Google's Margins Threaten Yahoo!

Google's financials, made public for the first time Thursday, won't bring much cheer over at rival Yahoo! (YHOO - commentary - Cramer's Take).

Since its recovery at the beginning of last year, Yahoo! has been feted in the market as one of the few companies that understands the Web and will make big profits there over time. But Google's numbers show that its profitability is far superior to Yahoo!'s.

This bodes ill for Yahoo! because it means Google has the ability to savagely undercut its rival, stealing customers and revenue. That is something Google looks poised to do most immediately with the introduction of Gmail, an email service with large amounts of storage. Yahoo! charges high fees for email storage and its service is maddeningly slow and awkward to use. If Google's email search is as fast and as clean as its other sites, Yahoo! email users will surely join Google in droves, along with advertisers.

Cost Benefits

Google provided some very useful financial data in its so-called S-1 document, which is filed when a company wants to sell stock to the public for the first time. Before now, investors had no idea about the size of Google's earnings, revenues and profit margins. Today, they can see a company that is already far more profitable than competitors like Yahoo! and Amazon.com (AMZN - commentary - Cramer's Take).

In 2003, Google earned $106 million on $962 million of revenue. But it is the margins that tell the story. Gross margin -- revenue minus cost of goods sold, expressed as a percentage of revenue -- is about the same at both companies, using a revenue number for Yahoo! and Google that excludes traffic acquisition costs. Google's gross margin in 2003 was 87%, vs. 86% at Yahoo!.

However, Google's real coup is to have proportionately much lower operating costs, which creates an operating margin that is far fatter than Yahoo!'s.

For example, sales and marketing expenses at Google were only 13% of revenue in 2003, compared with 36% at Yahoo!. Even product development costs, which one might think would be weightier at innovative Google, were a lower percentage of revenue last year -- 10%, vs. 14% at Yahoo!.

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In keeping with TSC's editorial policy, Peter Eavis doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He welcomes your feedback and invites you to send any to [e-mail].