Google: A Growth Company Masquerading as a Value Stock

By James Fantaci - June 20, 2012 | Tickers: AMZN, AAPL, FB, GOOG, LOW, SSNLF | 0 Comments

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Any Google (NASDAQ: GOOG) shareholder of the last two years has endured a rocky ride, and watched the stock get cheaper while revenues and profits have increased over 20%+ annually.  It has become a Rodney Dangerfield stock: it gets no respect!  While the company continues to grow at a rapid pace, innovate, and dominate in their core advertising search business, the stock now reflects a company that is a compelling value for those who can stomach the recent lack of conviction in the stock. 

Market sentiment toward Google has been somewhat suspect since Larry Page took over as CEO in April 2011.  When Google reported fourth quarter 2011 results, the stock plummeted 10% in after hours trading, which equated to several billion dollars subtracted from the market capitalization because revenues were approximately 300 million dollars less than analyst expectations - not company guidance.  That drop occurred seconds after the print without anyone having time to read the report. 

Was the company worth that much less? I think not. The first quarter 2012 results beat on both revenue and EPS, but there was some concern that the cost per click revenue was down 12%, even though the volume of clicks was up 39% from Q1 2011. The stock has since languished dropping from $651 to a low of $556.52 on June 14.  When the market price of the stock does not reflect company performance, it represents a great opportunity for investors with a long-term view.  

My belief is that Google is an excellent addition to a balanced portfolio, especially when you consider valuation in light of the company’s product landscape, key revenue drivers, the risks facing the company and your investment. 

Valuation

If you were to review Google’s numbers without the knowledge of the company or industry, you might be confused. On the one hand you would look at the forward P/E of 12.6, the current TTM P/E of 17.31 (26.21 P/E 5 year average), along with its PEG ratio of .96 and think maybe it is a Dow Industrial rather than a fast growing tech company.  However, if you were to compare these market metrics to Google's tangible earnings results, you might think someone was trying to pull the wool over your eyes. Google is conservatively projected to have 16+% EPS growth next year and historical growth above 20%, and gross margins of 69%. The result of this remarkable efficiency (especially for such a large company) is almost $334,000 in net income per employee (1.23 million in revenue per employee). The balance sheet is very strong given their strong cash flow even after the $12.5 billion acquisition of Motorola Mobility. 

Of course, the valuation cannot be discussed in a vacuum.  Arguments against continued strong growth have included the law of large numbers, decreases in cost per click, increases in spending, and competitive pressures.  Google is a large company, but it continues to grow its dominance in online search and e-commerce (expected to grow in double digits annually going forward the next 5 years). Additionally, while it is true that spending has increased, and is often articulated as a risk, I take the opposite view.  The company is investing in their people and future by retaining talent and challenging them to innovate. Many of their pet projects like the self-driving cars, and the interactive glasses have been much maligned, but these investments are emblematic of a culture that wants its employees to think outside the box and continue to think like a start-up.  While many of these projects will not be successes, the relatively small amounts of money  invested are a net benefit for the culture of the company and the product landscape going forward. 

Product Landscape & Key Revenue Drivers

Google products consist of search, cloud computing, and mobile products and services. That said, even though they have continued to expand their reach and product offerings, 96% of their revenue is from search.  According to ComScore, Google had 66.4% of search market share in February with Bing at 15.3%.  This is up from 65.4% in November 2011, and 15% for Bing.  The February figure almost matches Google’s all time best market share in December 2010 of 66.4%.  

In Q1 2012, there was a 39% increase in the volume of paid clicks, while the cost per click declined by 12%. This trend continued from the fourth quarter 2011.  Some of the slowdown in cost per click can be attributed to the world economy, and exchange rates, but much of this is due to their push into mobile which is less profitable on a per click basis.  39% growth is remarkable, and their margins remain very high. Also, consider that mobile is in the very early stages of growth. 

Google had $1 billion in mobile ad revenue in 2010, and $2.5 billion in 2011, which represents 150% year over year growth.  The growth is attributable to the success of their Android operating system.  Larry Page noted in his last earnings call that 700,000 phones are activated every day with over 250 million in use.  That is a remarkable statistic. In February, ComScore noted that Android had over 50% share of the smart phone market in the U.S., which surpasses Apple (NASDAQ: AAPL) to make Android the majority market share holder for the first time since it was launched. 

The ad revenue isn’t just in search.  Google increased their market share of display advertising to 9.6% in 2011.  Revenue from display ads doubled from 2010-2012 - much of this due to the mindshare of You Tube, a much lamented acquisition by analysts in 2006.  Larry Page noted in the latest earnings call: “You Tube has over 800 million monthly users uploading over an hour of video per second." Much of their current success in display is due to “True View” where viewers choose to watch particular ads. Advertisers obviously like the cost-benefit of opt-in display advertising because of the targeted nature of the product.  

While advertising partner information is not released by the company itself, according to Word Stream, Lowe’s (NYSE: LOW) accounted for the highest amount of ad spend at a whopping  $59.1 million in 2011. Amazon (NASDAQ: AMZN) was close behind.  Many of the country’s top companies, specifically those with strong e-commerce efforts have significant ad budgets with Google. 

While Google has continued to dominate in search, they have been playing catch up in the social media realm.  Larry Page noted prior to the release of Google Plus that employee compensation would be linked to their success in their social strategy. In the April conference call, he noted that membership in Google Plus has grown to 100 million users (compared to 40 million in October 2011).  He further noted that 60% of users engaged with the network daily and 80% weekly. While this is impressive, it is misleading because Google Plus is integrated into the whole ecosystem of Calendar, G-Mail, and Documents. So the use of Google Plus itself is difficult to measure. ComScore noted that for February Google Plus users spent 3.3 minutes using the core service compared to 7.5 hours on Facebook.  While it is not an apple and oranges comparison, it is clear that Google Plus is an interesting addition to the complete eco-system that is Google. It has not yet had the popular success of Twitter or Facebook, but it continues to gain mindshare. Google has several products that work well together, and Google Plus is an added value. 

The Risks

I believe the future for Google is bright, but not without some risk.  Outside of macro risks (if the world economy slows ad-spend will also slow), my concerns are more like items worth watching. If the company is not prudent, they risk becoming a victim of their own success with Android.  Google’s growing war with Apple is a benefit and a risk.  It is also important to assess how well they integrate their social strategy. That is an important component of retaining ad spend and as Facebook (NASDAQ: FB), and other social networking sites learn how to monetize their mindshare. This is not a zero sum game, but they will have to continue to stay vigilant.

Google’s latest acquisition, Motorola Mobility for $12.5 billion, was not only to gain valuable patents, but also suggests that they would like to enter the hardware business.  Google’s success has been driven by creating great software, successfully satisfying the needs of both business and the consumer.  They have never been a manufacturer.  By deciding to make their own smart phone and tablet, they stray from their core competence, competing against companies like Apple, or worse, Samsung - their longtime partner, where hardware is a strength. 

Samsung is now the top handset manufacturer in the world as the success of Android is not unrelated to the quality of Samsung’s phones, and vice-versa.  Samsung can’t be happy about the Motorola Mobility acquisition and it makes sense to wonder how this might affect their partnership.  One might argue, what option does Samsung have? The Android ecosystem is hard to replicate, and Microsoft’s software doesn’t measure up.

Then, there is Apple. Steve Jobs basically called Android a rip-off of the iPhone, and the once close partners (Eric Schmidt was previously on the Apple Board) have become instigative enemies. Apple just announced that their upcoming OS will no longer use Google Maps, that Siri will offer voice activated search, Apple will integrate Baidu into its OS in China, and Apple rubbed more salt in the wound by adding that they would be integrating Facebook into their platform, a further snub to Google.   The combative nature of the relationship is a double edge sword as the competition spawns innovation. For Google to compete not only on software, but also on hardware with arguably the world’s best manufacturer is a risk. 

Conclusion

Google continues to dominate in search, but they know that much of their future success is tied to mobile.  By buying Motorola Mobility, they are sending a signal that they want command over their future, by controlling hardware and software.  The Android is not only the top model in the U.S., it has a growing presence in emerging (growth) markets decimating RIM’s marketshare.  Google will continue to build their social platform, including the integration of ancillary services like You Tube which continue to evolve, gaining increased mindshare of the viewer and increased advertising revenue from business, while adding value to the whole ecosystem. 

The valuation has decreased while the company continues to perform.  The market has discounted the price because of risks in the economy and short term thinking without what I feel is a longterm view of where it is going. If you do a search for profits a few years out, I think you might find GOOG.

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