Google – We got Act I Right, Now what about Act II?

November 5, 2012 Printer Friendly Printer Friendly

On July 19th we wrote “Why You Should Buy Google In Advance Of Earnings And Hold It For At Least Six Months”. Well, it has been around 3 ½ months and the call looks pretty good. When we published the article Google was around 590 and is currently around 682 as I write this. So a gain of around 16% vs. 3% for the S&P 500. Not bad. If we were smart enough to write a blog entry on October 5th rather than today, we could have been crowing about a gain of almost 24%, as the stock briefly flirted with 774 before profit taking and then a disappointing earnings report set in.

Google Performance

The last blog was based entirely on technicals and is an interesting read in its own right. However, if we are going to consider what to make of Google for the future, especially given the run up, it is best to consider all of the factors that come into play: technicals, fundamentals and the business story.

Looking at the last factor first, there are a number of cross currents with the Google business story and they are hard to read. To wit, the Motorola purchase – good move, or giant distraction and cash drain? Monetizing mobile – new growth story, or a story of secular decline for traditional search? Management – focused, or all over the map?

On the fundamental side: Is it a story of slowing revenue growth and rising expenses? Or a plateau before the ascent of Mt. Mobile?


Google – Rising Expenses and Slowing Revenue Growth

Google Revenue and Expenses

Finally the Technicals. Do we have a broken stock (bad) or a consolidating stock (good)? Let’s drill a little deeper.

The Business Story

Let’s take a look at area each in turn, beginning with the business story. The big move for Google was purchasing Motorola Mobility for 12.5 billion dollars. Clearly, a high margin software business buying an also-ran low margin hardware business with negative cash flow and the possibility of alienating key partners doesn’t make a whole lot of sense. Two explanations here. One, we need those patents (most likely) or two, we are not very smart managers (not likely). The third possibility, resuscitating the company and having it contribute meaningfully to the bottom line, is quite remote. Pluto remote. So they made a strategic choice, using their capital to buy a large patent portfolio to help protect Android. All the while hoping to run it so as not to burn too much more capital in the future. This was a one of. And for a big deal, it is not a big deal since it not where Google’s future trajectory is defined.


Google Net Margin – Motorola has changed things

Google Net Margin

The big deal is search. How are the markets and the monetization of those markets changing? Is Mobile the next great growth story or a destroyer of the traditional search model? Let’s take a look. The annual revenue run rate of Google mobile is currently around 8 billion and growing rapidly (220% year over year increase). Mobile now accounts for approximately 17% of core revenue. Overall core revenue increased in the neighborhood of 20% vs. last year. Analysts project core revenue growth at mid to high teens going forward. Mobile is in its infancy as far as monetizing search goes. Android is the dominant smartphone OS, accounting for around 75% of worldwide smartphone activations last quarter. Google claims over one million activations per day. While Google gets no direct revenue for this, the dominance and the search revenue potential cannot be ignored.


Google Earnings – Past, Present and Future

Google Earnings

Google is a large diverse company with many R&D efforts and potential revenue streams being developed (Google Docs, Google Play, Chromebooks etc.) all of which could be meaningful growers in the future. However, with the potential of mobile search alone, which could kick core growth up even higher than the mid teens, it’s hard not to like the story.

The Fundamentals

So now, let’s take a quick look at fundamentals, starting with sales. Note that approximately 5B of the increase in sales for next year can be attributed to a full year with Motorola.

Google Sales

Revenue has grown strongly and that trend is expected to continue into the future. Revenue growth tends to be in the neighborhood of 20% per year, give or take. That is impressive. What is even more impressive is their expense growth. If you look at the table below, you will see that their net income is increasing at a slower pace than revenue growth, especially recently. This is due to the faster rate of expense ramp relative to revenue.


Google Bottom Line Growth is Slower Than Revenue Growth

Google Revenue Growth

Google spends a lot of money. They spend it on product development, on data centers, on hiring, on stock based compensation, on new initiatives, on acquisitions. They invest heavily in their future. With the increasing river of cash coming in from their core businesses, they certainly can afford to do it. The efficiency and return on their investments will be key factors in the company financial and stock performance in the future. At the end of the day, you have to decide how much confidence you have in the management team as efficient stewards of capital. So far, it is hard to argue with the results.

Let’s take a quick look at valuation.

Google's Valuation

The stock trades roughly at historical norms, around 20x trailing P/E. Cash per share is rising significantly and approximately 20% of the market cap is in cash. So while Google the stock is far from cheap, it isn’t expensive either, and is trading well within historical norms.


Google’s P/E Over Time

Google's Price / Earnings

The Technicals

Finally the technicals. Looking at a six month chart we see a big drop after the latest earnings release, which reverted the stock to trendline. There appears to be strong support around 660, and according to the RSI, we have a greatly oversold stock. So while Technicals are never a sure thing and can be interpreted in different ways, a strong case can be made for consolidation vs. further deterioration.

Google's Technicals

In Conclusion

So to sum up, a strong business story, punctuated by a potential dominating position in the next big area, mobile search. Valuation is fair, neither cheap or historically expensive. Technicals looking like they may be consolidating for the next move up. For me it comes down to management. If management can be trusted to invest their torrent of cash flow wisely, it is hard not to like Google for the long term. If your view of management is less favorable, then the rapid rate of expense rise vs. revenue and the distraction of Motorola Mobility would be of great concern. The stock will start to look expensive if management fails to grow the revenue side as well as the market expects.

Me, I am betting on management. I view Google as a long term core holding for growth oriented investors.

Disclosure: I do not currently own Google and do not plan to initiate a position in the next 72 hours.