Is Google’s management out of touch with how Google makes money?

I’ve never been blown away by the way Google’s management communicates with shareholders.

1. The 10-K presents “Cost-per-click” and “aggregate paid clicks”, both of which are terrible metrics.
2. The shareholder letters largely gloss over Google’s cash cows: its search advertising and display advertising businesses.

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Digital River (DRIV) and payment processing (V, MA, GOOG, EBAY)

Digital River is a company that offers:

1. Payment processing.  For (very) small software vendors such as myself, Digital River competes with Paypal (owned by Ebay), Google Checkout (now Google Commerce), and others.
2. E-commerce / online store.  This relates to automatically letting the user download the product once payment is received, product updates, etc. etc.  I use E-Junkie for this service.

Digital River has a lot of unhappy customers because it was upselling its customers’ customers.  The software vendors are unhappy since they can’t opt out of the upselling (nor do they profit from it) and some of their customers are turned off by the upselling practices.  Digital River doesn’t seem to understand its software vendors and has a terrible reputation among them (Google around… here is one example).  I will never do business with Digital River as a software vendor.  And I wouldn’t go long the stock.

Google (GOOG)

In my opinion, the most important points about Google are as follows:

1. Google has an amazing franchise in its Adwords (search advertising) and Adsense (banner/text ads) businesses.  These business are likely to continue to grow earnings at very high rates for the foreseeable future.
2. At a P/E ratio of roughly 22 and with a high growth rate, Google is somewhat cheap.
3. The biggest risk to Google is that of a competitor developing a better search engine.  In the history of technology companies, small startups like Google can quickly dethrone the market leader in the span of only a few years.  Google did this to the former market leaders such as Yahoo and Altavista.  Another company may do the same to Google.  I do not see Google as having a moat against a higher quality product.  It is not like the soft drink business where Classic Coke has a moat against better tasting products such as New Coke (now defunct) and Pepsi.  The technology industry is littered with corpses.  Not even network effects protected services such as ICQ and Myspace.

I believe that Google call options are compelling since the options minimize the tail risk and they aren’t expensive.

Online advertising (GOOG, FB, etc.)

I believe that online advertising offers significant value compared to traditional advertising because online advertising can be tracked very easily.  Internet advertisers can track the click-through rate on their ads and how many of those clicks convert into a sale.  This gives instant feedback on the ad’s return on investment.  Advertisers can optimize their advertising budget to maximize their profits and split-test different ads and landing pages (the webpage that the ad points to).