Google's Achilles Heel

Wall Street loves it. Consumers are begging for more of it. Other companies want to be it. But Google has its vulnerabilities--excessive reliance on search advertising, lawsuits, eroding public trust,

January 24, 2006

18 Min Read
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Does Google have an Achilles' heel?

Based on recent events, you have to wonder. Its stock price reached $475 after two significant announcements--Google Video Store and Google Pack--at the Consumer Electronics Show earlier this month. Then, just 10 days later, Google announced the $102 million purchase of dMarc Broadcasting, which develops an online system for advertisers to buy radio airtime. Google said it plans to move its advertising juggernaut into radio.

How hot is Google?

- Google's market cap, now hovering at around $132 billion, is bigger than IBM and Chevron.

- Piper Jaffray analyst Safa Raschtchy said the stock would likely soar past $600 this year.- Unlike high-flying Internet bubble companies of the 1990s, Google is profitable, with revenues growing an average 110% quarterly since it went public in August 2004.

- Google has a war chest of $7.6 billion for doing whatever it pleases.

- Google is one of the top 10 Web brands in the United States, and the second-fastest-growing Web site, building traffic 29% in the past year, according to Nielsen/Net Ratings. Only Apple's Web site is more popular; Yahoo and MSN lag far behind.

- Google is king of search-related advertising, and search-related ads are the fastest-growing sector of the online ad business, which is growing at 41% annually, Piper Jaffray said.

- Google has almost twice as many search ad clickthroughs as runner-up Yahoo. In December, Google had 16.5 trillion ad clickthrough, compared with Yahoo's 9 trillion, according to Nielsen/NetRatings.- Google earned $3.64 billion from U.S. online ad revenues in 2005, representing 69% of all paid search advertising, according to eMarketer.

Still, some prominent pundits are predicting a stumble for Google this year.

"Google isn't invulnerable, and in general the risks are where most people aren't looking," said Scott Kessler, an equity analyst with Standard & Poor's, who bucked the tide last week by saying in a research note that Google's stock was overvalued, downgrading the stock from hold to sell. Google stock prices took a hit as a result.

Google faces risks from being too dependent on search advertising, an onslaught of lawsuits--particularly one involving click fraud--eroding support from the public, lack of focus, and the competitive threat from Microsoft.

Google declined to comment for this article.Too Dependent On Search Advertising

Google's chief strength--its dominance in the search advertising business--is also its main vulnerability. Currently, 99% of its revenue comes from search-related advertising. The remaining 1% comes from sales of its enterprise search appliance.

"Google needs to broaden its horizons," said Martin Pyykkonen, an analyst with Hoefer & Arnett, pointing to the fact that although Yahoo also gets the bulk of its revenue from advertising--85%--those dollars are divided 50-50 between search and display, or "branded" ads.

Online advertising is divided into two types of ads: search and display advertising. Search-related ads are the simple text-based ads that appear on the right side of the page after completing a search. Display, or branded, ads include the banner ads commonly displayed on Yahoo and America Online; they contain graphics and, increasingly, video and animation, and are placed on pages specified by the advertiser.

Display advertising is an area that Google has yet to venture into. And although Google owns nearly 70% of the paid search advertising market, it only controlled 28% of the $12.9 billion market for all online advertising in 2005, according to online market-research firm eMarketer."Google needs to make that leap into display advertising," said Charlene Li, a Forrester analyst. "Right now, their advertising base is really comprised of direct marketers, not traditional brand marketers, and they really don't have the expertise and credibility that Microsoft and Yahoo and AOL have in that area."

The foray into radio advertising with the dMarc acquisition is a step in the right direction, Li said.

David Schatsky, an analyst with Jupitermedia, agreed, "It's in the very early stages, but this radio venture is a natural new marketplace for Google to apply its advertising expertise."

And in general, competition in the search-based advertising segment is heating up, and will at some point restrain the revenue growth of Google and dampen its momentum.

Yahoo, especially, is a competitor to watch in the pursuit of search advertising dollars. "Yahoo has been a strong No. 2 for Google since early 2002, and continues to improve when it comes to search and related advertising," said Kessler. In 2005, Yahoo had a "solid" year, made substantial investments in people and technology related to search, broadened its index substantially, and continued to work toward investment in an improved algorithm."The point is that Yahoo continues to invest very, very significantly in this area, and is doing good things, and will continue to do good things, which steps up the pressure," said Kessler.

This year, Microsoft seriously enters the fray, with the predicted potent combination of AdCenter and its next-generation operating system, Vista. A search engine will be built into the core of Vista, competing directly with Google Search and Google Desktop, and Microsoft is expected to aggressively pursue a variety of search-related opportunities that put it head to head with Google. "Microsoft is the wild card here," said Kessler.

And don't dismiss Ask Jeeves as a formidable competitor. "I see a big, aggressive, and well-capitalized company. You have to take Barry Diller seriously. At Fox, he was successful when people thought there was only room for three networks. He has a history of things that turn out very successfully," said Kessler.

Moreover, search is not inherently "sticky," said David Hallerman, a senior analyst with eMarketer. "If all you have is search, it's just hit and run. With Yahoo and AOL, people come to spend time. I think Google is trying to do a number of different things, and one of the smartest things they can do is to put out lots of little tendrils."

"What people underestimated about Google was how much growth was going to be in search-engine advertising," agreed Mark Mahaney, an equity analyst with Citigroup. "But at some point people will want to see signs of traction in other business areas."Google seems to be trying to change this by branching into a number of different areas. Most notably, Google recently announced Google Video, a pay-for-video service that would allow content owners to charge fees for Google users to watch programs on their PCs, with Google collecting a percentage of the fees for itself. Content will include prime-time and classic hits from CBS, NBA basketball games, music videos from SONY BMG, Charlie Rose interviews, as well as news and historical content from ITN.

Google Video could help Google diversify its revenue stream, something that it needs to do. But "if this catches on, it will put Google in direct competition with video-content providers like DirectTV and Comcast," said Chris Sherman, executive editor of Search Engine Watch. "And those are big players to go up against."

Google's acquisition of dMarc also is seen as an attempt to diversify its revenue stream. "The potential could be huge," said Sherman. "Remember, in the 1990s, everyone said Internet ads were a failure. Google transformed the model, and showed how it could be successful. It could do something like that in the offline world as well."

Legal Trials

Then there are Google's legal woes. Google has been hit by a number of lawsuits over the past 18 months that could mean trouble.Affinity Engines, a social networking service provider, filed a lawsuit against Google on May 25, 2004. The suit claims that Google's social network, Orkut, is using a source code that was stolen by Orkut Buyukkokten, an engineer previously employed by Affinity. The suit also alleges that Buyukkokten promised he would not develop a competing social-networking service when he left to join Google. Google has said the allegations are without merit.

Click fraud presents a more serious threat. Google search-related advertising is known as pay-per-click, because advertisers don't pay for the display space; they only pay Google when an Internet user actually clicks on the link. The price per click depends on the going price for the search term in question, which is determined by auction.

But there have been numerous examples of times when advertisers have had to pay for clicks that turned out to be manipulated or fraudulent in some way.

In June 2005, Click Defense Inc. filed a class action suit, alleging that Google has refused to take serious action against click fraud, leaving its advertisers vulnerable. Click Defense withdrew as representative plaintiff in the suit in December, and Advanced Internet Technologies, a Web-hosting company, filed to take Click Defense's place as lead plaintiff.

AIT, like Click Defense, alleges that Google hasn't taken steps to reduce click fraud on its pay-per-click advertisements despite the fact that it is aware of the problem. This negligence, AIT says, has cost it hundreds of thousands of dollars. Google says it is still in the process of determining how it will handle the allegations.Google has also taken some heavy public relations hits for its Google Books Search project (originally called Google Print), which has as its ambitious goal to scan millions of books and make them searchable online. In September, the Authors Guild filed a class-action lawsuit, charging that Google violated copyright law by digitizing books without the permission of copyright holders. In October of this year, major publishers represented by the Association of American Publishers jumped on the bandwagon with a suit of their own. Still, in November, Google resumed its controversial copying of library books.

Then, also in October, Rates Technology Inc. filed suit against Google claiming that Google Talk illegally uses Rates' technology for billing VoIP phone calls. Google Talk is Google's VoIP and instant-messaging platform, which the company launched earlier this year. The suit alleges infringement of two patents obtained in 1995 and 2001. Rates is seeking patent enforcement, damages, and court costs, and an injunction against Google's use of the technology.

"You take this cluster of legal problems, and it begins to get serious," said Stephen Arnold, a Google watcher and author of "The Google Legacy: How Google's Internet Search Is Transforming Application Software." "It may not shut down services, but it could cause advertisers to jump ship."

Eroding Public Perception

Legal issues, privacy concerns, and perceived conflict of interest are eroding Google's reputation, bringing growing skepticism about Google's famous mantra, "don't be evil.""Through sheer ambition, it is risking the goodwill it built up as a scrappy startup with naively benign objectives," said Schatsky. "It's very dramatic to see the change in public perception from technology wunderkind to Big Brother."

Privacy advocates fear that Google is collecting too much data about its users' search habits.

"Google is amassing an enormous amount of information about people, and it's not just public Web pages," said Bruce Schneier, founder and chief technology officer at Counterpane Internet Security Inc., a security managed-services and consulting firm. "There are enormous concerns that Google knows too much about you." Schneier also worries about the "inadvertent" aspects of Google's products and services that put users at risk. "Google's search engine is so good that hackers can use it to search for vulnerabilities that can be exploited," he said. "We've seen worms that use Google as a reconnaissance tool. These are very serious things that Google needs to address."

A major privacy issue that Google refuses to discuss has to do with its policy on complying with law-enforcement requests for data, said Chris Hoffnagle, legislative counsel for privacy group Electronic Privacy Information Center (EPIC). "On the commercial side, Google's policies look pretty good: they're very clear that they don't sell data to other companies," said Hoffnagle. "But they have refused to comment on the legal side. You have all these different products collecting information, and it becomes a pretty comprehensive and centralized database about individuals. How is Google handling requests from law enforcement? They won't say, which makes me believe that they know their policy is unpalatable."

Simson Garfinkel, a fellow at the Center for Research on Computation and Society at Harvard University, and the author of "Database Nation: The Death of Privacy in the 21st Century," said that Google has done a better job than most companies in making its policies both clear and understandable. "Unfortunately, it is at a disadvantage because of the lack of strong data-protection legislation in the United States," said Garfinkle. "Google should have a chief privacy officer. I don't understand why it hasn't created this position."The privacy issue came to a head last week, as Google said it plans to resist a subpoena from the U.S. Justice Department, seeking information about searches. The Justice Department is looking to reverse a court ruling claiming that Child Online Protection Act anti-pornography laws are un-constitutional. Google won praise from privacy advocates for standing up to the Justice Department.

Microsoft, AOL, and Yahoo went along with the subpoenas, saying that, since the information was aggregated search queries, no personal information would be conveyed to the federal government and therefore there were no privacy issues involved.

Google faces the perception of bias as a result of its recently consummated deal to buy 5% of AOL for $1 billion. Google always has prided itself on being neutral, a level playing field for advertisers to display their ads. But with the AOL deal to display banner ads and to directly sell Google search advertising, the search engine company opens itself up to more criticism.

"They've mounted a public-relations campaign to counter the perception of bias, but the perception is definitely out there," said Danny Sullivan, editor of Search Engine Watch.

And there's the very real fact that unscrupulous people can manipulate Google searches, leading to a distrust of results. The British newspaper The Guardian successfully influenced the Google search index with a spoof of a footwear product. At the start of the experiment, there were more than 11,500 research results on the term "eco-friendly flip flops." Within 2 days of the spoofers creating the site, Google discovered it, but ranked it at the lowest 100 pages of search results. But within days, by the end of the experiment--during which the newspaper used a number of relatively low-tech techniques for manipulating the results--the spoof site had rocketed to the top place of the other 11,500 sites.

Lack Of FocusSome analysts warn that there's the danger that Google is simply spreading itself too thin. "If they continue to expand into other areas, they could become a behemoth, slow to act and meet the needs of its core customers," said Jim Murphy, research director at AMR.

"Google has been very successful as a search engine, and very successful with Web advertising," said Sherman. "But look at some of the other projects they have attempted--they're taking some major steps away from what they are good at, and this imposes some significant risks."

In addition to all the other projects it has cooking, Google is running a wireless trials in various cities around the globe, leading some to speculate that it will eventually put up a large-scale wireless network that spans multiple cities or even countries.

And the dMarc acquisition is only the latest in a series of buy-outs. In May, Google acquired Dodgeball, the developer of social-networking software for mobile devices. In July, Google invested in Current Communications Group LLC, a company that offers broadband access over power lines. Also in July, the company snatched up the startup Android. Although little is known about Android, published reports of its activities include an operating system for mobile phones.

About all this divergence, Sullivan said, "this is potentially a significant challenge. Anytime they have a problem with search, people will say, it's because they're not focused on the right things. They have all these great people, but it's not as though all these people are concentrating on the core search technology."IDC's theory is that Google is looking to be a services rather than a technology organization. "One of the things we did was to poke around and see what domain names they own, and it's possible that they will be getting into banking, auctions, micropayments--all of that would make sense," said Susan Feldman, research VP of content technologies for IDC, who also expects to see Google getting into hosted application services. "We could see them acting as a middleman to a whole range of companies, providing a range of services through partnerships with content producers and application vendors."

And, of course, the risk of getting into hosted applications is that there are plenty of companies out there who already possess a lot more experience, said Forrester's Li, who also expects to see collaboration software, office suites, and other applications coming from Google, with or without partners. "The downside is that they would be facing a host of competition from vendors with much more expertise in how to design, build, and market applications," she said.

"They seem to be pursuing every business opportunity they can think of," said Rich Skrenta, CEO of Topix, a firm that focused on local search. "I really wonder about Google in five years: will it primarily be a search company, or a collection of freaky stuff?"

Mighty Microsoft

We've seen this scenario before. An upstart appears, with a better or perceived better technology, is seen as cool and exciting, and word gets out that we finally have a Microsoft killer on our hands. After all--or so the prevailing wisdom goes--Microsoft has become large and bloated, and unable to compete effectively. Then Microsoft pulls out the stops and the competitor dies.Microsoft already is making moves, with a massive reorganization and an announcement of a "sea change" in its software strategy that moves toward delivering services and value over the Internet. And in late 2005, in a widely published memo, Microsoft chief technology officer Ray Ozzie singled out Google as a company that Microsoft had seriously underestimated.

Indeed, there's high stakes here. Microsoft could see the erosion of its control over the platform for the next generation of software application development, according to faculty members of the Wharton School of Business at the University of Pennsylvania. "Google's goal is to reduce people's dependency on Microsoft," said Raphael Amit, a management professor at Wharton.

"The No. 1 competition for Google is Microsoft," declared Chris LeTocq, an analyst with Guernsey Research. "Google owns Web search, and is moving to the desktop, and Microsoft owns the desktop and is moving to the Web. All the comparisons and the risks can be found right there."

Author Arnold has analyzed Google's patent portfolio, technical publications, and engineering documents and concluded that Google has an ambitious plan to push the battle for the hearts and minds of computer users off the desktop and onto the Web.

"As everyone knows, Microsoft owns the desktop. But it's possible that the core platform could be moved to a higher level, and programs could be written to the browser rather than to the operating system," said Arnold.This was the goal of Netscape's Marc Andreessen, back in the 1995 when Andreessen famously boasted that the Web would reduce computer operating systems to nothing more than a "poorly debugged set of device drivers."

That statement turned out to be the red flag for Microsoft, which reared up and crushed Netscape. Although the struggle between the two companies was dubbed a "browser" war, it was really a struggle for control of the operating-system platform. When applications are written in the Web browser, they work equally well on any operating system. Although individual computers still need operating systems, it doesn't matter which one, from the point of view of the application. Thus the operating system may eventually become the commodity that Andreesen predicted it would be--and that hits Microsoft where it hurts, according to Amit.

Search Engine Watch's Sherman doesn't believe Google will take on Microsoft directly so much as encroach on its territory as digital convergence becomes more of a reality. "Is it possible that Google will offer an Office clone? Perhaps, but I don't see Google as having that as a primary mission," said Sherman. "Rather, the whole notion of what we think of as computing is changing and evolving. Google is very focused on making it easier to use and consume information, no matter what kind of media, or what kind of device you happen to be using. More and more, it looks like it will collide with Microsoft in that arena."

Stymied By Its Own Success?

Although most people think of Google as a search company, they are really a future-looking media company--and this is something they have yet to master."Whether they like it or not, they are a media company," said Allen Weiner, an analyst at Gartner. "What they provide is very valuable aspects of media, all wrapped up in search. But they're missing the internal talent and internal capability to think like a media company. Everything is from a technology perspective, and that is a real shortcoming."

And the sheer velocity of growth could seriously impact the company. "It's very difficult to manage this kind of growth--they hired 800 people last quarter, and when you grow that fast, how do you know that all the people you've hired will be employed as efficiently?" said Citigroup's Mahaney. "Problems inevitably occur when you're ramping up at this rate."

William Morrison, an influential analyst with JMP Securities, who is extremely bullish on Google, agreed.

"Its revenues are growing so fast that the kinds of internal struggles that any growing company faces are rendered invisible. Managing this kind of growth is extraordinarily difficult." The "unusual" management structure Google has, where everything is managed from the top by founders Larry Page and Sergey Brin and CEO Eric Schmidt also is a risk, said Morrison. "As I understand it, Larry and Sergey and Eric still approve everything. At some point they will have to give up some of that control and move to a more organized, hierarchical management structure," said Morrison, who is still forecasting 80% revenue growth for Google in 2006, and who is pleased that Google is moving out into new areas.

"They've got a lot of money. I like seeing them investing in high-risk, high-reward activities, the way they're doing. It's an exciting company to watch," Morrison said.0

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