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Victor Niederhoffer



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Conversion on the Road to Mountain View: Rethinking Google

Tears in the Eyes

The estimable Dr. David Brooks of Brigham brought to my attention Jurgen Thorwald's 1956 book "The Century of the Surgeon," containing within it a tale of heroism and tragedy rivaled only by the best in O'Brian's "Reverse of the Medal" or Rand's "Atlas Shrugged."

The story starts with Horace Wells, a humble dentist from Hartford, arriving at Harvard Medical School in January 1845 to demonstrate his new discovery: the use of laughing gas as anesthesia. John Warren, Harvard's austere and authoritarian head of surgery, told the assembled students in his solemn, haughty, aloof manner: "There is a gentleman here who purports to have something which will destroy pain in a surgical operation. If any of you would like to hear him you are at liberty to do so." Wells then proceeded to pull the tooth of a brave volunteer. The patient screamed. The Harvard students broke out into riotous laughter and chants of "Humbug! Humbug! Humbug!"

Finally, Warren, stepped forward and quieted the crowd with a gesture. "With a touch of self righteousness of age, and of that acceptance of pain which had become an article of faith," he made it clear to Wells with polite formality that any further comment would be superfluous, and stalked out of the amphitheater. Laughter and catcalls rang out once more. Wells threw his instruments into his satchel and hurried out, eyes fixed on the floor.

Nineteen months later, in October 1846, Well's assistant, Dr. Morton, was given the chance to make another demonstration. A young patient had a tumor on his tongue; Warren was to perform the surgery. "Warren bent over [the patient], his face expressionless as ever. He rolled up his sleeves and took his scalpel in hand. Then, with a lightning motion, he made the first incision. There was utter silence in the hall...the patient did not stir. Carefully, Warren scraped out the tumor. Not a sound! The surgeon severed the last threads of tissue, applied a ligature. Still nothing."

Warren straightened up. His face was pale, his smirk was gone. "Gentlemen," he exclaimed at last, " this is no humbug." "And suddenly there was wetness on his lined, parched-looking cheeks. Warren, the terse, aloof, unemotional Warren, had tears in his eyes."


I felt a similar shock at the falsity of my beliefs after finishing "The Google Story" by David A. Vise and studying some of the financial and descriptive reports on the company. Gentlemen, this is no humbug. Google's combination of proprietary software, repeat business, strong brand, wide customer base, technological innovations in hardware and software, growth of its basic product line through diffusion and word-of-mouth via the Web, and the steady flow of new products with great potential in all stages of the pipeline completely overturns my previous skepticism of the lofty multiples and intensive insider selling that are part and parcel of this company.

I will describe my reasoning in subsequent memos. For now, I have changed my position, in the old-fashioned tradition of Russell Sage, from speculator looking for overnight profits based on statistical anomalies related to the vividness of fear, uncertainty and doubt emanating from last week's horrible performance after the earnings announcement, to long-term buy-and-hold investor based on a complete reversal in my belief system similar in magnitude to Warren's.

A Man from the Moon

If anyone told me that someday I would own a stock that had a multiple of 40 based on estimated 2006 earnings, run by two computer geeks that professed a disdain for profits, whose mantra was "Don't Be Evil," who spend two weeks each year at Burning Man, who had a holy terror of allowing their CEO to become chairman of the board and managed to give him 5% of their company partly in exchange for a investment of $1 million in preferred stock, who vetted all their employees based on aptitude test scores, whose culture was based on hiring an executive chef who boasted that he once was a part-time chef for The Grateful Dead and cooked only with organic foods, who bonded because of their common Montessori school background, liberal sensibilities and participation in a peace march relating to the Iraq War, who had no compunction about teaching Wall Street a lesson in how to market their IPO, and wished to market it based on a philosophic letter expressing their liberal sensibilities, with my buy decision based in part on a breathless celebrity-journalism puff piece emphasizing the principals' Darman/Sununu-like aptitude test scores, in a book whose "accuracy" was approved in advance, with massive insider selling in the billions each day according to a fixed schedule that allowed the principals to sell even before earnings releases that they refused to give guidance on, who boasted that they would never smooth earnings, and, most of all, who held the Sage as a venerable guide for how to run a company and how to look at the all-too-materialistic interest of all investors and of self-serving businessmen in particular -- why, then, I would have told them, as Artie liked to say: "Get out of here!"

And yet, with tears in my eyes, I have to admit that I own the stock. Let's start with sales the last four calendar years of $0.4 billion, $1.5 billion, $3.2 billion and $6.1 billion, and operating earnings of $0.2 billion, $0.3 billion, $0.8 billion and $2.1 billion. If ever there was an example of riding an early part on a S-shaped growth curve, this is it. Under the circumstances, the trend in quarterly earnings, that they only went from $0.69 per share in the fourth quarter of 2004 to $1.54 per share in the fourth quarter of 2005 and that the IBES estimates for the first few quarters of 2006 are now only $2.00 a share, seems rather to miss the forest for the trees. My goodness, if a company is growing by a 75% a year or so, doesn't it deserve a multiple more than twice what See's Candy might sell at?

It might be best for me to step back and analyze this company as a man from the moon might, since I don't know anything about search technology except that I wrote my thesis on content analysis, and I certainly don't know anything about the competitive situation among the constantly changing Internet technologies.

Nobody Asked Peter Gardiner, but he comments:

If one take the example of GOOG and compares it to other companies with huge first-mover advantages in hugely growing, highly profitable industries, and does the counting, the tears may be wasted at this price. Take, say, MSFT when it had 9 billion oi revs (similar to GOOG). The op margins, free cash flow and net margins are roughly the same. Should GOOG grow at the same rate on top and bottom lines (high and low 20s% per annum respectively) as MSFT did from 1996 to 2005, and we do a simple DCF with current rates (remembering that the greatest part of the value for such a high-multiple company, or indeed any company with a P/E over 15, is at the back end in the perpetuity) we get a prspective NPV for GOOG around 180 or so -- pick a different rate if one wants a different number. So to justify the current price, GOOG would have to grom 50% faster over the next 10 years that the largest monopoly on the face of the earth AND still preserve its huge margins. But wait: What effect will the future GOOGs of the world have on such a scenario? One thinks of the profits foregone by MSFT in GOOG's wake for a lesson.

I think you were right in the first place.

Stefan Jovanovich replies:

GOOG's problems are with its rate card. Paid search rates are declining faster than the company projected so their increases in volume have led to a slower (though still spectacular) rate of profit growth.

Mr. Brin's arrogance has a great deal to do with his Stanford diploma. Palo Alto has never been a wellspring of modesty or humility. That should not, however, prevent us from respecting the brilliance and energy so often do come from the Farm. The problem is that lack of a musical ear ("Don't Be Evil" has a terrible meter) and an inability to laugh at oneself (The Farm was never, in fact, a farm; most of the Stanford campus is a former WW I cavalry training ground.) In those ways, GOOG as a company is very much on same path that led to the "H-P Way".

Allen Gillespie adds:

One of the thoughts that keeps me attracted to the GOOGs and EBAYs of the world is this thought: what is the value of the MLS service for real estate? How many real estate agency owners do I know that are well off? What is the value of a list of links to all internet information?

Ross Miller offers:

As any devoted reader of my commentaries would know, Google's motto is "Don't Be Evil" not "Do No Evil." The real version has better meter and a very different meaning. The full explanation from Google's prospectus (which I doubt any member of the mainstream financial media has ever read) is:


Don't be evil. We believe strongly that in the long term, we will be better served-as shareholders and in all other ways-by a company that does good things for the world even if we forgo some short term gains. This is an important aspect of our culture and is broadly shared within the company.

Google users trust our systems to help them with important decisions: medical, financial and many others. Our search results are the best we know how to produce. They are unbiased and objective, and we do not accept payment for them or for inclusion or more frequent updating. We also display advertising, which we work hard to make relevant, and we label it clearly. This is similar to a well-run newspaper, where the advertisements are clear and the articles are not influenced by the advertisers' payments. We believe it is important for everyone to have access to the best information and research, not only to the information people pay for you to see.

Steve Ellison reports:

As it happens, I recently co-wrote a paper on Google (Google Strategic Plan, by Brent Hummer, Greg Jones, Audre Wilde, Steve Ellison) for one of my classes. I found many other interesting facts that did not make it into the paper, including the Googleplex's past life as the home of Silicon Graphics.


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