Google vs Microsoft Part 2: The Business Model Flaw

In part 1, we discussed why Google stock was not a good bet in terms of only some basic financial calculations and ratios. Today, we will discuss a fundamental business model flaw in Google.

The only reason one might consider investing in Google at this point is if it can somehow offer incredible growth and earnings, but this is unlikely. Considering that their executives are not confident, that should be reason enough to believe that Google will not grow much more. However, there is also a flaw in their business model, which will lead to their eventual downfall.
The raging war between Google and Microsoft for domination of the world is hot as ever, but though for a while Microsoft appeared to be down, Google cannot win this war. Both companies boast an enormous product array, investing in many different areas in technology on both the consumer and enterprise end. Most of Google’s offerings are touted to the consumer, but Microsoft is generally more profitable on the enterprise end. However, that does not mean either of them want to lose any potential profits, and so they compete heavily on both sides. Then let us take a look at some of their core products and why Microsoft will ultimately be the victor.
Google predominantly is a search engine. They may have a lot of different products, but their revenue comes almost exclusively from the search ad business and Google Adsense/Adwords. In fact, most of their other products either make negligible amounts or plainly lose money: YouTube, Blogger, Gmail, Google Apps, and Google Earth, to list some of the widely known (they have many more unprofitable products). Google Apps is the only one that may have some potential for future earnings, but faces the formidable Microsoft Office monopoly. The only part of it that is appealing is the low-cost and some of the cloud features offered. Unfortunately for Google, Microsoft is soon to host Web versions of Office, and will soon offer cloud counterparts for Office as well. All of these products that Google has can only be sustained simply because the search engine ad business makes so much money; compared with Microsoft which makes money through a variety of products: Windows, Office, Server, and Xbox. There is also another crucial difference: Google makes money only from ads, while Microsoft makes money by selling products and services.

Such is the flaw in the business model of Google, and ultimately, it is not good if Microsoft begins to take ANY of Google's search engine share.

If you'd like to see the earlier post on the Google the tech company stock vs Microsoft in part 1, then just click the link.

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Google vs Microsoft Part 1: Stocks

One of the hottest names in the tech industry, Google (GOOG) seems to be taking the world by storm, bringing all sorts of new products such as Google Wave, Chrome OS, and even their own phone. But is it really what it seems to be? Google’s strongest competitor is none other than the world’s 7th most profitable company: Microsoft (MSFT). 7th? That doesn’t seem TOO high does it? Well actually, it is, because the top 6 are all oil and gas companies and we all know how much of an energy demand we have right now. Microsoft is clearly a potent competitor to Google, and the reality is Microsoft is the future of the technology world.

Before we discuss the merits of Microsoft, let us simply tackle the fundamental problems with Google stock and their business.

Valued at $590 currently, this is far beyond their pre-recession values. That’s astounding, and the only reason it is like this is because of the perceived potential for growth. However, their percentage return on equity is only at 16%. Return on equity is simply the amount of earnings they have expressed as a percentage of total shareholder value in the company (which is assets minus liability). Compare that with Microsoft: an incredible 36%. In fact, Warren Buffet, the world’s most famous investor by far is known to only invest in companies with ROEs at least above 20%. That makes Google seem like a weak candidate. In addition, their operating and profit margins and return on assets are all lower than Microsoft’s. What’s more, it is clear that even insiders at Google have no confidence in their company. The amount of Google stock owned by insiders is less than 0.5%. The amount of MSFT stock owned by insiders is over 10%. Plus, Google Co-founders Larry Page and Sergey Brin who sit on the company’s board of directors do not hold any Google stock. That’s right, they hold 0 Google stock. They have no faith in their own company. Neither does the Google CEO Eric Schmidt. There is no real reason to invest in a stock that does not have the confidence of its executives. Google stock is simply not compelling.

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Google stock shortcomings

Currently, Google is heralded as a great tech company with the power to revolutionize many things. However, their stock is not necessarily a good option right now.

One of the important metrics in determining the strength of a business is the Return on Equity percentage. This is simply the amount of earnings per year as a percentage of the total amount of value in the company (anything of value minus all debts). Higher percentages equate to a more profitable business and capable management.

Google has an ROE of merely 16%, while Microsoft has an incredible 36%. This shows that MSFT’s management is far superior, and that they have a business that makes a lot more money for less . Generally, companies with low ROEs (less than 20%) are mediocre and many will phase out or lose money eventually.

Now, there’s a reason that management seems to perform badly at Google, and that’s because they have no confidence and no commitment to their company. Plus, Google Co-founders Larry Page and Sergey Brin who sit on the company’s board of directors do not hold any Google stock. Neither does the Google CEO Eric Schmidt. [Source: Yahoo! Finance]. When a management does not hold any stock in their company, they have no reason to make the company better because their money is not at stake. With Google, only 0.5% of their stock is held by insiders at the company, so no employees of Google really have a reason to make Google better.

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Google Searches just keeps climbing

As you can easily see from the chart on the left, Google's searches in July have grown 16% while Yahoo and Msn have both gone down around 10%. Google's growth rate has also exceeded the total growth rate of Searches by 13%.
In June, Google's searches rose by 19%, while total searches rose by 6.3%. Obviously, it seems that more and more people are searching, and picking google to do their searches.

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New Search Innovation from Microsoft

As Microsoft continues to trail search giants Google and Yahoo at 3rd place, they seek to attract more of the market with their new search innovation which could also raise certain questions.
This new idea is based on using previous search queries and search patterns of the user. They believe that by doing this, they can make searching easier for the user, seeing as "often users use search engines to explore subject areas broadly", as said by Satya Nadella, senior vice president of Microsoft's search, portal and advertising platform group.

The problem here is that by monitoring search patterns to produce results like this, the information can also be used to further target audiences with ads. This could also lead to higher priced ads. The main problem is with the intrusion of privacy. Basing ads on keywords is much less invading than if the ads were served to highly targetted audiences based on their searching pattern.

In my opinion, this is really nothing to worry about. It's a small price to pay for better searches, and I don't think it really affects anything. If you don't want to be bothered by the ads, then jsut don't look at them or consider them, seeing as they're probably not in your search results anyway. I generally have a policy of not clicking on the ads unless the companies' websites actaully appear in my search results as well. I also don't think that changing the search results by relevant patterns will help much. It's not like a search result is going to move 2 or 3 pages because of this. Though if it does, then maybe it will help.

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