GOOGLE @ $165 Are these guys for real?
Four months after the IPO, Google's stock has soared, the company is selling scads of online ads--and its bosses realize it has to grow up fast.

(FORTUNE Magazine) – JON GALES LOVES GOOGLE, BUT NOT FOR THE REASON YOU MIGHT think. It's a terrific search engine, sure, but what Gales really likes is that Google is making him money. Gales's website,, is a compendium of news and reviews about cellphones that after a year and a half attracts about 200,000 users a month. Google supplies the ads for the site, visitors click on the ads, and because of the site's popularity, Google sends Gales monthly checks of $5,000 or more. That's a decent chunk of change for any sole proprietor. But for Gales, the numbers are eye-popping. He's only 19 and lives expense-free at home with his parents in Tampa, posting four or five items in the course of the day while parked on the living room couch with his laptop. Says Gales: "If things keep going the way they are going, I'll be making more money than my dad next year."

Google is making money for lots of people these days, whether they're tiny website entrepreneurs, giant corporations like the New York Times Co., or the legions of shareholders who have seen Google's stock price roughly double in less than four months. (It was trading around $175 as this issue went to press, but $165 is a round number many analysts have used in valuation models--and a level the volatile shares have yet to dip below in recent weeks.) From its humble beginnings in Larry Page's and Sergey Brin's Stanford dorm rooms six years ago, the company has become the latest mecca for clever engineers and a $2-billion-a-year growth machine.

Last quarter Google's Ebitda, Wall Street's proxy for operating income, totaled $321 million, vs. $322 million for nine-year-old eBay, $260 million for ten-year-old Yahoo, and $114 million for nine-year-old Amazon. Google is much smaller than those fellow dot-coms but is growing faster. Its sales and Ebitda each doubled last year and the year before that. Google's operating profit margin, at more than 60%, is bigger even than Microsoft's at its peak. Such virtues, revealed for the first time during Google's public offering, made the August IPO one of Wall Street's most eagerly awaited births ever. And sure enough, Google has emerged as a robust baby. By happily continuing to buy the stock despite a P/E ratio on estimated 2004 earnings of 65, investors are betting that this newborn is destined for a long, lusty life of fat profits and fast growth.

But the doubters--and there are many--point to shadows in the nursery: questions about Google's geeky, dot-com-era management style and the possibility that it can't cope with growth; recent sales of stock by insiders and other major stakeholders (including Time Warner, FORTUNE's parent and owner of AOL, which lately unloaded $188 million worth); and increasing pressure from Microsoft, Yahoo, and other formidable rivals that would like to crush this infant in its crib. Far from hailing Google as the next eBay or even the next Microsoft (search the web on that phrase and Google's name does come up), the skeptics see Google as just the latest dot-com-bubble stock. Who is right?

FORTUNE recently spent weeks interviewing current and former employees--CEO Eric Schmidt was the only current employee who spoke on the record--as well as analysts, customers, and rivals, and this much is clear: While the company is still extremely young and the valuation question is ticklish (we'll come back to that), Google is shaping up as a real Internet powerhouse. It's doing so by staying ahead of its rivals in its core search technology, installing a grown-up management team, and becoming a dominant force in online advertising. Seth Godin, a well-known online advertising consultant and former Yahoo employee, used to be dubious about Google's prospects. Not anymore. "They were right, and I was wrong," he says. "They've created the first new and effective ad medium in 50 years. It's brilliant."

Even if Google isn't the next Microsoft, it won't be the next Netscape either. The odds are, whether you believe in the recent run-up in the stock or not, Google will be a player. Mary Meeker, Morgan Stanley's Internet analyst, has been calling Google the "eBay of information" for three years. She may be right.

For starters, take a look at how rapidly the company innovates to stay ahead of its rivals. Back in the day, Wal-Mart figured out among other things that constant improvement of inventory-control systems would get merchandise on and off the shelves faster--and result in lower prices. (Everyone sold the same dog food and batteries, after all.) Intel constantly improved its processor speed; Dell innovated by, for instance, constantly improving its efficient manufacturing and distribution systems. Google works in a similar way by constantly tweaking its signature search product and all its offshoots at a rapid rate. It might not have the impregnable wall against competitors that its blue-chip peers in tech have--digital auction house eBay with its network effect or Microsoft with its desktop monopoly--but it's trying to build something comparable through quick and easy-to-use innovations that keep surfers coming back.

In the past year the company has rolled out no fewer than a dozen tasty online search improvements designed to build traffic. Its Gmail service gives users an e-mail address plus a gigabyte of free online storage and the ability to easily save and find old messages and files. A new desktop search feature lets you locate information on your hard drive as easily as Google lets you find it on the web. Google SMS allows limited searches from your cellphone--whether it has web access or not. And it's not just the Western world that Google wants to win: This fall the company augmented its tool to allow translation back and forth of web pages written in eight languages, including Chinese.

The product parade isn't just about techies showing off--it's a matter of survival. Yahoo, Amazon, and Microsoft have all rolled out search products this year; each tries to outflank Google in a unique way. Yahoo now not only lets you search the web but also includes a "local search" function, enabling you to quickly zero in on, say, a nearby bar. Amazon lets you search inside books, affording free access to a world of copyrighted material that doesn't appear elsewhere on the web. Microsoft's MSN Search combines web searching with a function for everyday factual questions. ("What's the population of Iraq?") It draws on Microsoft's Encarta encyclopedia and other databases and reflects the hundreds of millions of R&D dollars the Redmond giant has invested in natural-language understanding (for a quick review of MSN Search, see box). Microsoft makes no secret of its wish to unseat Google as the search king. Indeed, at Microsoft's annual shareholders' meeting in November, CEO Steve Ballmer insisted, "We will catch up, and we will surpass" Google.

So far, Google has fought off Ballmer and other challengers. A year ago some industry watchers speculated that Yahoo's new search engine would displace Google because Yahoo had 157 million registered users--and since Yahoo knew more about the people using its search engine, it could offer better-targeted advertising. Instead, Google gained ground against Yahoo in search this year, according to Safa Rashtchy, a Piper Jaffray analyst. "Just look at the growth of search revenues at each company," he says. And it is working hard to develop a more personalized relationship with its users. Take Gmail: With the e-mail service, not only does Google have a quick way to easily reach its millions of subscribers, but it also scans the contents of their e-mail box to send out targeted ads. Or perhaps you've signed up for Google news alerts--another innovation launched this year that lets you filter articles from Google News for automatic delivery to your e-mail address. Or you use Picassa, a desktop photo organizer Google acquired this summer, to send pictures to your family. Both let Google know where to find you.

Knowing where to find you--and then learning more about you--isn't a small thing. It is, in fact, the Holy Grail of web commerce. The more Yahoo, Microsoft, and Google know about you, the more targeted and more valuable they can make their searches and ads. And if Google's Wall Street fans are right, advertising is what will power Google into eBay's league. Already every major financial services firm, airline, and automaker, as well as hundreds of thousands of other businesses, hawk their wares on Google. The formula is simple. When you search for information on your favorite Caribbean isle, Google makes sure you see travel-related ads, not ads for house paint. Advertisers are charged only when you click on their ads--something Google users prove remarkably willing to do. Google today captures a whopping $1.9 billion of an estimated $10 billion spent annually on online ads. It's also rocking the offline world of direct mail and Yellow Pages advertising, both of which have seen steep declines.

Google keeps the innovation machine chugging in its online-ad business as well. Ads are sold primarily in two ways (see illustration next page). The ones that appear on all its search sites--which span the Internet in 104 languages--account for the bulk of its revenues, some $1.5 billion a year. But Google also licenses its search and targeted advertising setup to other sites. If you go to AOL, the New York Times, or the Washington Post websites and do a search, you are using Google technology and seeing Google-generated ads. It also places ads for much, much smaller media gurus like Matt Daimler, a 27-year-old networking engineer in Seattle. Two years ago Daimler got so frustrated with getting bad seats on long business flights that he started, which collects and displays information about the best and worst seats on airplanes. The hobby became a business when he and his wife added Google ads to the site. Days after they had signed up for the service, Google began sending scads of travel-related ads their way. The company takes a cut of the ad revenues--it won't tell guys like Daimler (or us) how much--and sends the rest as a monthly check. The ads turned the site into a $120,000-a-year business.

In all its activities Google's goal is to get as deeply meshed as possible with advertising customers. It already handles online advertising for most of the FORTUNE 100, corporate giants with multimillion-dollar ad budgets like Citigroup, Sony, and Wal-Mart. Its ambition is to go further, cataloging every product a big company has and then advertising each one of them with unprecedented efficiency on the web. So if Wal-Mart has too many ceiling fans in some stores, for example, its computers could talk to Google's and automatically trigger a series of ads to interested customers in the right neighborhoods. Sound far-fetched? Google is confident it has the engineering and computer power--thousands of servers running Linux and Google's proprietary software, plus legions of brilliant gearhead programmers--to pull it off. Says CEO Schmidt: "Take any large consumer packaged-goods company. How many products do you think they have? Probably millions, by the time you take into account all the geographic variants. We want every one of those products to be advertised in the appropriate market within Google in the right country and so on."

Few question that Google has terrific tech. But no company grows into a world-beating blue chip on tech alone. Great companies also need great management to keep getting to the next level. Does Google have it?

The unwieldy triumvirate at the top--Google is run by Schmidt, 49, as well as founders Brin and Page, both 31--doesn't necessarily comfort doubters. The company also continues to sport the atmosphere of a dot-com startup, and we've seen how that can turn out. There are few offices at Google, which now employs 2,700 folks, of whom 900 are techies. Brin and Page have an office down the hall from Schmidt's six-by-ten walk-in-closet-sized office, but they share it. The place looks like a dorm room, with roller hockey gear, scooters, and radio-controlled model planes scattered amid two desks, a couch, beanbag chairs, and PCs.

The good news: There seems to be a method to the madness. A majority of the people Google hires--the best and the brightest in most cases--come right out of college or grad school, which is why the company goes out of its way to re-create the life they just left. Says Schmidt: "If you go to the Stanford computer science building, you'll see two, three, or even four people in an office. That model is familiar to our programmers and us because we were all in those offices too. We know it's a very productive environment." Its dining facilities are legendary: Google serves three free meals a day prepared by the former chef of the Grateful Dead. (Judging by the late Jerry Garcia's girth, we don't know if that's a good thing.) It also provides free laundry and banking facilities for its staff. You could literally live at Google full-time; last year, when the company occupied its new headquarters in Mountain View, Calif., some people even tried--until Schmidt told them they were violating the fire code. Google starts meetings at seven minutes after the hour. "It was my idea because that's how college works," Schmidt says. Classes often begin at 9:05 or 9:10.

It's also a good thing--and this ties into Google's ability to innovate--that the company remains notoriously elitist about its hiring, though it is bringing on about 25 new people a week. A team of nearly 50 recruiters divided by specialty combs through résumés, which applicants must submit online, then dumps them into a program that routes those selected for interviews to the proper hiring committee and throws the rest in the electronic trash. Interviewing for a job is a grueling process that can take months. Every opening has a hiring committee of seven to nine Googlers who must meet you. Engineers may be asked to write software or debug a program on the spot. Marketers are often required to take a writing test. No matter how long you have been out of school, Google requires that you submit your transcripts to be considered. The rigorous process is important partly for the obvious reason that in high tech, as on Wall Street, being the smartest and the cleverest at what you do is a critical business advantage.

Even better, Google has done some old-fashioned corporate restructuring. A year ago people who worked at Google, who did business with the company, or who tried to get a job there often left sour. They described Google as a disorganized madhouse run by people too arrogant to be interested in fixing the problems. They darkly predicted that the founders' aversion to standard business procedures and hierarchy would cause Google to implode. Now Google has a head of human resources and three levels of management instead of one; it has divided chunks of the organization into teams organized by product or function. "It has scaled [up] pretty well," Schmidt says.

Some customers still complain. One says that doing a simple deal with Google is harder than doing a complicated deal with Microsoft. But others who used to gripe about Google's disorganization say there's actually been some improvement. A CEO recalls how a year ago Google made him and his negotiating team start over and over with nearly half-a-dozen new engineering reps: "The guy across the table would work with us for two months and then get swapped out for a new guy who didn't have any knowledge of the deal, so we'd have to keep starting from scratch." Today, he says, one person is in charge of his account, and issues get dealt with immediately and professionally. Says another executive who has done business with Google: "They're less arrogant, and they listen better."

Less arrogant, plenty innovative--but is that enough to make Google worth $165 a share? Wall Street analysts certainly think so; 12 of the 25 who cover it rate the company a buy at these levels, and there are no sells (and yes, we've seen this play before too). Believers like Morgan Stanley's Meeker assume the company can continue to grow revenue 25% per year on average for the next decade. Goldman Sach's Anthony Noto recently assumed that earnings could also rise by a 25% annual rate through at least 2009, which then justified his new "target price" of $215.

Now let's check such math and figure out just where it implies Google might be ten years out. Assuming 20% annual returns from that $165-a-share level (a reasonable investor expectation given the risks), its market cap would soar from around $45 billion today to $278 billion by 2014. That is a lofty height where only a handful of blue chips stand today--GE, Exxon Mobil, Wal-Mart, Citigroup, Pfizer, and Microsoft, to be precise. Dazzling? Yes. Doable? Only if everything over the next ten years goes right.

One company where everything did go beautifully well for a long, long time, of course, was the Google of the 1980s--Microsoft. A happy soul who bought a share of MSFT in 1986 at its IPO was rewarded with a staggering ten-year return of 6,650%, as Microsoft soared from a market cap of just under $1 billion to over $60 billion. That's a gain far in excess of the relatively modest 518% return a buyer of Google today could look forward to, assuming the earnings forecasts of the Notos of this world pan out. Why? Mainly because six months after its IPO, Microsoft still boasted a P/E of only 17 or so.The price back then, in other words, was right, which in turn made Microsoft's subsequent rocketlike growth pay off bigtime. (And lest we forget, the beast of Redmond also enjoyed the unrivaled benefit of that little virtual monopoly over PC operating systems.)

For all its impressive technology and verve, Google, as noted earlier, has no such clear competitive advantage. That may help explain why--as was true during the late, great dot-com bubble--many insiders are rushing for the exits. Three top executives, engineering chief Wayne Rossing, general counsel David Drummond, and human resources chief Shona Brown, said in SEC filings at the end of November that they had sold blocks of stock worth millions of dollars. At about the same time founders Brin, Page, and Schmidt announced plans to sell big chunks of their stockholdings over the next 18 months. Brin and Page said they would sell 7.2 million shares each, or roughly 19% of their holdings, and Schmidt said he'd sell some 2.2 million shares, or about 15%.

History, of course, offers many lessons. Consider one other: Amazon. In December 1999 the company that would go on to change the face of retailing saw its stock peak at an adjusted price of $106.69. Five years later it is trading at $38, having bottomed a few years back at around $6 a share. Which price would you prefer to have bought at? Yet throughout this wild ride, Amazon founder Jeff Bezos was innovating, investing, and building a great company. Google seems well positioned to repeat or even exceed that impressive corporate performance. Just don't bet the rent money on it.