A Long-Term Bet With Short-Term Troubles
Mohsin 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) has seen an impressive run after its 12% decline on last quarter’s earnings miss. The company will release its quarterly earnings report next week, and I believe investors should expect improved mobile monetization but cost per click (CPC) will suffer further due to general macroeconomic weaknesses.
There was a lot of fiscal cliff uncertainty in the last quarter of 2012, and that could have significantly affected advertisement spending and thus CPC. Google remains a good long-term bet, but its stock could fall on an earnings miss, based on my CPC decline thesis.
The stock is currently giving a 10% upside on its mean sell-side target price, and I recommend investors buy on post-earnings dips.
Google is one of the world’s largest and most iconic technology companies. The search giant has a market capitalization of $238 billion and, in the last five years, its stock has appreciated 13%. The company runs a number of different websites including Google and YouTube. Its primary source of revenue is online advertising.
The company is a pioneer and leader in online advertisement and offers a number of different cutting edge advertisement tools. The following tools are they key revenue generator for Google:
- Adwords: It forms the center stone of Google’s advertisement model.
- AdSense: It enables Google’s partner websites to deliver ads through its Adwords advertisers.
- Google Display: A display advertising network which is based on images, text and videos.
- Ad Exchange: It’s a real time ad marketplace for exchanging display ad space.
Google has also successfully entered the mobile operating system market. Google’s Android has taken the world by storm, becoming the largest mobile operating system in a very short period. The OS has significantly affected a number of companies and transformed the smartphone landscape. The company is currently competing with Apple's iOS and Microsoft's WP8. The iOS is limited to Apple hardware but the new WP8 will compete directly with Android, for attention of smartphone manufacturers.
Google has a long history with both competitors and it’s tied with Apple (NASDAQ: AAPL)in a number of law suits, but neither has been able to deliver a decisive blow. In this tough landscape, developing a sustainable competitive advantage is the key.
The competitive advantage of Apple is its own superior hardware. Apple has never been a ‘fan’ of Android. According to the late Steve Jobs, Google had infringed on the iOS and he was willing to launch ‘Thermo Nuclear Warfare’ to protect the uniqueness of the iOS.
The rise of Samsung’s Galaxy S3 has been the biggest blow to Apple’s competitive advantage, because it has taken over as the premium smartphone in many markets. While S3 is the biggest threat to the iPhone, Google is competing directly with the iPad, through its own Nexus devices. It seems that Apple is feeling the heat because in recent news, Apple has cut supply orders for parts due to low demand. This fall in demand for the iPhone, although due to S3, is indirectly a victory for Google.
Unlike Apple, Microsoft (NASDAQ: MSFT) does not develop its own hardware to support its WP8 and is largely dependent on Nokia, HTC, Samsung etc. The company has been largely unsuccessful, in its previous attempts to enter the smartphone OS market. In the past, Android played a major role in pushing Microsoft out that market and this rivalry has been revived after the launch of WP8.
The competitive advantage of WP8 is the developed ecosystem of Windows, as it is already used by almost everyone in the world. If the new OS is able to provide a unified experience across different devices, it can give the Android a run for its money.
In its last quarter earnings, Google missed analyst expectations by reporting an EPS of $9.03. There were three primary reasons for the earnings miss: FX fluctuations, Motorola Mobility losses, and CPC decline. While the Motorola Mobility issues are not related to Google’s core business model and FX losses are a part of doing business, the stock depreciated 12% after earnings came out due to the 15% YoY and 3%decline in CPC.
TAC and CPC
Another factor which led to lower than expected profitability was the increase of 25% in TAC (Traffic Acquisition Cost). The primary reason behind CPC decline has been lower spending on advertisement by businesses due to a globally adverse macro-economic outlook. Therefore this decline does not point out to any basic weaknesses in the Google’s business model, but points towards the short term impact of the bad economy.
Improved Mobile Monetization
The positive news from the quarter was the improvement in mobile monetization which has been a primary investor concern. In the last quarter, mobile revenues reached a run rate of $8 billion and mobile advertising run rate increased to an impressive $6.5 billion, according to Barclay’s research. Thus in the last year the revenues from mobile advertisement have almost doubled (YoY 160% growth). This is primarily due to the increase in smartphone penetration and Google’s improved mobile monetization. This shows that Google’s advertising model is becoming stronger due to increased smartphone penetration and Google’s improved ability to cash on Android popularity
Google will report its quarterly earnings next week. I believe these earnings would reflect the fiscal cliff uncertainty and as a result, the bottom line would suffer. Other companies with advertisement based business models have blamed the macro economic uncertainty for the fall in their CPC. I believe this weakness would be reflected in this quarter’s results and investors should expect more pressure on CPC. This decline can force the company to miss its earnings target and as a result, experience a decline in stock price.
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