What’s Weighing Down Google’s Stock?

A funny thing is happening to Google on the way to near-certain immortality. Its stock, it seems, is as fallible as any other.

Consider the year-by-year appreciation of Google’s stock price:

  • 2004: Up 126.8%, from the offering price of $85 to $192.79.
  • 2005: Up 115.2% to $414.86.
  • 2006: Up 11.0% to $460.48.
  • 2007: Up 1.5%, as of April 12.

Google, which joined the S&P 500 a little more than a year ago, has since failed to outperform that index: The S&P 500 returned 16.5% in 2006 and is up 2.1% this year. So after two years of glorious gains, Google has since lived a life less ordinary.

What’s going on here? It’s well known that Google’s revenue growth rate is slowing, as it does with any company that is getting larger. But it’s not as simple as that. Google’s profit margins are rising. And investors can be awfully forgiving about slowing revenue growth if margins are getting fatter.

Whether or not you factor in traffic acquisition costs, Google’s revenue percentage growth has slowed from three digits to two in recent years. But its operating margin has risen to 33% in 2006 from 20% in 2004 (the year of its IPO), while its net profit margin has risen to 29% from 13%.

But as any investor knows, there are other factors besides profit growth at play in stock performance: things like financial transparency, speculative trading and liquidity. All of these have buffeted Google’s stock at one time or another since it went public, but liquidity – that is, the balance or imbalance of supply and demand for its shares – is right now the determining factor.

One event that is having an underappreciated impact on Google’s stock is the secondary stock offering in September 2005, which added 14.2 million shares to the 19.6 million already in the market. That offering began a gradual tilting of the balance-o-meter of Google stock in favor of supply over demand.

Demand for Google remained high in 2005 as the company blew away earnings in the third quarter ($1.51 a share vs. the Street’s estimate of $1.36) and Net stocks in general rallied toward the end of the year. But think about this: Google ended the first week of 2006 at $465.66. If you bought it 15 months ago, you haven’t made money.

The supply caught up with demand. If anyone was hot on Google, thinking it might fulfill the orgiastic fantasies of analysts who had a $2,000 price target on the stock, there was always someone more than happy to sell shares to them.

Google added to the supply of shares when it bought YouTube for $1.65 billion in a stock acquisition. Google’s 10-K says it issued another 3.2 million shares for that. Since those stocks were issued on Nov. 13, the stock has traded flat to down.

Then there are all those stock options that are starting to trickle into the total number of Google outstanding shares as they are vested and exercised. In a thoughtful article Wednesday, the San Jose Mercury News asked whether employees who are receiving the last of their four-year allotments of Google’s pre-IPO options will bolt.

The story pointed to the obvious cultural and HR questions that such events raise: will Google’s valued veterans move on to create startups that could steal Google’s thunder? Will a class-system emerge where wealthier employees are resented by the newly hired? Google, as you’d expect, is making intelligent moves to stave off these problems.

But from a liquidity standpoint, there remain problems. On the one hand, exercised options add to the number of stocks outstanding, further dampening demand. On the other, a stagnant stock price – like Google has seen for five quarters – could deter new hires who are motivated by the lure of options gains.

Google could solve this problem the way most tech companies do: by buying back its stock in the open markets. At nearly $500 a share, that’s a pricey proposition. And it would betray the company’s oft-declared intention to invest only in future growth, not its stock.

In the now legendary “Owners Manual” that Larry and Sergey penned for shareholders, Google swore that it wouldn’t care about capital gains as much as “doing no evil” and “making the world a better place.”

Now, like so many tech giants before it, Google is faced with the unsavory reality of taking cash that could be spent on its future and instead spending it on the unglamorous reality of stock buybacks. Whether it makes this move or not will have, in time, an increasingly bigger weight on investors and employees, past and future.

Kevin Kelleher is a writer living in the San Francisco Bay Area. He has a regular stock column at TheStreet.com and is a contributor to Wired, Business 2.0 and Popular Science. He has previously worked at Bloomberg News, Wired News and The Industry Standard magazine.