is wise but it may not please the short-term oriented Street.

Much ink has been spilled about click fraud – human or automated methods to click on advertisers’ links to run up the cost of pay-per-click advertising – as a potential iceberg to Google’s Titanic. Estimates of the amount of revenue Google derives from fraudulent clicking range from nil to north of 25 per cent but nobody knows. Google goes to great lengths to manage this issue, and 25 per cent seems high.

Even removing the spectre of click fraud, search advertising may be in for less rosy times. As Jeff Matthews pointed out on his excellent blog, two advertisers – FTD and Blue Nile – have said they are moving away from search because it has become too expensive.

Meanwhile, a recession or economic slowdown in the US will curtail advertising – even search. Companies that track Google ad auctions, such as Adsense Heaven, show a big portion of the 1,000 most expensive search words include home equity loans, debt restructuring, career colleges and other groups that may be particularly vulnerable to a downturn or higher interest rates.

Assigning a reasonable multiple on Google’s stock is difficult – depending on what growth numbers you plug in, you can put the stock’s value at $85 or $2,000. Here’s where Google’s valuation stands today: based on Wall Street’s collective estimate of $8.86 a share in 2006 earnings, the stock has a P/E of 41. Estimates for free cash flow of $2.5bn to $3bn put the price to free cash flow ration at 36-43 – but, as Henry Blodget noted on his blog, free cash flow growth has slowed from 600 per cent in the second quarter to 120 per cent in the third quarter to about 60 per cent in the most recent quarter.

Can Google support these valuations? “It’s rich but not out of the ballpark,” says Wharton professor Jeremy Siegel. But Google must sustain earnings growth north of 30 per cent a year for the next several years or else the stock will contract. If growth slows, Google’s stock may resemble Microsoft, which is trading at December 1998 levels. While Google has grown much faster out of the gate, it has a problem Microsoft never had to face: Microsoft.

The intangible challenge Google faces may be best summarised by a quote from the film Miller’s Crossing. As one character tells the crime boss: “You run this town because people think you run it. Once they stop thinking it, you stop running it.”

Given how fluid online dominance has proved over the past 10 years, this paradigm has real world implications. Advertisers, web users, employees and, of course, investors stick with Google because of its dominant position. If more advertisers follow Blue Nile and FTD’s cue, or simply do more comparison shopping, Google’s status may erode. If the hiring spree at Google diminishes the talent pool or the well-cultivated culture, core employees may move on.

If investors push the stock down as growth slows, Google may lose a tax benefit related to stock-option selling. In the first nine months of 2005, Google earned $1.5bn in pre-tax income and paid $5.6m in taxes, thanks in part to a $271.7m options-related tax benefit. If Google’s tax rate rises closer to its effective 2006 rate of 30 per cent, cash flow will take a hit.

Of course, no one knows what the future holds for Google – my guess is that the stock will climb back above $400 before settling down at $250 or below a year from now. The bull and bear case both come with a lot of “ifs”.

But at current levels the ifs on the bear side look a lot less expensive.

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