Google GOOG announced fourth-quarter earnings Thursday against a backdrop of high expectations, with results modestly ahead of our forecast but meaningfully below consensus, resulting in a dramatic sell-off in the shares. We are not changing our fair value estimate and consider the shares to be undervalued, although we would prefer a bigger discount before encouraging new investment.
Results were strong across the board, with quarterly revenue from Google properties (primarily including Internet search and YouTube) and revenue from ads placed on partner sites growing 29% and 15% versus 2010, respectively. With total advertising revenue growing 27% versus 2010, we still believe Google is modestly gaining market share in online advertising, a remarkable feat given the size of this Internet behemoth and a testament to its wide economic moat. Additionally, controlled spending helped improve quarterly operating margins to 33%, ahead of our expectations.
Although costs per click (or CPC, the average amount advertisers pay when consumers click on an ad) declined 8% from the prior quarter, we think it is important to look beyond that single metric to paid clicks, which grew 17% versus the third quarter. Google regularly tweaks its advertising algorithms and enhances ad formats to improve the user experience and maximize revenue. According to product vice president Susan Wojcicki, algorithm changes had a positive effect on revenues. In other words, we believe that every search generated higher revenue per search, despite the decline in CPC. The increase in paid clicks is the greatest quarterly gain since the fourth quarter of 2006.
Over the course of the next quarter or so, we expect some regulatory overhang and investor angst as Motorola Mobility MMI is folded into the Google family. Although we do not expect either issue to affect our overall thesis, uncertainty surrounding Google has historically led to volatility in the stock price.
Lastly, we have little doubt the Internet search market is maturing, and Google’s tweaks to its advertising algorithms can only go so far. Heavy investment by Google in Android (a mobile operating system), Google+ (its social network) and YouTube as well as other initiatives is warranted, in our view. History has not been kind to Internet companies that failed to invest into adjacent markets and exploit key competitive advantages. Many of these initiatives may take several years to generate free cash flow, but we believe management's long-term view will ultimately generate excess returns on capital and strong shareholder returns.
Thesis 10/18/11
In today's lexicon, the words "Google" and "search" are practically interchangeable. Every day, the average user searches on the Internet at least twice. Last year, these searches generated about 20 billion clicks per month. This seemingly trivial activity has generated billions of dollars of cash and provided Google an opportunity to build a strong portfolio of assets for users and advertisers. This portfolio not only provides a long runway for Google to continue growing, but also gives the company the most defensible position in the Internet segment of our coverage list, in our opinion.
As the pre-eminent leader in search, Google maintains more than 60% of worldwide market share; no other competitor has even 10%. We believe the company's early technical advantages attracted users who now use it habitually, creating a switching cost based on familiarity with the engine. While the firm may face near-term headwinds from efforts by Microsoft's MSFT Bing and social network Facebook, we expect the larger players to win share from weaker players, including AOL AOL and IAC's IACI Ask. Although we expect small movements in market share, we believe Google's dominance will persist and not lose more than 3-5 points of share.
A strong secular growth trend for online advertising is core to our thesis, although Google will suffer in the short term if we enter into another global recession. Still, faster growing geographies such as Asia are propping up overall growth rates as western Europe has recently been slowing. We forecast global Internet ad spending to grow in the midteens annually during the next five years. We expect that Google will leverage its dominant position in Internet search and support strong growth in display and mobile advertising, allowing it to meet or exceed the overall industry growth rates.
Although competitors like AOL and Yahoo YHOO have routinely claimed competitive advantages in display advertising for content rather than search, Google is not on the sidelines. In fact, the company generated $2.5 billion in display advertising in 2010, exceeding Yahoo's display revenue for the year. While we would be more enthusiastic if it announced large deals with branded advertisers, we still expect Google will participate quite aggressively in this market. The company is continuing to innovate around its DoubleClick Ad Exchange in an attempt to offer advertisers ways to incorporate real-time bidding and directly target audiences with specific demographics as opposed to choosing websites. Ultimately, advertisers want specific targeting; providing technology that helps automate this targeting delivers tremendous value in maximizing budgets. Furthermore, Google recently announced a plan to invest an additional $100 million in its heavily trafficked YouTube website. As rich video content continues to move online, we are optimistic about YouTube's value and ability to monetize its content.
Google's shrewdest move as of late has been its heavy investment into the mobile arena. In 2005, Google purchased a small mobile software company called Android. Android was open-sourced (the code is shared with the community using a free software license) to allow handset manufacturers and users to load applications that software makers build. During 2010, Android's share of smartphone shipments vaulted to 23% according to IDC, well ahead of market leaders Apple AAPL and Research in Motion RIMM. While many industry watchers are scratching their heads over the significance of a business that generates no direct revenue for Google, we are more enthusiastic: The move protects the firm's economic moat and provides new revenue streams. With Android living on smartphones, more users are likely to use Google's services. In fact, we have seen estimates of Google's market share in mobile search exceeding 90% last year.
Still, there are risks on several fronts. First, we cannot ignore the potential impact of social networks such as Facebook, Twitter, and LinkedIn. While we believe these will not be an immediate or direct threat to Google's search business, we do believe they are immediate and significant competitors for display ads. Additionally, these firms undoubtedly will invest in search capabilities, and we could be wrong about their ultimate success. We also believe the returns on capital for the new businesses will be lower than the returns in its core search business. As many companies are investing heavily in content strategies, Google will have to continue investing in an attempt to keep pace in attracting more branded advertisers.
Valuation
Our fair value estimate is $744 per share, representing a 2011 price/earnings multiple of 27 and an EV/EBITDA multiple of 17. We forecast revenue to grow nearly 15% annually during the next five years, slightly ahead of overall online ad industry. Google reports its business in three market segments: Google websites, Google Network websites, and other.
Revenue driven by Google websites include its search engine and web properties such as YouTube and Google Finance. Although we expect minor short-term loss of market share in search, we believe that improvements in monetization (the conversion of a search to a paid click on an advertisement) and overall market growth will help drive revenue. Additionally, with additional investment in display revenue technology and content on YouTube, we have modeled Google websites to grow more than 18% per year. We also expect uplift from mobile search to support strong revenue growth in this core business. Excluding YouTube, search is the most significant cash generator and highest-margin business for Google. On the other hand, we are more conservative in our view of revenue coming from Google Network. Google Network represents revenue earned by the placement of ads on partner websites. We anticipate this growth will lag the market, growing at 8% per year through 2015.
While we believe Google could easily drive operating margins substantially above 40%, it would have to ratchet down its investment in R&D and its data centers to achieve these targets in the short term. We expect operating margins to stay below 30%, reflecting increased investment and higher personnel costs caused by the pay raise instituted in January. After this year, we forecast operating margins to begin expanding again and reaching 32% in 2015. Because Google is heavily investing in new markets, we still expect free cash flow to be depressed over the next few years. However, we expect growth in free cash flows to exceed 25% annually through our explicit forecast period.
Risk
Although we believe Internet search is habitual, explicit switching costs are relatively low. Fickle consumers may move to a competitor that is able to establish a stronger brand or a more useful experience. Google is investing in new businesses where it is less competitive, which may lead to a deterioration in its operating margin and return on capital. Advertisers may find new ways to reach their target audience in a cost-effective manner, like Facebook. Finally, competition in technology is fierce, and employee retention may become more difficult and cause an increase in operating costs.
Management & Stewardship
Co-founder Larry Page was named CEO in April, taking over from Eric Schmidt. Schmidt was CEO from 2001 to 2011, a period that saw Google define its business model, become a public company, and stay at the forefront of the Internet advertising industry as the largest company by revenue and enterprise value. Schmidt is retaining his position as chairman of the board and serving a more active role in lobbying Washington. With Schmidt as a key executive, the company essentially has been managed by a three-person team of him, Page, and co-founder Sergey Brin. The company's equity has a dual-class structure that concentrates the voting power in the hands of these three executives, who hold two thirds of the voting rights. They also have a significant economic interest in the firm at more than 15%, which helps to align the interests of management with the shareholders.
We are comfortable with management at the firm, but employee retention will be a continual challenge for Google. Page's style and efforts will not mirror Schmidt's and may cause some short-term disruption. In fact, the senior vice president of product management resigned the week that Page's new title became official. Although we don't view the move as emblematic of any looming management issues, we would not be surprised to see other similar moves as competition for personnel is ruthless in the technology sector. To address these concerns, the company is rumored to have given a 10% pay raise to every employee effective in January.
Overview
Financial Health:
Google's balance sheet is flush with almost $35 billion in net cash and about $4.2 billion in short-term debt and long-term debt.
Profile:
Google manages an Internet search engine that generates revenue when users click or view advertising related to their searches. This activity generates more than 80% of the company's revenues. The remaining revenue comes from advertising that Google places on other companies' websites and relatively smaller initiatives, such as hosted enterprise products including e-mail and office productivity applications.
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