The High Cost of Google’s Transformation into a Technology Conglomerate
Maxwell 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) recently reported its financial results for the second quarter of 2012. It reported net earnings of $8.42 per share, an increase of 9.6% compared to the same period last year. Despite the strong results, it missed consensus analyst estimates of $10.09 per share. Revenues reached $12.21 billion, higher by 35% year on year. This also beats consensus revenue estimates of $11.1 billion. For the year, analysts expect Google to post $42.52 per share earnings. This translates to an increase of 18% from the previous year’s earnings per share. The recent quarterly performance suggests that it is on track to beat full year analysts’ estimates.
Its quarterly result is relatively better than its peers. For example, Yahoo! (NASDAQ: YHOO) announced earnings per share of $0.18, a decline of 4% and behind estimated earnings of $0.20 per share. It recently appointed former Google executive Marissa Mayer as its new chief executive. The disappointing second quarter results underscore the hurdles that Mayer faces as the company’s leader. On the other hand, Microsoft (NASDAQ: MSFT) reported a $492 million loss from its $6.2 billion goodwill impairment. Overall, Google’s solid quarterly financial performance is due to its superior search engine algorithm. This has attracted users and generated better conversions for its clients. Its quarterly results also included the results of Motorola Mobility. It also highlighted the higher costs of its transformation from a search engine company to a mobile company.
Google’s Transformation Has Costs
As previously mentioned, revenues reached $12.21 billion. Excluding the $1.25 billion contribution from Motorola, revenues increased by 3% from the previous quarter but 21.5% on a year-on-year basis. The Motorola business segment alone accounts for more than 10% of total revenues.
While Google still continues to derive a majority of its revenues from its advertising business, it is making headway to newer businesses. The transformation will benefit the company in the future as it diversifies its revenue source. If we strip out the income contribution from its mobile segment, Google’s revenue would have grown at the slowest pace since 2009. The slowdown can be attributed to the weak overseas currencies, resulting in lower revenues when converted to its reporting currency, the US dollar. According to Chief Financial Officer Patrick Pichette, the ongoing debt crisis also contributed to a difficult operating environment. Thus, the shift to newer businesses like mobile makes perfect sense.
Google is also well positioned to capture the growth in its mobile segment despite a lack of differentiation from its competitors. Almost every technology giant has mobile devices, apps and cloud services. These include big names like Apple (NASDAQ: AAPL), Microsoft and Amazon (AMZN). This strong competitive position will translate to higher mobile revenue growth in the future.
Last month, it introduced Nexus 7, a seven inch tablet which will compete with major tablet makers. Also it has released a new version of its Android operating system, Jelly Bean. The strategy is to offer mobile devices so people could use Google services on the go rather than devices and services of its competitors. Furthermore, Google is expected to benefit from the secular shift of online to mobile usage for small and medium sized advertisers.
For the quarter, Google’s gross margin declined significantly to 59%. The standalone Google gross margin was 63.7%. This is also a decline of 71 basis points and 116 basis points, respectively from the previous and prior year’s quarters. The lower gross margins are due to lower prices of its advertising business and higher distribution costs from its mobile business. Its expenses also included severance pay and amortization costs related to the Motorola acquisition. Other operating expenses include content acquisition, credit card processing and manufacturing and inventory-related costs.
While growth initiatives have appeared positively, investors will soon question how this will affect margins moving forward. For instance, the hardware business segment (i.e., Motorola Mobility and Nexus) revenue reached $1.25 billion but is still losing money. I believe that Google will still be able to support this segment as it has a formidable cash balance. Based on the recent quarter, it has cash and short term investments of $43.12 billion. It also generated $4.25 in operating cash flow from the previous quarter. This translates to a free cash flow of $3.48 billion. This is more than enough to cover the current cash burn of its hardware business.
The key advantage of Google is the amount of data it holds on consumers. The company interprets individual interests so it can tailor fit consumer preferences. Investors should expect that new product launches will be a regular occurrence in the company. Despite being a mature technology company, it brings in fresh new products to address emerging needs of consumers. Thus, margin compression is not an immediate concern for management as it embarks on new sources of growth. I believe a better metric that it tracks is the incremental cash flow it generates from a certain level of investment. Its current return on incremental cash flow is around 19%. This is definitely better than most companies in America.
At present, its share price is currently trading 9% below its 52-week high of around $670. Over the last 6 months, it has slightly gained by 3%. This translates to a valuation of 12 times forward earnings. Its peers are valued higher. Yahoo! trades at 13 times forward earnings. Search engine giant Baidu (BIDU) is valued at 32 times earnings.
The overhang on its share price is due to many legal cases it faces related to patents and competition. Also the lower ad rates have been a big concern for investors. These valuations are undemanding considering that Google still corners more than 95% of the advertising market. I’d like to view share price declines as an opportunity for conservative investors to buy Google. This is despite the company’s guidance that profitability will be flat in the coming years from margin contraction. Given its flat stock performance, the margin contraction is already discounted in the share price.
StockCroc1 has no positions in the stocks mentioned above. The Motley Fool owns shares of Apple, Google, and Microsoft. Motley Fool newsletter services recommend Apple, Google, Microsoft, and Yahoo!. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.