2 Takeaways From This Company's Earnings
Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Google (NASDAQ: GOOG) shareholders have been patient. They have stuck by you and watched you move into new areas and businesses. They believed that you would manage your cash for their benefit and for investors who bought at the beginning of this year they have been rewarded with a return of...nothing. That's right at the beginning of 2012 shares traded at about the level they are today. Now it's true that savvy investors could have bought as low as about $556 and gotten out near the top at $774, but how many people do you know are that good? The truth is, shareholders have patiently waited and the waiting needs to end. Google needs to either institute a significant share repurchase plan, or institute a dividend, and one of the other needs to happen now.
It's Not About the Cash it's How You Use It:
To be clear, I'm not suggesting the company start a dividend or share buyback because I don't like seeing cash and investments on a balance sheet. I don't honestly care if the company has a ridiculous amount of money on their balance sheet, if the shareholders are making a nice return from capital gains. However, when a company like Google turns in a quarter like they just did, you have to start questioning why management believes it can handle the cash better than you can. In the recent quarter, Google's revenue wasn't the problem. In fact, revenue including Motorola increased 45% and excluding Motorola it was still up 18.58%. The problem was in how Google spent the money to get these results. The company's non-GAAP EPS decreased 7.1%, and for a company with all of the competitive advantages that Google has that just isn't acceptable. The three biggest contributors to Google's EPS downfall were research & development, sales & marketing, and general & administrative expenses. I'm fine with research & development increasing faster than sales, but the other two categories suggest Google needs to cut the fat from the Motorola acquisition and soon. Looking at the company's different divisions, results were just okay.
Paid Clicks and Cost-Per-Click Isn't the Issue:
Google revenues increased 15% at Google sites and 21% at Google Network sites. Prior to this earnings release, analysts were calling for about 15% growth in EPS over the next few years, so these results sound pretty good. Much has been made about the decrease in costs per click, but this isn't really the big deal everyone thinks it is. In fact, Google's cost per click has been declining since December 2011. What has also been happening is Google's paid clicks have increased significantly over this same time frame. In June 2011 Google's paid clicks increased just 15%, by December 2011 they were up 33%, and in the company's most recent earnings they increased 33%. What appears to be happening, is Google is discounting the cost-per-click to increase the number of paid clicks.
I've written about this before, and said this change coincided with a decline in Microsoft's (NASDAQ: MSFT) Bing search engine market share. My comment at the time, is this is either terrific irony or Google's battle plan. Considering that in Microsoft's recent earnings, they reported Bing's market share had declined 1.6% on a year-over-year basis, this battle plan appears to be working. However, the problem is as Google dominates the market, they aren't growing earnings or free cash flow like they used to.
Dominant Market Position = Small Cash Flow?
What makes little sense in Google's earnings is the fact that the company could increase revenues by such a significant amount, and then spend their way to disappointing bottom line results. While it's true that Google's operating cash flow increased by 1.27%, who can get excited about that? The company still generated about $3 billion in free cash flow, and sits on a net cash position of $45.7 billion. However, this cash isn't being put to good use because diluted shares increased 1.79% through a lack of a buyback program. In addition, Google's refusal to pay a dividend looks like stubbornness rather than a good business decision.
Those 2 Takeaways I Promised:
Google needs to make better use of its cash by either paying a dividend or instituting a share repurchase plan. If we look at their competition we can get an idea of how this might work. A share repurchase program is fairly straightforward. Google has been consistently producing almost $3 billion in free cash flow per quarter. In the last four quarters, the company has missed estimates by $2.11 per share in total. For the company to meet earnings estimates, Google would have needed to repurchase about 5.45% of their diluted shares in the last twelve months. Here is the ironic thing, in order to buy back 5.45%, the company would have needed to spend $2.75 billion a quarter on share repurchases. With the company producing $3 billion in free cash flow, using $2.75 billion on share repurchases would make things much tighter, but what's the alternative? In a low interest rate environment like this letting investments pile up while missing estimates just doesn't make a lot of sense.
So what about a dividend? This would be a more direct way to reward shareholders, and would allow the company to appeal to a broader range of investment managers and individual investors. Two of the company's competitors are Apple (NASDAQ: AAPL) and Microsoft. Apple is paying about 23.38% of its free cash flow in dividend payments, and Microsoft is using about 21% of its free cash flow. If we assume that Google paid an average of the two at 22%, they would use about $688 million a quarter on dividend payments. With 333.314 million shares outstanding, the company's indicated dividend rate would be $2.06 per quarter or $8.24 per year. At current prices, this would equate to a 1.21% yield. While this wouldn't win the company any prizes for the best dividend on the planet, it would give shareholders some income in their pocket. In addition, this idea would still allow Google to use 78% of its free cash flow in whatever way it chose.
The bottom line is, Google management needs to step up to the plate with either a share repurchase or a dividend. If the company can't make this happen, I don't see a reason for investors to stick with the company. It might sound crazy, but given the company's recent earnings report, either Apple or Microsoft look like better values. Apple pays a dividend with a yield of about 1.75%, and despite its “disappointing” earnings is still growing at a very nice pace. The company's cash and investments now represent 21.66% of its market cap, and I firmly believe Apple will crush estimates with their holiday season sales. Microsoft is selling for a very cheap P/E on next year's earnings of just 8.71. The company pays a dividend of 3.25% and as we saw that only uses about 25% of the company's free cash flow. While it will take several quarters to determine if Windows 8 is a hit or a dud, the company's operating systems run 90% of the world's PCs and that doesn't seem like it will change soon. Microsoft's cash and investments represent an impressive 27.43% of the company's market cap at the current time. I know that Google has staunch supporters, but the company's earnings makes me question their management. Their competition is rewarding shareholders directly and it's time for Google to do the same.
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