Google: Global Growth at a Great Price

Leo is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Which is the better tech stock, Apple (NASDAQ: AAPL) or Google (NASDAQ: GOOG)? Let’s get real. Apple and Google are very different companies that generate revenue in completely different ways. To compare the two would be like comparing apples to oranges -- pardon the pun.

Reality Check

Everybody loves comparing Apple to Google because Google Android - which has taken over nearly 70% of the smartphone market thanks to handset manufacturers Samsung, Sony and HTC - is widely seen as the iPhone’s strongest adversary. This enmity was amplified with Steve Jobs’ widely circulated quote, “I'm going to destroy Android, because it's a stolen product. I'm willing to go thermonuclear war on this.”

But although Android-powered handsets have eaten away at Apple’s once-dominant smartphone and tablet market share, Google doesn’t make a cent off its operating system. Hardware manufacturers can license and install Android for free.

Android's not about software sales. It’s all about locking users into Google’s ecosystem - GMail, Docs, Calendar, YouTube - and keeping them there. It’s about making Google the default search choice to keep lengthy records of users' search preferences - to craft targeted ads that generate Google’s true source of revenue: display advertisements.

And as long as Google can keep users locked into its search engine, revenue will continue to grow. Just take a look at the recently compiled stats regarding search engine market share around the world and the United States.

Search Engine Market Share, January 2013

<table> <tbody> <tr> <td> <p><span><span><span><strong>Search Engine</strong></span></span></span></p> </td> <td> <p><span><span><span><strong>Global Market Share</strong></span></span></span></p> </td> <td> <p><span><span><span><strong>Search Engine</strong></span></span></span></p> </td> <td> <p><span><span><span><strong>U.S. Market Share</strong></span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span><em>Google</em></span></span></span></p> </td> <td> <p><span><span><span>88.8%</span></span></span></p> </td> <td> <p><span><span><span><em>Google</em></span></span></span></p> </td> <td> <p><span><span><span>86.3%</span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span><em>Microsoft Bing</em></span></span></span></p> </td> <td> <p><span><span><span>4.2%</span></span></span></p> </td> <td> <p><span><span><span><em>Microsoft Bing</em></span></span></span></p> </td> <td> <p><span><span><span>7.3%</span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span><em>Baidu</em></span></span></span></p> </td> <td> <p><span><span><span>3.5%</span></span></span></p> </td> <td> <p><span><span><span><em>Yahoo</em></span></span></span></p> </td> <td> <p><span><span><span>3.1%</span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span><em>Yahoo</em></span></span></span></p> </td> <td> <p><span><span><span>2.4%</span></span></span></p> </td> <td> <p><span><span><span><em>Facebook</em></span></span></span></p> </td> <td> <p><span><span><span>1.4%</span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span><em>Ask.com</em></span></span></span></p> </td> <td> <p><span><span><span>0.6%</span></span></span></p> </td> <td> <p><span><span><span><em>Ask.com</em></span></span></span></p> </td> <td> <p><span><span><span>0.8%</span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span><em>Other</em></span></span></span></p> </td> <td> <p><span><span><span>0.5%</span></span></span></p> </td> <td> <p><span><span><span><em>Other</em></span></span></span></p> </td> <td> <p><span><span><span>1.1%</span></span></span></p> </td> </tr> </tbody> </table>

Source: http://www.karmasnack.com/about/search-engine-market-share/

Now that’s how Google makes its money. 

The Foolish Fundamentals

Google’s recent fourth-quarter earnings, which handily topped analyst estimates, reflected the strength of its advertising platforms. The company posted earnings of $10.65 per share, or $2.9 billion, on revenues of $12.16 billion - topping the Thomson Reuters analyst consensus of $10.56 per share on revenues of $12.16 billion. Google’s strong revenue growth also pushed its annual revenue over $50 billion for the first time in its history.

Let’s take a look back at Google’s earnings and revenue growth over the past five years, compared with its cash flow and operating margins.

<img src="http://media.ycharts.com/charts/1a02dcd085ae0ab4544b1732632eba16.png" />

GOOG Revenue TTM data by YCharts

For the better part of those five years, Google has been a solid growth story, and its disciplined growth has kept earnings growing alongside revenue, a delicate balancing act which many Internet companies have struggled to maintain. Growing Internet companies tend to post strong revenue gains while overspending on marketing and expansion.

However, in the past two years, margins contracted, cash flow decreased, and expenses rose. A large part of that decline was caused by its 2011 acquisition of Motorola Mobility for $12.5 billion. Google acquired Motorola to expand its defensive moat with its extensive patent portfolio, but also inherited its long-suffering handset business. Motorola is still unprofitable, posting an operating loss of $353 million in the fourth quarter, despite generating $1.51 billion in revenue.

Google is also reportedly working on a “Google X” Phone using Motorola’s handset technology, to create a first party competitor to the iPhone. In my opinion, this would be a step in the wrong direction, since Google’s previous “first party” handset effort - the Nexus - was only mildly successful. In addition, a handset launch would further crimp Google’s operating margins.

Versus Industry Peers

How does Google measure up to Yahoo! (NASDAQ: YHOO) and Facebook, its closest comparable competitors?

<table> <tbody> <tr> <td> <p><span><span><span>Company</span></span></span></p> </td> <td> <p><span><span><span>Forward P/E</span></span></span></p> </td> <td> <p><span><span><span>PEG Ratio</span></span></span></p> </td> <td> <p><span><span><span>Price to Sales</span></span></span></p> </td> <td> <p><span><span><span>Price to Book</span></span></span></p> </td> <td> <p><span><span><span>Return on Equity</span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span><strong>Google</strong></span></span></span></p> </td> <td> <p><span><span><span>14.02</span></span></span></p> </td> <td> <p><span><span><span>1.14</span></span></span></p> </td> <td> <p><span><span><span>4.87</span></span></span></p> </td> <td> <p><span><span><span>3.41</span></span></span></p> </td> <td> <p><span><span><span>16.61%</span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span><strong>Yahoo</strong></span></span></span></p> </td> <td> <p><span><span><span>17.84</span></span></span></p> </td> <td> <p><span><span><span>1.59</span></span></span></p> </td> <td> <p><span><span><span>4.79</span></span></span></p> </td> <td> <p><span><span><span>1.53</span></span></span></p> </td> <td> <p><span><span><span>28.30%</span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span><strong>Facebook</strong></span></span></span></p> </td> <td> <p><span><span><span>47.33</span></span></span></p> </td> <td> <p><span><span><span>2.01</span></span></span></p> </td> <td> <p><span><span><span>14.41</span></span></span></p> </td> <td> <p><span><span><span>4.68</span></span></span></p> </td> <td> <p><span><span><span>N/A</span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span><em>Best Value</em></span></span></span></p> </td> <td> <p><span><span><span>Google</span></span></span></p> </td> <td> <p><span><span><span>Google</span></span></span></p> </td> <td> <p><span><span><span>Yahoo</span></span></span></p> </td> <td> <p><span><span><span>Yahoo</span></span></span></p> </td> <td> <p><span><span><span>Yahoo</span></span></span></p> </td> </tr> </tbody> </table>


Surprisingly, Yahoo appears to remain on even footing with Google at current prices. This can be attributed to the comparative simplicity of Yahoo’s business model - search and advertising. Yahoo is not set on acquiring handset makers, boosting its patent portfolio and creating cloud-based operating systems like Google.

Yet that's what makes Google strong. Although nobody expects Google to double from these levels, it still has a lot of room for growth, as evidenced by its 5-year PEG ratio.

Advertising Revenue

The key to Google’s growth is its advertising revenue. In the fourth quarter, Google generated $12.9 billion in “advertising and other” revenue - a 22% increase over the prior year quarter. It also posted a 24% year-over-year increase in paid clicks.

Although Google’s cost-per-click (the amount advertisers pay Google for each click) decreased 6% from the previous year, it represented a 2% increase from the third quarter. While Google’s cost-per-click is still declining, it is a huge improvement over the 15% decline it posted in the third quarter. The total volume of paid clicks rose 24%, offsetting the price decline.

The Mobile Dilemma

Google controls 93.3% of the U.S. mobile search ad market, according to online advertising analysis firm eMarketer. Yet the market remains small, at less than $2 billion. eMarketer’s Clark Fredricksen states, “Advertisers remain hesitant to pay rates per mobile click comparable to those on the desktop, as mobile searchers are still less likely to convert into purchasers than their desktop counterparts.”

This trend is worrisome for Google, Facebook and Yahoo shareholders, since an increasing number of consumers are using smartphones, tablets and hybrid mobile devices as their primary computing device.

However, I believe that this concern is overblown, since advertisers will naturally pay more for mobile advertisements as PC sales decline. We are simply in the middle of a paradigm shift, and advertisers will eventually adjust accordingly.

The Bottom Line

Investors shouldn’t buy Google thinking that the stock will double next year. At 14 times forward earnings, Google is more a value play than a momentum one. Yet Google isn’t a stodgy mature tech stock, such as IBM or Cisco, that has leveled off onto a growth plateau.

Google is still spending its $48 billion cash hoard on acquisitions and investments instead of dividends or stock buybacks. While some of those investments are questionable - such as a driverless car and wind farms - that attitude is what keeps Google exciting. Nobody could ever blame the company of being myopic.

As the first stop for advertisers on the Internet, Google can define e-commerce advertising trends, rather than be forced to adapt to them.  That's why Google will be an excellent investment in global growth at a great price, as long as it maintains its margins and grows its cost-per-click revenue at a resonable rate. 


Leo Sun owns shares of Apple. The Motley Fool recommends Apple and Google. The Motley Fool owns shares of Apple and Google. You can follow Leo Sun on Twitter at https://twitter.com/leokornsun for more investing ideas.

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