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Buffett falls for free ride Google

Er, data smelters aren't cheap, Mr. Oracle

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In his recent letter to Berkshire Hathaway shareholders, Warren Buffett appeared to flirt, ever so briefly, with Google.

Buffett and partner Charlie Munger have shied away from technology companies, confessing a lack of understanding for their wares and unease over the pace of change in the technology racket. That said, the grand poobah from Omaha found time to celebrate both Microsoft and Google during the 2007 letter (PDF) to the Berkshire clan.

"A company that needs large increases in capital to engender its growth may well prove to be a satisfactory investment," Buffett wrote. But then he added that, "It’s far better to have an ever-increasing stream of earnings with virtually no major capital requirements. Ask Microsoft or Google."

The bit about major capital requirements caught our attention, since Microsoft and Google are engaged in a data center arms race.

Google's annual statement for 2007, for example, highlighted the burden of these data center costs.

"We believe our operating margin will experience downward pressure as a result of increasing competition and increased expenditures for many aspects of our business," the company said.

Google shelled out $2.4bn on property and equipment during 2007, while pulling in $16.6bn in revenue. The company also spent $2.1bn on research and development and stock-based compensation, in part, to keep its data centers humming and to keep smart workers happy.

While more profitable than a longtime Buffett favorite such as Coca-Cola, Google dished out almost $2bn more in capital expenditures than Coke will spend this year. Google will likely increase that spending in 2008 and the years to come if the announcement of so many $600m data centers is any indication.

Microsoft too looks set to pump billions and billions of dollars into its infrastructure.

This type of spending makes the so-called "cloud computing" types look less attractive than old-line software sellers, at least in the near-term.

In the good old days, Microsoft could spend a $1bn for a new version of Office and then just print CDs or have PC vendors burn the software onto their machines. This model required very little investment from Microsoft for distribution.

Now, however, we're talking about companies such as Google, Microsoft, Amazon.com, Yahoo!, IBM and Sun Microsystems building data smelters - a line we stole and tweaked from Horst Simon, a computer scientist at Berkeley. The costly information plants of these technology giants eat up just as much energy as, say, an aluminum smelting center, but there's no physical product that appears as a result of the consumption. Instead, the data smelters just swap around and store bits.

Beyond powering the systems, these companies must spend hundreds of millions of dollars on server, storage and networking equipment to fill the centers.

We hardly expect Buffett to stay up-to-date on the latest in data center technology and perhaps we're missing some part of his thinking. Lord knows, you will all be sure to inform us about such mistakes. Please accept the apologies in advance.

But we do wonder if some of the financial gurus out there aren't missing what it will take from an investment standpoint for the major technology players to have a serious go at the next wave of computing. ®

Bootnote

We'd go into more about how Google's secrecy and management eccentricities seem to violate a number of Buffett's other value investing principles, but this is not the time or the place.

Instead, have a listen to our interview with a man who grew up learning from Buffett, or read this outstanding (PDF) speech from Munger.

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