Google's GOOG
third-quarter earnings report brought hand-wringing from the market and
new issues to light for us. While we believe our long-term thesis is
intact, we are concerned that we may have been overly optimistic about
operating leverage, given the changing revenue mix. Still, although we
may modestly decrease our fair value estimate after completing our
analysis, we consider the company slightly undervalued at these levels.
Perhaps most importantly, we see no evidence of diminishing competitive
advantages.
Revenues for Google Sites grew 15% compared with 2011,
while revenue from the Google Network (ads placed on partner sites)
grew 21% versus 2011. The strong dollar created a headwind to results as
well, with a negative impact on Google's stand-alone revenue growth
rate (excluding Motorola) of 600 basis points versus 2011. As Google
Network revenue outpaced Google Sites, we believe this may be the start
of an important trend: Google will increasingly rely on placing ads and
distributing content for content owners to subscribers, but fee sharing
and content acquisition costs will constrain the company's ability to
gain operating leverage from the business.
With respect to
operating costs, we note that other costs of revenue increased 57%
sequentially (while Google's stand-alone revenue grew 5%). Even after
accounting for effects of acquisitions and costs from the launch of the
Nexus 7 tablet (Google's Android tablet), we estimate that other costs
of revenue increased more than 30% versus the prior quarter. We believe
this dramatic increase highlights Google's evolution toward a content
distribution platform. Although the firm recognizes gross revenue by
selling content on YouTube and Google Play, we suspect the bulk of the
economics flow to the content owners, resulting in lower gross margins.
If these efforts become even more significant relative to the total
company, overall operating margins will suffer. Although we believe the
company has other levers within is expense base to eventually expand
margins, we may take a more cautious stance.
Thesis 03/05/12
After
rising to prominence by attracting massive numbers of users and ad
dollars for its Internet search product, Google is investing in its next
act.
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. The market for Internet search advertising is still growing in
the double digits, while display advertising is growing thanks to newer
innovations tying display ads to specific actions, including clicks,
leads, and customers. Also, 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,
we estimate the company generated more than $4 billion in display
advertising in 2011, 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.
The importance of Android cannot be overstated, particularly in light
of the massive adoption of smartphone and tablets. Android is an
open-source mobile operating system (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 2011,
Android's installed base of smartphones vaulted to 38% market share
according to Gartner, 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 LNKD.
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.
Our
fair value estimate is $780 per share, representing a 2012
price/earnings multiple of 23 and an enterprise value/EBITDA multiple of
14. We forecast revenue to grow more than 12% annually during the next
five years, slightly ahead of the growth rate for the 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. 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.
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
Cofounder
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 cofounder 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.
Generally, we are encouraged management's by the long-term focus on
capital allocation, although the lack of transparency around milestones
for new projects presents an analytic challenge. We are encouraged that
past acquisitions including DoubleClick, Android, and YouTube are
bearing fruit and deepening the company's moat. Additionally, the
management has recently begun pruning products that have not been
hitting internal success metrics, a positive development, in our view.
Overview
Google's
balance sheet is flush with more than $44 billion in cash equivalents
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 revenue. The remaining revenue
comes from advertising that Google places on other companies' websites
and relatively smaller initiatives, such as hosted enterprise products
including email and office productivity applications.
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