Analyst Note 03/14/13
Google GOOG
announced it is closing more products and features, including Google
Reader and the Google Voice app for Blackberry. Although none of these
closures affect our forecast, fair value estimate, or economic moat
rating, we believe these moves support our general thesis that
management is disciplined in its capital allocation efforts. Still, this
"spring cleaning" effort to manage expenses does not alter our view
that the company is unlikely to benefit from meaningful improvements in
operating margins. While the company trades at a modest premium to our
fair value estimate, we believe investors should look to allocate new
investment dollars to other names that are more attractively valued.
Thesis 01/23/13
With
a dominant Internet search product as its foundation, Google has built
an impressive portfolio that individuals use frequently, beyond search.
These new products allow advertisers to reach out to potential customers
multiple times, in multiple ways. Google's importance to the future of
advertising has only just begun.
Consumers are using new devices (smartphones and tablets, for example), new operating systems (Windows Phone by Microsoft MSFT, Android, and iOS by Apple AAPL)
and new interfaces (voice search), and these changing behaviors shine a
light on other successful products Google has built in order to keep a
hold on users and provide a greater benefit to advertisers. Google's
mobile operating system and browser help to unify users' experience as
they move from one device to another. The firm's success in products
such as Gmail, a browser (Chrome), and Google Maps provides a cohesive
experience for users and helps Google show more relevant ads. These
applications are important. At the end of 2012, Apple issued a mea culpa
for favoring its own mapping product over Google Maps, demonstrating
the importance of several of Google's products. Executives from Google
claimed its mapping product was downloaded more than 10 million times
within two days of launching on Apple's App Store. Furthermore, the
Chrome browser is the most widely used browser in the world.
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 even as pockets of economic weakness
hit various regions. 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.
As the preeminent 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 Bing and social network Facebook FB, 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 to 5 points of
share.
We believe that both Facebook and Google are wide-moat firms that
will grow revenues faster than the online advertising market. Although
they compete for display advertising dollars, we would not expect one
firm to disrupt the other. In fact, we estimate that Google generated
more than $5 billion in display advertising in 2012, modestly exceeding
Facebook's display revenue for the 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.
We
have revised our fair value estimate from $780 to $740 per share,
representing a 2013 price/earnings multiple of 23 and an enterprise
value/EBITDA multiple of 14. We are forecasting very modest operating
margin improvements from a 2012 trough, which is the primary cause for
our revision. We forecast revenue to grow more than 13% 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 13% 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 be
greater than the market, growing in the mid-teens annually through 2016.
As operating expenses have continued to climb, we are becoming more
watchful of the firm's limited potential for operating leverage as it
enters new businesses. While we believe Google could easily drive
operating margins substantially above 40%, it would have to ratchet down
its investment in research and development and its data centers to
achieve these targets in the short term. It would also need to share
less revenue with its partners, which we believe could potentially
disrupt the company's advertising ecosystem. We expect long-term
operating margins to reach the mid-20s, as the revenue mix continues to
move away from desktop search, its most profitable segment. 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.
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 been pruning products that have not been hitting internal
success metrics, a positive development, in our view. The company also
reached an agreement to sell Motorola's Home business to Arris ARRS, a positive development as we did not believe the segment would generated excess returns and it also had no strategic benefit.
Overview
Google's
balance sheet is flush, with more than $45 billion in cash equivalents
and about $6.2 billion in short- 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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