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Is Google overvalued?

September 1, 2015

Facebook And Other Apps For iPhone And HTC Mobile HandsetsFacebook And Other Apps For iPhone And HTC Mobile Handsets

Tuesday’s market carnage has hit tech companies hard, but Google less than others. Since announcing the creation of a new corporate structure last month, Google(GOOG) has mostly seen its stock climb, even as Wall Street darlings like Netflix(NFLX) and Apple (AAPL) continue to trade at sub-par levels. It’s understandable, given that the new structure gives investors greater transparency into Google’s successful core advertising business separate from its more speculative ventures like the self-driving car or robotics.

With online advertising account for 90% of the company’s revenues, investors are clearly betting on Google’s bread and butter. In addition, Goldman Sachs (GS) recently upgraded Google’s stock to a ‘buy’ recommendation with a price target of $800 per share, up from $680 per share previously. The average price target from other analysts is $766.48 per share, a nearly 25% increase from its current price level.

Yet it’s precisely Google’s dependence on this revenue stream that makes the company vulnerable to a price correction. The tech giant is facing an assault on two major fronts that could disrupt its prospects.

The first involves its preferential treatment of search results to facilitate its own businesses. India’s regulators have accused Google of abusing its dominance of the search market to prioritize the listings of advertising customers as well as its own shopping service to the detriment of competitors. Such accusations have also been leveled against the company in Europe, where regulators filed antitrust charges earlier this year, setting up a protracted legal battle.

While Google is unlikely to change its policies anytime soon on this front and it could be argued that, monopolistic or not, the company’s alleged search engine rigging is good for shareholders since it boosts earnings, it also creates a major question mark about future profits from this segment depending on how these issues are decided by regulators. It also raises the specter of U.S. regulators taking a harder look at Google’s practices stateside, as they eventually did with Microsoft (MSFT).

Not to mention that the practice of parsing search results to benefit advertising and its own services could backfire for Google with search engine users, who could be turned off by the idea of their search results being deliberately skewed. Right now Google’s abusive practices are mainly a matter of heresy, but as these legal battles play out publicly, the company’s credibility with users could be damaged, which in turn would hurt its advertising real estate.

The other, and even bigger, problem for Google is Apple’s (AAPL) announcement this week that its new operating system iOS9 will enable users to block ads on its Safari browser, and Wells Fargo analyst Peter Stabler estimates that ad blockers will reduce spending on Internet ads by $12.5 billion world-wide in 2016, according to The Wall Street Journal. That could make a big dent on Google’s mobile advertising business, which a Goldman Sachs report pegs at $11.8 billion annually – 75% of which comes from iPhones and iPads.

A survey by Cowen & Co. cited by The New York Times also shows that 16% of users who bought the last iPhone switched from Android (in China that rate was 29%) and since ad-blocking means faster loading times for web pages, Apple’s new feature could entice even more people to convert. That means increasing dependence by Google on Apple for its advertising revenues.

The danger here is that even if Google can make a deal with Apple to deliver its ads without blocking, it would likely have to pay Apple a hefty premium for that privilege, eating into its profits. Bizarrely, Google has responded to this threat by offering a workaround to developers to circumvent the restrictions, but this would disable a lot of iOS9’s security features, which users certainly won’t welcome.

Finally, social media juggernaut Facebook (FB) is giving Google fierce competition in mobile and online video advertising. Even though the absolute size of the mobile advertising market is increasing rapidly, Google’s share of it fell from 52.6% in 2012 to 46.8% in 2014, while Facebook’s share rose from 5.4% in 2012 to 21.7% in 2014, according to research firm eMarketer.

To be sure, Google will continue to be an immensely successful and innovative company, but at a price-to-earnings ratio of more than 30 times, investors are clearly expecting outsized future profitability. That profitability can be hurt in small or large measure by the above challenges, which is why markets should rethink how much Google is really worth with the prospective difficulties facing its core business.

S. Kumar is a tech and business commentator. He has worked in technology, media, and telecom investment banking. He does not own any shares of Google or any of the companies in this article.