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Google: Both Sides Now

Kevin Kelleher

If they handed out awards to stocks like they do for movies, there's no question who would win the grand prize for 2005: Google(GOOG Quote). Not only was it up 115% last year -- capping a 127% post-IPO jump in 2004 -- it drew the largest amount of discussion, examination, speculation and obsession.

So, as we tear the final sheets from our desk calendars, it's time to become absorbed in new questions: Whither Google in 2006? Will the stock pull off the proverbial hat trick? Or is the highest of Internet highfliers headed for a fall?

You don't have to go far to hear arguments in favor of both scenarios. In fact, if you're like most Google junkies, you probably find yourself on both sides of the debate, depending on the day.

One day, Google is secretly plotting to take over the entire Internet; the next it's destined to be undone by that very hubris. Today, Internet advertising is booming; tomorrow there will be hand-wringing about Google's inability to make money beyond search.

To sort out this analytical tug of war, here are two good reasons why Google will rise in 2006, two why it will fall, and the likely outcome for the stock in the coming year.

Bullish Case No. 1: Search Stays Huge

Will Google ever find a revenue stream beyond search ads, as Yahoo!(YHOO Quote) has? The answer is it won't really matter in 2006. The market for online ads is forecast to grow 32% to $16.6 billion, according to Credit Suisse First Boston. And there's every reason to believe that search-driven ads, which are more easily targeted to readers' interests, will draw in more than traditional banner ads.

More importantly, Google will remain primarily a search company for the next few years, if not for good, by design. The first number in the company's 70-20-10 rule requires all employees to spend 70% of time on Google's core business, which is search advertising. Listen to Google execs and it's clear that they aren't anywhere near where they want to be in search technology.

And that's key. Because the better Google gets at making ads into something you actually want to see and click on -- as opposed to something you labor to filter out -- the more attractive the Internet becomes to advertisers. That means Google can siphon off even more money from television, radio and print advertising. Sure, Yahoo! and others are catching up to Google quickly. But there could easily be new, big search improvements rolled out in 2006 that put Google ahead again.

Bullish Case No. 2: Mobile Search Breaks Wide Open

Right now, using search on a mobile phone or handheld is an onerous process that people use largely for novelty or when they desperately need an address or phone number. But what if it were as easy to search on your Motorola(MOT Quote) Razr as it is on your Dell(DELL Quote) PC?

For online ad firms like Google, it would be very big. It would mean enabling hundreds of millions of new searches per day and possibly jumpstarting local search, which has yet to fulfill its promise. Google Mobile has been available for a while, but can improve. The more intuitive and user-friendly Google can make this process, the more ads it can sell.

In overseas markets, where mobile devices are more tightly woven into everyday lives than they are here and where PCs are often not an option, the opportunity is even bigger. Much depends on what Google has in store: The company rarely tips its hand on new technologies, but if this area isn't a top priority this year, it's making a big mistake.

Bearish Case No. 1: Inevitable Backlash

Purely in terms of public perception of the company, 2005 came in like a bull and went out like a bear. Bloggers and journalists -- yes, me included -- grew critical, if not whiny and petulant. Comparisons with Microsoft(MSFT Quote) became commonplace.

In 2006, the perception issue will be different, more complex and probably more troublesome. Google is a large company, with nearly $5 billion in annual revenue and a market cap several times larger than brand names like Coca-Cola , Nike and Disney (DIS Quote). Like those companies, Google will make the inevitable move from cute, friendly brand to reviled, conflicted corporation. Power like Google's means thousands of paper-cutlike compromises to maintain your interests.

It's something you can fight but can't win. It's the trajectory charted by Charles Foster Kane and Michael Corleone: If you don't want to get crushed by the system, you have to become the system. The catch for Google is that it set the bar too high for itself early on, vowing -- as you read it now for the millionth time -- to "do no evil."

This is an issue for investors because Google's brand is tangled up in that mantra. The company may never put flashing banner ads on its home page, but it's already set foot on the slippery slope of graphic and video ads, and it's finding it can't make ads more personal without intruding on users' privacy. Both will surely alienate its biggest fans, and create an opportunity for its rivals.

Bearish Case No. 2: Liquidity Factor

Google traders surely have noticed that the stock has grown more volatile since rising above $400. It used to be that buyers would emerge whenever the stock dipped. Now they seem more tentative. The stock was down 4% in the last four days for no good reason, then kicked off the new year with a 5% bounce after a $600 price target was stuck on it by Piper Jaffray.

In 2005, the institutional investors who craved Google for a long-term investment had every chance to sate their appetites on the stock. And they surely got in at a good price -- Google was trading around $295 when its secondary offering went through in September.

Google issued 14 million shares in that offering, and insiders have sold more than 20 million shares since the company went public. So, while demand has been sated by big investors, there are more shares around than ever. If Google doesn't buy back its stock -- and it's shown few signs it's willing to play such games to benefit investors -- the liquidity scales could tip in favor of excessive supply.

At the same time, it's starting to become a given that Google's stock will just keep going up. Google's financials have spiraled upward and surprised so often that investors are becoming conditioned to expect a blowout every quarter. One of these quarters, they'll be let down. That, coupled with Google's infamous secrecy, will really make the stock volatile.

Bottom Line: A Bumpy Road That Eventually Leads Higher

There's not a competitor who can steal the thunder from Google, although there is Yahoo!, which has shown a knack for nipping at its heels. Google may need to find new revenue, but it has a few years to do it. Within search, all signs indicate it won't blow its opportunities, but expand them. So, the stock is likely to power higher.

The difference is that it's going to be a more turbulent ride. It's not going to be as easy to double your money in Google in 2006 as it was in 2005 and 2004. It can happen, but you'll need to choose the right strategy and stick to it through thick and thin.