Description

GOOG’s current valuation of 15.7x forward earnings (includes options expense; adjusted for net cash position) provides an opportunity to invest in a highly profitable, cash generative company with a self-sustaining, dominant leadership position at an attractive valuation.  I see good upside to the current stock price from the fair value of the core search business alone.  Additional upside exists if the “free options” in growth investments such as Display, Mobile/Local, YouTube, and Applications become significantly profitable in the future.

 

I believe that the main reason for GOOG’s current undervaluation are fears that we are entering a deep recession (with I agree with) and concerns that the impact of this recession will be a large miss to Q408 an 2009 consensus estimates (which I think are overblown at the current valuation).  I believe that after sharp decline in GOOG’s stock price over the past few months, implicit expectations are reasonable and short-term myopia has created a chance to buy a great business at a price that is too cheap relative to the long-term prospects of the business.

 

Before delving deeper into the thesis and risks, I would like to provide some background information for those not very familiar with GOOG’s business:

 

Business Description

 

Shares Out:             319mm            Price:                         $328                   Net Cash/Sh:            $45.1           

Mkt Cap:             $104.6bn            Net Cash:             $14.4bn            Adj EV:             $90.2bbn

 

EPS History / Forecast

	2006	2007	2008	2009	2010
Pro-forma EPS	$10.60	$15.59	$19.20	$20.74	$22.90
y/y Growth		47.1%	23.2%	8.0%	10.4%
Pro-forma EPS w/ Ops Exp	$9.46	$13.55	$16.50	$17.97	$19.95
GAAP EPS	$9.94	$13.29	$14.97	$17.71	$19.63
Ops Exp Excl in Pro-forma	$   1.14	$   2.04	$   2.70	$   2.77	$   2.95
GAAP EPS - Pro-forma EPS	$   0.66	$   2.29	$   4.23	$   3.03	$   3.27
Pro-forma PE	30.9	21.0	17.1	15.8	14.3
Pro-forma w/ Ops Exp PE	34.7	24.2	19.9	18.3	16.4
Unlevered PF w/ Ops Exp PE			17.4	15.7	14.2
GAAP PE	33.0	24.7	21.9	18.5	16.7

 

Note:

·      Analyst consensus expectations are based on pro-forma EPS that exclude one-time charges and stock options expenses.

·      Stock options expenses impact 2008 and 2009 EPS by $2.70/share and $2.77/share

·      “Unlevered PF w/ Ops Exp PE” figure above adjusts valuation for GOOG’s net cash position and its associated interest income

 

 

GOOG is the leader in Internet search-based advertising.  In 2008, GOOG is expected to generate $21.7bn in gross revenue and $15.7bn in net revenue.  Search is expected to generate 97% of net revenue.  US represents 49% of gross revenue and international 51% (UK 14%, Intl ex- UK 37%).  GOOG is a highly-profitable, cash-generative company.  GOOG currently operates at a ~30% EBIT margin on gross revenue and 45% on net revenue.  GOOG spends 9% of gross revenue on R&D (~$2bn).  GOOG is expected to generate FCF of $4.8bn in 2008, or ~$15/share.  This represents pro-forma EPS conversion of 78%.  GOOG has an ROIC over 100%.  The greatest drag on GOOG’s FCF relative to net income is CapEx—GOOG will spend $2.7bn in CapEx in 2008 vs. D&A of $1.2bn.

 

GOOG is the dominant player in search with a 64% global share of search queries (63% of US, 65% of ex-US).  GOOG has been steadily gaining share in search.  GOOG’s share of the US market has gone from 55.8% at Q208 to 58.5% at Q408 to 61.6% at Q208 to 6336% at Nov-08.  At Nov-08, YHOO GOOG had a 63.3% share, YHOO a 20.5% share, MSFT a 8.4% share, AOL 3.8%, and ASK 4.1%.  All of these share figures are based on comScore data.

 

Not all searches generate revenue for GOOG—GOOG only gets paid when a user generates a “paid click” by clicking on the sponsored links that typically appear above and on the right of the search results.  The links that appear in the main area on the left generate no revenue for GOOG when they are clicked.  GOOG’s revenues are determined by the number of paid clicks times the “cost per click”.  The “cost per click” is determined through an auction process in which would-be advertisers bid for placement on certain key word searches.  The actual placement award and cost per click paid by an advertiser is a function of the bid price, the quality score assigned by GOOG, and other factors (the formula driving this is a closely kept secret).

 

Long-term drivers for growth in GOOG’s core search market include: 1) growth in base of Internet and broadband Internet users (who spend much more time on the internet than non-broadband users), 2) greater awareness and utility of search which drives more searches per user, 3) the potential to increase the percentage of searches that have paid links associated with them—GOOG currently has a 43% coverage ratio while YHOO is at 63% and MSFT at 56%, 4) GOOG’s share of overall searches and paid clicks, and 5) growth in “cost per click” (CPC). 

 

‘Cost per click” (CPC) is a very important driver of revenue that is a function of the number of searches and paid clicks, the number of advertisers wishing to advertise via search, and the returns that the advertisers are getting from search.  It is my belief that in the short term (one or two quarters), CPC is the single biggest driver of variability and uncertainty in the rate of revenue growth.

 

One issue with GOOG is that it is something of a black-box: GOOG keeps disclosure on metrics and breakouts to a minimum.  The only revenue-related figures that GOOG releases are gross revenue, net revenue, revenue by geography (US, UK, and Intl ex UK).  GOOG only releases one underlying metric associated with revenue: the sequential and y/y growth rate in paid clicks.  GOOG does not even publish an absolute figure on the number of paid clicks.  GOOG does not provide paid click growth by geography.  However, from the sequential and y/y growth rates in revenue and paid clicks, an analyst can calculate the sequential and y/y change in CPC on a overall basis.  It would be interesting to know how much of GOOG’s revenue comes from retail, finance, auto, travel, health, education, etc.  Unfortunately, GOOG provides no such breakout.  The closest thing people can do is use com-Score data that shows the % of paid clicks that occur in each area.  However, since the CPC can vary considerably for each area (i.e. finance has a very high CPC), the revenue breakout by vertical is somewhat different.  GOOG has mentioned what categories are its top drivers of revenue in past presentation.  While analysts differ in their exact estimate, my best guess on revenue breakout is as follows: Retail 20%, Financial 16%, Auto 10%, Travel, Telecom, and Entertainment.  GOOG does not provide any figures on what types of customers generate revenue, but my estimate is that 40% comes from Large Fortune 1000 companies, 40% from small/medium, and 20% of the “long tail” of very small and local businesses.

 

The key data points that analysts monitor on GOOG are: 1) reported sequential and y/y growth rates in revenue (US, Intl, UK), paid clicks, and CPC, 2) comScore share data that shows on a monthly basis GOOG’s share of overall searches, and 3) comScore data that can be used to triangulate at paid click growth.  There are no third party data sources that give hard data on cost-per-click (CPC) intra-quarter, but analysts do channel checks with search engine marketers (SEMs) and with buyers at GOOG’s customers to get a handle on this.  Ultimately, the data points to estimate both paid click growth and CPC growth have considerable error to them and create a lost of intra-quarter noise and controversy to GOOG.

 

GOOG has a number of initiatives beyond search which both the bulls and bears point to.  The bulls point to the fact that these initiatives are currently generating minimal revenue and that EPS is burdened by the associated expense.  Bulls expect some of these initiatives to generate meaningful revenue and profit in the next few years, providing an added lift to the long-term prospects.  Bears do not expect these initiatives to turn profitable and believe that GOOG will continue to waste money on these and other initiatives.  In my view, the most important initiatives over the next 3-5 years include: 1) Mobile/Local (little near term rev, but most significant opportunity in 3-5 years in my opinion, 2) YouTube, 3) non-YouTube display advertising (using the DoubleClick platform).  There are numerous other initiatives such as Google Applications (GOOG versions of Word, Excel, PowerPoint) and Andriod (an operating system for cell phones)..

 

Thesis / Investment Positives

·      Room for growth in core search market (both in US and Intl):

o   Increasing base of Internet and broadband users (who spend much more time on the Internet and search more)

o   Increasing awareness & utility of search driving more searches/user

o   Increasing share of search (see figures in Business Description above)

o   Increasing the coverage ratio (% of searches where Google puts a paid link); Increasing the number of paid links per search page

o   Increasing the cost per click of each paid click through both improvements in targeting/relevancy and increases in the number of advertisers competing for key words

 

·      GOOG’s search business has very powerful competitive advantages

o   Search is a “winner-take-all” market where a search engine that is slightly better than the next competitor will hold a much greater amount of share

o   The ability of a search engine to provide better results is a function of both the ingenuity of the underlying search algorithm and the number of searches done on that site.  Actual usage patterns are a key input to relevancy algorithms.  Google’s superior market share allows its search results to be better than the next competitor, which creates a self-perpetuating aspect to Google’s dominance.

o   Network effects:  Even if some genius somewhere came up with a better algorithm for search, it is unlikely it would dislodge Google.  I believe the fact that everyone is now accustomed to going to Google for superior searches, the fact that more users results in better outcomes, and the fact that search is actually a capital intensive businesses with the need for large investments in serves and communication infrastructure to create faster and better searches is a huge hurdle. I don’t think new entrants have a chance.  Even deep-pocketed competitors like MSFT are having a very hard time.

o   Strong brand (Google is a verb); sticky/happy customers

 

·      Search advertising should hold up relatively well in a tough economy and a deep recession in advertising spending

o   As marketing budgets are squeezed, targeted, measurable ads are becoming more valuable to advertisers

o   As consumer budgets are squeezed, people use the web for comparison shopping to hunt for bargains online and in stores

o   Search typically cheaper than display and has higher ROI; it is transaction-based rather than brand-based and advertisers are much less likely to cut transaction advertising in a downturn as this directly impacts their revenues

 

·      International search still ramping up; search share and penetration are already high in UK and other Western European countries, but the potential for Google to replicate its success exists in many other countries, particularly in Asia.  Success in these countries will require good execution, but Google has already demonstrated solid progress in developing these opportunities.

 

·      Upside from “free options” on 1) YouTube, 2) Display, 3) Mobile/Local, 4) Apps, 5) Android, 6) numerous other initiatives:

o   Upside to stock price can be justified from reported EPS/FCF which is burdened with losses from these developing initiatives

o   In the long term (say 3-5 years), I think mobile/local has the biggest opportunity.  I see minimal revenue form this in 2009/2010, but several years out it could become a large multi-billion dollar opportunity.  This is the only initiative where I clearly see how it can move the needle in a meaningful way.

o   YouTube has a tremendous user base.  The thing Google has to figure out is how to monetize it.  Advertisers have been reluctant to advertise around user generated content, but GOOG is making progress.  YouTube is also starting to distribute professional content which is creating new monetization opportunities.  I think it is reasonable to see YouTube growing from $190mm in estimated 2008 revenue to $420mm in 2009.  This only moves the needle a limited amount relative to the overall net revenue base.

o   Google acquired DoubleCick and is going to try to develop this platform to generate revenue by offering services to provide more targeted display services than is currently available.  Privacy issues and legal challenges will continue to provide a limit on what GOOG can do here.  It is hard to know how big this can become.  At this point, I don’t expect too much.  I think it is reasonable to see this revenue base going from $300mm in 2008 to $370 m in 2009.  The question is can they find a way to grow to multiples of this size in 2010 & beyond?

 

·      Strong income / cash flow / balance sheet

·      Seasoned management team

 

Positive Change

·      Google is growing up; company recently started showing OpEx & CapEx discipline 

·      From a recent WSJ Article:

o   “The financial crisis has created a new sense of urgency within the company.  Top executives say they remain committed to projects they believe hold long-term potential, but are prepared to starve the lesser ones”

o   To better predict revenue, the company implemented quotes for ad-sales reps and tied the pay of more employees to performance

o   More prioritization of projects / eliminating experimental projects

 

·      Delayed OK Data center; Q308 CapEx down significantly (but how much is quarter to quarter noise vs. result of newfound discipline remains to be seen)

 

·      New CFO—Patrick Pichette.  Trained in “Six Sigma” management practices... looking to reduce inefficiencies and delay spending when possible

 

·      New VP of Financial Planning & Analysis, Francois Delepine, was hired to standardize and more tightly manage the budget process; finance teams started allocating more new hires to groups that generated the most revenue per head

 

·      Strong FCF generation (but company to date has not done any buyback or made any dividend payments, and buybacks/dividends are unlikely for at least the next 3 years)

 

 

Risks / Negatives

·      Limited operating history makes it very hard to predict performance in a normal downturn let alone an unprecedented one like the one we expect in 2009

o   Revenue-per-click (RPC) (a.k.a. CPC) could drop off significantly

o   The number of paid clicks could drop off significantly

§  I believe short term economic weakness is likely to have a bigger impact on RPC/CPC than on the number of paid clicks because RPC is driven by an auction process and is a function of the intensity of competition for key words.

§  I believe the severe drop in GOOG’s stock price over the past few months is already pricing in a severe deterioration in these metrics; I see the potential for the actual outcome to be better than the implied expectations

·      We are in unprecedented macroeconomic territory, but the early unofficial read is that the hit to Google’s business will be manageable.  Impact of recession on Google will not be officially known until Q408/Q109 results are reported.  However, all analysts who cover Google get a read on this by doing channel checks with SEMs (search engine marketers) and buyers at advertising companies.  While there are considerable differences in what the different analyst are hearing (most expect CPC to be flat y/y while one analyst thinks we could see a -10% y/y decline in Q408), even the worst expectation from these channel checks allows for earnings power that can support a higher stock price than current trading levels. 

 

·      Growth opportunities beyond core search market may never develop into large revenue opportunities that will drive meaningful growth from GOOG’s huge revenue base.  Google can be criticized for being spread too thin, not prioritizing projects, and not backing good ideas such as Applications with enough execution to reach commercial success where the difference between 90% and 100% of functionality is the difference between failure and success.  I can easily see how all initiatives other than Mobile/Local search fail to ever generate enough revenue to drive meaningful growth to Google beyond the core search market.  Also, it can be argued that GOOG lacks competitive advantage in many of the non-search areas that they are pursuing.

 

·      Goofy culture/Strange Googlisms: 1) 10% of corporate profit goes to fund Google,org, 2) engineers get to spend 20% of time (Friday’s) as undirected time on pet projects

o   “Inside the company, it was considered crass to talk about whether a project would eventually make money” say current and former product engineers… “The measure that mattered most was whether a new idea would be good for the Internet user’s experience”

 

·      FCF has not been used for buyback or dividend; so far, cash has built up on the balance sheet and has been used for a few acquisitions: will future use of cash be value creating?

 

·      Strong brand does not always equal great stock (Xerox, Kleenex, etc)

 

·      Potential for GOOG’s share to moderate or decline:  The trend in GOOG’s share of search to date has been towards consistent and positive share gain.  If this trend were to reverse, it would be treated very poorly by the market.  GOOG’s rate of share gain does appear to be moderating as YHOO and MSFT are left with their core loyal base.  However, I believe that GOOG will continue to gain 20-30 bps of share per month for the next several years and that GOOG’s share can continue marching above 75% as the virtuous cycle extends GOOG’s dominance.

 

·      Growth of special interest/destination websites: The growth of special interest websites such as Bankrate.com or WebMD puts competitive pressure on Google by giving would-be advertisers an alternative vehicle for acquiring customers.  I believe this threat hits Google’s business on the fringes and is manageable since would-be advertisers will not want to rely solely on this limited subset of users.  However, the existence of advertising alternatives such as this needs to be recognized as a negative pressure on Google’s business.

 

·      Growth of dominant Internet retailers (like Amazon):  I believe that consolidation and the growth of highly recognized, dominant Internet retailers are a negative for GOOG since it results in less vibrant competition for new customers.  GOOG fares best when there is a fragmented base of healthy would-be advertisers fighting for awareness and customers. 

 

·      Microsoft’s LiveSearch/Cash Back Initiative:  Microsoft recently launched an attack on Google that utilizes two angles: 1) the economics to the merchant are based on “Cost per Action” vs. “Cost per Click” and, 2) at least for the time being, MSFT is passing on the majority of the advertising revenue that it would receive to the customer in the form of cash-back discounts that can often range from 3-6%.  Currently, awareness of this offering are low (I wasn’t aware of it until I researched Google) and this initiative has not had a meaningful impact on Google to date and I don’t expect it to be a big problem.

·      Unexpected derailment on way to world domination--  At one time only a few years ago, YHOO and EBAY were also praised for their network effects, dominant market position, and the great path of growth that was expected to come from that.  While these two companies still dominate their space, display lost out to search (which wasn’t even a factor a few years ago) and EBAY’s growth flattened out much sooner than expected a few years ago.  Could the same thing happen to Google? 

 

Summary of Long-term View

·      In the long-term, I believe that search will remain a key means of reaching potential customers, and its relevance to the overall advertising pie will increase.  I believe search will continue to gain share of the overall ad dollar pie, and Google will continue to gain share in search.  I believe the number of internet users will increase over time.  I believe that ad budgets will grow over time and that search ad budgets will grow even faster than that.  I believe that this activity will translate into 1) more searches and paid clicks, and 2) increasing cost per click (CPC).  Much like the real estate market and beach front property, there is a finite supply of desirable key words and placements on the search results.  Over time, more dollars competing for this finite supply will result in increasing CPC and a growing revenue opportunity.

Catalyst

Revaluation to a multiple commensurate with LT growth prospects is the main catalysts. Other catalysts include: EPS holding up despite deep recession; Google shows greater expense management and operating discipline though 2009.