Monday, October 22, 2007

How Profitable is Google's Core Biz? 75%+ Profit Margin

Google booked free cash flow of $1.1 billion in Q3, more than any other media company we know of.  The company also improved its operating margin (on net revenue) to 50%.  In other words, it's a fantastically profitable $16 billion global business that is still growing at better than 50% per year.

But guess what?  "Fantastically profitable" doesn't even begin to describe the earnings power of Google's core business.  For example, this is not a business that has mere 50% profit margins--a level that just about every other company on earth would kill for.  Rather, this is a business that probably has better than 75%+ operating margins--a level that only one of Google's fellow behemoths, Microsoft, could ever hope to match.

(And if Google has anything to say about it, Microsoft won't be enjoying its monopoly operating system and office suite profit margins for long).

How do we know Google's core search and AdSense businesses have better than 75%+ profit margins?  Because, for the last four quarters, Google's rate of hiring (people) has significantly outpaced revenue growth.  Salespeople and engineers take 6 months to a year to get fully productive, so most of the 6,000 employees Google has added in the past year aren't yet fully utilized...
Given the number of products Google has rolled out, moreover, only a fraction of these folks (except sales) are likely dedicated to search and AdSense.  Google is not yet generating meaningful revenue from any products other than search/AdSense, so this means that these folks are dead weight on the P&L.  But Google still has a profit margin of 50%.

How fast has Hiring grown relative to revenue?  Here are the y/y quarterly progressions for the past three quarters:  (For details, please see this online spreadsheet).

NET REVENUE:        66%, 63%, 62%
EMPLOYEES:          80%, 74%, 70%

That's a lot of unproductive weight that has been easily absorbed.

Why is this important?  First because it gives Google an amazing amount of cash flow to reinvest in other businesses.  Of the $2+ billion a year that Google is currently spending on engineering, for example, probably only half of it is dedicated to supporting the current core businesses (Google says 70%, but this seems unlikely).

Second, because all those salespeople the company has hired over the past year are eventually going to get fully productive, and when they do, revenue should grow far faster than headcount.  This means that,

Third, Google's latent earnings power is enormous.  At some point, the company will finally scale back hiring (from Schmidt's comments on the call, it sounds like this has just happened).  As it does, expense growth will slow, while revenue productivity from existing employees will grow.  Unless the company rapidly ramps spending on other non-revenue generating projects, therefore, Google's profit margin could leap upwards in the coming year.

By the way, we've just seen this movie before--with Google's CAPEX spending and free cash flow.  Two years ago, when it realized how big its opportunity was, Google ramped CAPEX spending far faster than revenue.  For six quarters, this held its Free Cash Flow down, at a level of about $2 billion a year.  In the last two quarters, however, Google's CAPEX has stabilized, while the company's revenue has skyrocked.  This combination has caused Free Cash Flow to go through the roof:

NET REVENUE:        73%, 66%, 63%, 62%
CAPEX:                   49%, 73%, -18%, 12%
FREE CASH FLOW: 32%, 30%, 363%, 111%

What's that called?  Earnings power.