Google Says to Investors: Don't Think of Flipping
By ALEX BERENSON
April 30, 2004
Wall Street loves Google, but the feeling isn't mutual.
That is the message permeating nearly every page of the public offering statement that Google Inc., the Web search engine company, filed yesterday. In a frank and provocative statement, the company's leaders argued that companies cannot manage for the long term unless investors and analysts have limited say in the way they are run.
In this, they are responding to a widespread belief that investor pressure for predictable short-term earnings growth led many publicly traded companies to engage in accounting gimmickry and business improprieties in the 1990's. Google says that it will not offer quarterly earnings guidance and that it expects shareholders to understand even if it makes unprofitable short-term investments.
"A management team distracted by a series of short-term targets is as pointless as a dieter stepping on a scale every half-hour," Larry Page, one of Google's co-founders, wrote in a "Letter From the Founders." The letter, which appeared at the front of the statement, was signed by Mr. Page and his fellow founder, Sergey Brin.
Many institutional investors may cheer that attitude. But another part of the company's strategy will draw some criticism. Google aims to insulate its executives somewhat from shareholder demands. The company will have dual classes of stock that will give company insiders much more voting power than public investors to elect directors. The company's disdain for the traditional stock offering process is also evident. Instead of selling a small number of shares at a predetermined price, which often stokes demand for the stock when it begins trading, Google will auction its shares to the highest bidders. In that way, the windfall profits from the offering will go to the company and its private shareholders, not to favored customers chosen by Wall Street investment banks. In its registration statement, Google explicitly warns investors not to buy the offering in the hope of making a short-term profit by flipping their shares.
Google can behave with so little regard for shareholders' wishes because its business is so attractive that investors will be clamoring to buy stock no matter what conditions the company sets. The company's sales and profits are increasing at a spectacular rate, at least for now, and its profit margins appear to be among the highest in corporate America.
In 2003, Google reported an operating profit of $340 million on sales of $960 million. But the 2003 figure appears to understate the company's cash profit margin, since it includes very high expenses related to stock options that will probably decline in future years. On a cash basis, Google had an operating profit of $570 million in 2003, and an operating margin of 62 percent.
Given those figures, Google will easily command a market valuation of at least $30 billion, and perhaps much more. EBay, which had an operating profit of $660 million on sales of $2.2 billion last year, is valued at $54 billion; Yahoo, with sales of $1.6 billion and operating cash flow $428 million, is valued at $36 billion.
So the offering will make billionaires of Google's top three executives. Mr. Page, 31, and Mr. Brin, 30, each owns about 15 percent of the company, conservatively worth more than $4.5 billion; Eric Schmidt, the 49-year-old chief executive, has stock options on 6 percent, worth $1.8 billion.
Those figures are eye-popping, even in Silicon Valley, which during the 1990's generated fortunes on a seemingly weekly basis. But if the registration statement is a guide, the prospect of riches has not dulled the reservations that Mr. Page and Mr. Brin have about the public markets.
"As a private company, we have concentrated on the long term, and this has served us well," Mr. Page wrote in the public offering statement, which companies must file with the Securities and Exchange Commission before selling shares. "As a public company, we will do the same. In our opinion, outside pressure too often tempts companies to sacrifice long-term opportunities to meet quarterly market expectations. Sometimes this pressure has caused companies to manipulate financial results in order to 'make their quarter.' "
Mr. Page pledged that Google would never manipulate its results or allow accounting decisions to dictate its business decisions. Nor will the company provide quarterly earnings guidance, as most public companies have done for the last two decades.
Neil Barsky, a former analyst for Morgan Stanley who runs a hedge fund in New York, said Google's attitude was refreshing and candid.
"There is a slavishness that companies feel that they have to play to Wall Street quarter in and quarter out, and that is not the way the real world works," Mr. Barsky said. "They're saying, 'Merely because we go public and because analysts will feel the need to comment on every quarter does not mean that we will manage our business for short-term pressures.' I agree to that 100 percent. That's the right way to run a business."
But Google evidently does not trust shareholders to think long term. Under the dual-class voting structure, the new shares it sells to the public will have only a tenth as much voting power as the shares current investors own.
"New investors will fully share in Google's long-term growth but will have less influence over its strategic decisions than they would at most public companies," Mr. Page wrote. He compared Google to Berkshire Hathaway, Warren E. Buffett's company, which also has a two-class structure.
Not all investors think this is a good idea. Thomas Giovine, a hedge fund manager in Los Angeles, said shareholders should punish Google for its failure to give new investors the same rights as its founders. Once a company goes public, its founders must understand and accept that they are responsible to public shareholders and are no longer fully in control, he said.
"The guys sitting in the boardroom are just employees that the owners are paying to run companies as best they can," Mr. Giovine said.
Still, Google's motives seem decent, he said. "At the end of the day, it's probably a good thing to get Wall Street to think longer term."
The company's offering process will also give Wall Street less control over its shares and new shareholders much less of a chance to make a short-term profit. During the late 1990's, many technology companies offered a small number of shares to big investors at a price far below the price that individual investors were willing to pay. When the shares began to trade publicly, those big investors often would flip their shares to smaller investors for huge profits. For example, VA Linux, a computer company, rose from $30 to $239.25 when it opened for trading in December 1999. VA Linux's stock closed yesterday at $2.15 a share.
But Google plans to set its offering price differently. The company will ask investors how many shares they want to purchase, and at what price, and then try to sell enough shares to the highest bidders so that its stock is unlikely to rise quickly on its first day.
"We are working to create a sufficient supply of shares to meet investor demand at I.P.O. time and after," Mr. Page wrote. "We would like you to invest for the long term, and to do so only at or below what you consider to be a fair price."
As a result, investors who buy Google stock in the hope of making a quick profit may be disappointed, Mr. Page wrote. "Short-term speculation without paying attention to price is likely to lose you money, especially with our auction structure."
Of course, the structure also guarantees that Mr. Page and Mr. Brin, who plan to sell part of their holdings in the offering, will get the highest price possible.
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