Description

Pitch:
Despite the recent run in the equity over the last 12 months we believe Google continues to offer compelling value relative to the business quality, category dominance, and growth outlook of its franchise – investors also get free call options on “Other Bets.” We see ~25% upside from current prices by year end 2018 excluding these bets.  GOOG could continue to compound at attractive rates beyond this forecast period.  

Specifically, for 2019 GAAP EPS we believe GOOG can generate $55 per share in “Core EPS”, which backs out money losing “Other Bets”, and could trade at a 19x forward earnings multiple by YE18.  After adding in the impact of excess cash on the balance sheet at this time one could arrive at a price target of ~$1200, up from ~$950 today.

Google overview:
Google is the dominant search business in the world (ex-China, Russia). As written previously on VIC - search is such a great business. Our work suggests search remains the highest ROI form of advertising. 85% of Google revenue comes from advertising. Google currently captures 14-15% of global advertising budgets. The company has seven products with >1Bn MAUs: Search, Android, Maps, Chrome, YouTube, Google Play, and Gmail. Google Search has 90% share of search in most countries. Android, its mobile OS, has ~90% share of smartphones globally (vs. 5% in 2010). Its video platform, YouTube, serves ~20% (and growing) of all video consumed on the Internet. This is a business with very dominant positions.  

Advertising Industry overview:
The advertising industry has seen a massive shift towards online spending, and while total ad spend growth has not deviated much from GDP growth, the allocation of ad dollars has continued to flow away from traditional forms of media (print, radio, TV) into online. Moreover, the shift has not decelerated – instead it has accelerated as online has grown. In 2015 and 2016, digital’s share increased by 3.8% and 3.2%, vs. an average of +2.3% from 2010-2014.  It’s important to discuss Facebook and Google when discussing the advertising industry, although, this write-up only contemplates investor’s potential upside at by investing in shares of Google.  

Facebook + Google appear to have won digital advertising – their combined share of digital growth has averaged 107% over the past 3 years, meaning that the total revenue growth of all other digital advertisers has been negative.

Why is the share shift occurring? Google & Facebook have:
Increasing share of user time spent.  Advertising $$s are correlated with where people are spending their time.  Smartphone penetration has increased the time spent on the Internet. Even in a developed market like the U.S., it appears as if digital time spent has roughly doubled since 2010 (smartphone + tablet + desktop/laptop).  Globally, we estimate that total digital time spent can increase +65% between today and 2022. Hours spent on smartphones should more than double.

Google & Facebook appear to have won mobile. In 2015-2016, they enjoyed 100%+ share of incremental online ad spend. Massive audiences plus huge (and growing) information advantages over competitors. We believe that Google & Facebook’s ability to interpret user info and leverage the data to improve user experience & advertiser ROI is world’s better than traditional players.  Unlike other mediums with massive reach (cable TV), Google & Facebook can perform mass customization which should make value per impression much higher. Despite this, monetization per unit of user time remains below traditional formats like TV, suggesting to us that there is room for digital ad prices to grow.

Superior and improving abilities to measure ROI for advertisers. Google & Facebook’s ability to measure the impact of their ads on offline purchases continues to improve.  These improvements are especially valuable for Google as queries with commercial intent are likely growing at a much slower rate than overall queries.

Digital Spending Outlook:
We believe that in addition to what is traditionally defined as advertising, marketing dollars (such as direct mail, telemarketing, etc) will increasingly flow into digital advertising.   Total “marketing” spend is roughly equal to advertising spend in the U.S. Globally the split is similar.

We assume that total advertising + marketing dollars grow in-line with GDP, yet marketing grows below GDP (direct mail and telemarketing strike us as decliners), which implies “advertising” grows > GDP.  Our 2022 forecast for global “advertising” spend is ~10% above consensus.  Consensus expects the share gains of digital to decelerate. MAGNA projects that digital will take 2.7% share of ad dollars per year from 2017-2022, vs. 3.3% on average over the past 3 years.

We believe that digital share gains will accelerate. We project digital will take 4.1%/year of ad dollars from ‘17-‘22.  The two key pillars of this argument are (a) the Google UK analog – the UK is the most developed market – and (b) our belief that the marketing dollars flowing into advertising will flow directly into digital.


Google – Why Now?  Revenue growth runway remains underappreciated:
TAM is perhaps much bigger than the market believes.  Medium-term TAM = Total Advertising Spend (to which the market anchors) + Marketing Services.  “Marketing Services” like sales promotions (discounts + signage), telemarketing, and mail marketing will move online as commerce moves online. This should result in a reclassification to “advertising.”

Although telemarketing, direct mail marketing, and directories are considered “marketing services”, we do not believe they’re any less likely than traditional “advertising” to lose significant share of $$s over time to digital.  

~12% of commerce in the U.S. is online today, so there is plenty of room for growth, even accounting for Amazon’s (~35% of U.S. online GMV) inevitable large gains from the aforementioned promotions bucket. Online retailers, who are share gainers, are much more intensive buyers of digital advertising. At the same time enhanced return measurement capabilities are accelerating brick & mortar retailer acceptance of digital advertising.  Over the very long term we expect various expenses inherent in a brick & mortar world (rent, in-store employees) to shift to digital advertising, though this view isn’t factored into our ’17-’22 projections.

Tailwind from shift to mobile world more significant than understood.  Mobile = Significant increase in total queries + (eventually) higher price per search due to better customization/targeting & expanded advertiser network + higher search share as Android has ~90% share.  Smartphone penetration stands at ~26% globally, so has plenty of room to run. Time spent per smartphone should continue to increase with improved infrastructure in emerging markets.  What mobile lacks in screen size it should make up for with superior targeting and CTR.  Local searches appear to be ramping quickly and largely un-monetized.  Google may have only penetrated 10% of US SMEs and local performs at 2x rev/search than the average revenue per search.  

Video appears to be at an inflection point, and Google has arguably the most valuable video platform in the world.  YouTube, which was bought for $1.65Bn in ’06, effectively introduced Google to brand advertising, a huge market.

Video is currently ~15% of Google gross advertising revenue, and it is growing ~2x the consolidated rate.  In the U.S. YouTube currently monetizes at 60-70% the level of TV despite significantly better targeting.  

Long-term YouTube should monetize (defined = ad load * price) better than TV due to superior targeting.  YouTube ad load is reportedly below other Internet properties. It serves ~20% of the web’s videos, but only ~10% of the web’s video ads (Barrons). YouTube annual revenue/user is slightly below Twitter’s despite having nearly 3x time spent/user.

Our research has been bullish on YouTube’s ability to increase revenue per time spent over time.
YouTube is likely being capitalized today at ~$5-10 Bn ($11Bn Rev x 3-4% NI margin * 20x = $7-9Bn)
At estimated TV monetization levels, estimated LT margin, but existing time spent and ad load levels,

YouTube would be worth $40-45Bn ($17Bn x 12.5% NI margin * 20x = $42Bn).  

Durability in the Most Mature Market:  20% ’16 growth in the UK, the most mature advertising market in the world. In fact UK revenue % growth has had a positive correlation with higher online ad penetration since 2009!


Recent results:
Google’s low-20s revenue growth has proven durable thus far.  From 2010-2016 total revenue growth has been around these levels and bottomed in 2014 at 19.8% but has since accelerated to 23-24% including Q117.  


Margin trajectory and capital allocation appear to be heading in the right direction:
Built-Up of opex/costs implied fat = Margin of Safety.  Our work over the years on Google has suggested significant excess fat within the business

YouTube:  We believe YouTube is currently being run at below normalized margins. It was reportedly break-even in ‘14.  The flow-through of the above-mentioned price increases coupled with operating leverage should alleviate the pressure of outsized growth from this structurally lower margin business.

New CFO Ruth Porat joined in Q2’15.  Commentary in articles suggests she is very good.  

Ruth Porat commentary while at Morgan Stanley…

"We're going to be very clinical and flexible in the way we allocate that capital across the franchise in a way that optimizes returns."

"It's really dead weight capital in that it's supporting assets that aren't generating revenue...And as they roll off they go from negative ROE to neutral, to zero, and the objective is then to take that excess capital and put it behind areas that are most accretive to the overall franchise."

"The process is really to provide the analytics, the tools, the dashboards to the businesses to ensure that ingrained throughout the organization is a real focus on expenses and expense management, and we view that as an ongoing part of the way we run the business."

Underlying margin expansion:
The trailing two year Core Google EBIT CAGR is ~27% we estimate if you adjust for the estimated FX impact vs. the reported 21%.

Said differently, since 2014 Core Google has seen ~200bps GAAP operating margin expansion despite ~200bps of margin headwind from FX (estimated) and the outsized growth of margin dilutive YouTube and Google Cloud Platform (i.e. Google’s AWS).

Actions taken since Ruth’s appointments:
In August 2015 Google separated its Core from its non-Core businesses via the creation of Alphabet.  Google placed CFOs at all its subsidiaries, which are now responsible for all the costs associated with their business units.  Google revised its comp systems. They now pay bonuses for killing projects, for example.  Shuttering / increased discipline at select Other Bets: Titan + Google Fiber as examples.  

Fiber: In Oct ‘16, Google halted expansion in 8 cities & laid off 130 employees.

Titan: Google’s plan to beam Internet access from high-altitude, solar-powered drones was shut down in early 2016 after being purchased in 2014.

Reduced capex intensity and initiation of share repurchases.

Valuation is undemanding:
Core Google (i.e. adding back Other Bets losses and net cash) trades ~20x NTM GAAP EPS, only moderately above the S&P 500 despite much better growth prospects and dinging earnings for stock-based compensation.

Google ownership comes with cheap long-term call options:
Google Cloud Platform: This is the fastest growing business within Alphabet and is lumped into “Core Google”.  GCP is not a first-mover like AWS. It does not have legacy vendor relationships like Microsoft. However, the product has supposedly improved substantially. It is Google’s fastest growing business.

The market opportunity is massive, and Google has won a few well-known customers (Coke, Spotify, Airbus).  In addition, Google appointed a well-respected industry expert (Diane Greene) to head this business in November 2015. Our research was positive on the new leadership.

We assume GCP remains a distant 3rd player carving out ~10% share of the global cloud services marketplace and eventually earns margins similar to AWS, adjusted for revenue level (i.e. GCP does $8Bn revenue in 2022 and earns 25% operating margin vs. AWS at $8Bn and 25% margins in 2015).

Check out Diane Greene’s presentation from October on YouTube. https://www.youtube.com/watch?v=XHVAIIeFNcw


Capital Allocation:
With Ruth Porat in the CFO seat, it’s more likely GOOG pulls an Apple…  ~50% of sell-side analysts do not explicitly give Google credit for net cash in their valuation, so practically speaking any share reductions would be “found money.”

Automotive OS:  Google is positioned well to become the de facto operating system for future automobiles. Americans spend a lot of their time on the road – on average ~50 minutes in 2016 per AAA. This compares to the average U.S. consumer spending ~40 minutes on Facebook each day.  >40 auto brands had brought Android OS’s to their cars by YE’15.  Waymo’s recent partnership with Lyft is another encouraging development. Google Pixel.The Google Pixel has great reviews and a similar price to the iPhone.  Citi estimates Google’s hardware revenue was ~$2.3bn in 2016 (total “Other” income is $10bn). This would include the Pixel as well as other devices (i.e., Google Home). Apple sold $137bn of iPhones in 2016.


Risks:
Sentiment is positive – most of the 49 analysts are buy-rated

Regulatory – This is our primary long-term concern.  With monopolies – even natural monopolies where consumers don’t pay for the service – there comes regulatory risk. In this case, the risk we’re most focused on is the use of private information. Information is a key source of competitive advantage, so any rules limiting Google & Facebook’s ability to collect and use user information impair the value of the respective platforms. There could be negative headlines and fundamental developments from Europe over the next 18 months given some of the recent press around Antitrust.  

Search - Walled gardens – eCommerce & Travel are industries particularly at risk here. We’re betting the pie is so large it doesn’t matter that Google is likely losing share of queries with commercial intent in two important verticals.  eCommerce has LDD % share of U.S. retail; Amazon has ~35% share of U.S. eCommerce. Travel is still seeing HSD growth in search queries in the most challenged markets per our research.  Voice search – Amazon’s personal assistant Alexa has the early lead in becoming the operating system of the home. Today hardware manufacturers are building Alexa-ready devices much more than they’re building Google Home-ready devices. To the extent Alexa wins the battle for the home operating system and home voice searches cannibalize – instead of being incremental to – desktop & mobile searches, then Google’s long-term revenue growth trajectory will be pressured, potentially materially so.

YouTube - There is a limit to the quality & diversity of UGC content. It is possible YouTube content quality is never diverse enough or doesn’t have enough high quality supply to address the entire TV market’s demand.  A shift towards high quality original content or licensing existing high quality content would be an expensive and risky endeavor.

Valuation:
We assume Google roughly maintains its share of incremental online advertising growth (50-60% in 2015-2016 to 45-50% during our forecast period).  After the creation of Alphabet in late 2015 Google’s financials split into two segments: Google and Other Bets.

We model Google maintaining a consistent 38% Core EBIT margin throughout our projection.  Our research and study of Ruth Porat suggests that there is upside to Google’s historically loose cost controls. However, we expect mix shift away from higher margin products to lower margin products to offset cost improvements.

Other Bets:
The Other Bets segment significantly drags down Google’s consolidated margins – in 2016, Other Bets reported revenue of ~$800mm and an operating loss of $3.6 billion.

While Other Bets has consistently lost money, Google appears to have reined it in slightly during 2016 (for example, shutting down Google Fiber), with the loss plateauing at $3.6 billion vs. $3.5 billion in 2015 (whereas in 2015, the loss doubled vs. 2014).  We assign zero value to Google’s Other Bets segment.

Conclusion:
Google seems like a good risk reward with free call options and the ability to compound EPS beyond our forecast period.  We value Google on a multiple of Core GAAP EPS, excluding the drag of Other Bets.  We expect Google to generate Core GAAP EPS of $55 in 2019.  We give Google credit for its net cash position, and assume 19x exit P/E multiple to arrive at a $1,200 price target by YE’18.  

Disclosure:
We and our affiliates are long Google - GOOG - and may buy additional shares or sell some or
all of our securities, at any time. We have no obligation to inform anybody of any changes in our views of GOOG. This is not a recommendation to buy or sell securities. Our research should not be taken for certainty. Please conduct your own research and reach your own conclusion.

Catalyst

Earnings

Other bets

Capital allocation