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Bubble Bath

Gaga over Google.

It has been barely four years since the dot-com bubble burst, but Google's impending initial public offering (IPO) has investors, analysts, and financial journalists partying like it's 1999. Over the past two weeks, the financial media have praised Google and its thirtysomething founders in a manner unseen since Netscape and its own wunderkind founder went public fewer than ten years ago. The IPO, which is likely to take place within the next few months, "is generating enormous hype," noted The Wall Street Journal, "and for once an Internet IPO may actually deserve it." Indeed, thanks to Google, crowed a Washington Post editorial, "After some years of dot-bomb gloom, we look forward to a new phase of fun and innovation."

Nor is Google's IPO an isolated incident. Nine tech companies have gone public in the first three months of this year, versus just one during the first quarter of 2003. "It's a good time to go public," says Mark Mahaney, an analyst with American Technology Research. "The Internet capital markets are extremely receptive." Even that may be an understatement. Market analysts say Google's $2.7 billion IPO could balloon to a market capitalization of more than $30 billion, compelling evidence that pent-up demand for hot tech stocks is driving Googlemania.

Problem is, there are serious questions about Google's long-term viability--the kinds of questions that, under normal circumstances, would dramatically dampen excitement over the company's IPO. And it's not just Google: Many of the other tech companies with recent IPOs look suspect upon closer inspection. The fact that journalists and analysts haven't bothered to dwell on these unpleasant realities suggests that, not only are we on the verge of another tech boom, but we're probably on the verge of another tech bubble as well.

To be sure, Google has done extremely well since it emerged six years ago from a grad-student research effort. At the heart of the search engine is a sophisticated algorithm for listing websites in order of their relevance, or the number of times other sites have linked to them. Thanks to its ability to link unobtrusive ads (which appeals to users) with this powerful search method (which appeals to advertisers), the company has been in the black since 2001, with $100 million in 2003 profits and $64 million so far in 2004.

But that success has less to do with the company's superiority over its competitors than with good luck: Google hit its stride at a time when the big guys were looking elsewhere. In 2001, search was seen as a useful but unprofitable aspect of the Web; ironically, thanks to Google, today it is viewed as pivotal to the software sector's future. "The cat is out of the bag," says Scott Kessler, an analyst who covers high-tech firms for Standard & Poor's. Word has it that Microsoft will feature an immensely powerful search engine in the next generation of Windows, due out by 2006. Not only will it incorporate a Web-search algorithm similar to Google's, it will also be able to search a user's desktop, local area network, and e-mail. "Microsoft loves complex software like search," noted Forrester Research analyst George Colony recently. "The company started in the languages business. Taking down Google with better search is in its strike zone."

As a result, Google stands a good chance of becoming not the next Microsoft, but the next Netscape. Like Google, Netscape was a small firm that went public, to great fanfare, largely on the strength of its hold on the browser market. (And, like Google, it was led by an Internet genius whose wizardry initially dispelled questions about his firm's long-term potential.) But, only a few years after Netscape went public, it had been eclipsed by Microsoft, thanks in large part to the latter's ability to tie its browser into its operating system. Today, Netscape is a largely forgotten subsidiary of America Online. And, while Google actually has a viable business model--something Netscape never really developed--the potential for a trouncing by Bill Gates is nonetheless large. As it did with Internet Explorer, Microsoft is likely to embed its browser directly into its Windows software. Combine that ease of access with the fact that the Microsoft browser will be more functional, and it's tough to see why many Windows users would even bother with Google.

Worse, Microsoft is hardly the only competitor poised to eat away at Google's market share. The next generation of search engines, analysts say, will be intensely personalized, allowing users to search within specific geographic regions and returning results filtered through a variety of stored user characteristics. On this front, it is Yahoo!, which, until early this year, had actually used Google to power its search function, that is ahead of the pack. Yahoo! has the advantage of being able to cull demographic data from its millions of subscribers (to e-mail and other services) and match them with advertisers, a kind of personalization that is viewed as the holy grail of Internet marketing.

Even if Google does somehow remain on top of the search-engine market, it will still find itself in a precarious position. Though many analysts expect the search-engine advertising market to expand rapidly, the fact that Google relies on ads for 96 percent of its revenue makes it "a one-trick pony vulnerable to the swings of the market," as The Toronto Star noted recently. Google has responded to these concerns by rolling out its own free e-mail service (called Gmail), and insiders expect other services--such as instant messaging--within the year. (Gmail will not only bring in more users, but, by scanning e-mails for key words and then embedding ads linked to those terms, it will create another revenue stream as well.) But simply entering a market does not guarantee success. "Even if the actual service is compelling," says Kessler, "it has to be very special to get people to sign on," given all the other services available.

And there's a final pitfall: Whether Google stays focused on search or moves on to other services may not, in the end, be its decision. In April 2002, a software-development firm named Overture sued Google for violating its patent on a method for ranking search results. Not surprisingly, last year, Yahoo! bought Overture and thus stands to benefit immensely should it win the suit. Such a decision could either force Google to pay an exorbitant licensing fee or allow Overture to set a fee so high that Google has to get out of the search business altogether. "If Overture wins this, [Google's] primary revenue driver is out the window," says Chris Sherman, an editor at, an online trade publication. While the case is barely out of the discovery phase, the success other companies have had in pursuing similar patent-infringement violations in recent years suggests there's a good chance Overture could prevail.

Still, if Google were just a single, isolated example of investors misjudging the prospects of an upcoming IPO, it wouldn't be much to worry about. Sooner or later, the company's stock price would fall back in line with its potential for earnings growth, and the fallout from that correction would be confined to a relatively small group of overly optimistic investors.

The problem is that the hype surrounding the Google IPO looks symptomatic of a broader phenomenon: a return to the irrational exuberance of the late '90s. A raft of dot-coms are suddenly throwing their hats into the IPO ring. And, while some of them--such as Netflix (the online DVD rental company) and RedEnvelope (an online gift retailer)--are relatively mature companies with proven moneymaking abilities, investors are also starting to throw cash at the kind of unproven firms that defined the '90s bubble. Marchex, for example, an untested 15-month-old online advertising broker, has seen its stock rise 65 percent since its March 30 IPO., a firm that manages other companies' sales relationships (and perhaps the second-most anticipated IPO this season), had to postpone an earlier offering because of a Securities and Exchange Commission investigation. And Seven, a software developer, went public recently despite a $12 million annual loss on $6 million in revenue.

Why hasn't the market learned the lessons that seemed so clear after the tech bust early this decade? For one thing, the rapid democratization of the stock market during the '90s continues today. Thanks largely to the continued growth of pension funds and discount brokerages, more Americans have money in the market today than they did at the height of the boom. That means that, even though many first-time investors got burned, a whole new crop of first-time investors has emerged to take their place in the past few years. Second, it's not clear that even the investors who did get burned ever got over the exuberance of the late '90s. "Memory can be offset by greed," says Tom Taulli, the manager of the Oceanus Value Fund and an adjunct professor at the University of Southern California. "It's always, `This time is different; this is a different company.' We get hundreds of e-mails a day from people who say, `I want to put my life savings in Google.' Have they read the prospectus? Probably not. Could they even read it? I doubt it."

On top of this, the analyst/investment-banking relationship that came in for so much scrutiny during the last few years still hasn't been completely repaired. This, despite reforms that forced a tentative split between investment bankers and equity analysts. As long as IPOs represent big commissions for these firms, it's difficult to see how any analyst working for them can be counted on to assess IPOs objectively.

Finally, the dynamic of institutional investing deserves a share of the blame. Up until the mid-'90s, many large, institutional investors sat out the tech boom, worried--accurately, as it turns out--that the companies whose market valuations were rising so rapidly had little chance of actually turning a profit. But, once a small number of institutional investors got in the tech game--and proceeded to make huge annual returns on tech stocks--it became difficult for more clear-eyed fund managers to resist the pressure. (Particularly since most fund managers are evaluated against their peers.)

This same dynamic seems to be taking hold again, as fund managers vow not to get left behind in the kind of bull market they might have been slow to embrace the last time around. And, this time, funds are much more willing to buy and sell stocks quickly, meaning that they care less about the fundamentals. "Turnover rates are higher than before; they're very fickle on Wall Street," says Taulli. Indeed, fund managers have come around to the idea that momentum investing--that is, buying stocks whose prices are rising, even if they're not inherently valuable, in order to unload them later--is a necessary evil and something they can no longer avoid if they want to retain clients. As investing icon Peter Bernstein, long known as an advocate of conservative, buy-and-hold management, rhetorically asked a group of institutional money managers last year, "What if moving around more frequently is now a necessity rather than a matter of choice?"

In an ideal, rational world, all the concerns about Google and the other companies going public would frame the discussion over their IPOs. But, rather than push us closer to that world, the same forces behind the recent dot-com implosion are pushing us once again toward a return to the heady, antediluvian days of the late '90s. As one tech consultant wrote recently, "Google's IPO is expected to signal the horn's blast trumpeting the beginning of the next IPO land rush for tech companies everywhere." Why does everyone think that's a good thing?

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