GOOGLE INC GOOG
July 02, 2015 - 5:58pm EST by
miser861
2015 2016
Price: 523.40 EPS 22.50 26.50
Shares Out. (in M): 690 P/E 23.2 19.7
Market Cap (in $M): 362,000 P/FCF 12.5 10
Net Debt (in $M): 60,000 EBIT 23,594 27,495
TEV ($): 302,000 TEV/EBIT 12.8 11.0

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  • Internet

Description

Google trades for 11x consensus NTM cash earnings per diluted share, net of cash (after deducting $7 billion of unpaid U.S. taxes on cash held offshore).  A business with high barriers to entry and growth rates like Search should trade for at least 20x earnings in my opinion.  In addition, I believe that if YouTube and Google Cloud Platform traded independently, they would get valuation multiples higher than Search since they are both growing greater than 40% YOY.  There is a perception that Google management are bad capital allocators when they may actually be among the best corporate capital allocators, when they choose to allocate capital.  They recently hired an investment banker, Ruth Porat, from Morgan Stanley to be CFO.  If Porat catalyzes no change in disclosure or capital allocation I think you still make good money from here.  If she catalyzes change I think you make more money.  I don’t see a scenario where you lose substantial money.

 

Search

Google created the search engine for all intents and purposes.  The search portals that existed before – Yahoo, Excite, AltaVista – focused on maximizing the value of their portals, which conflicted with the goal of creating a great search algorithm since it cannibalized banner ad impressions.  Google was the first search provider that applied rigor to improving search results.  They’ve improved the algorithm continuously with nearly 20 years of cumulative learning, at a cost of tens of billions of dollars.  They’ve spent heavily to shave milliseconds off of search results, personalize search results, and minimize the cost of their data centers.  They aggressively deploy search earnings into a virtuous loop, hiring some of the brightest engineers in the world to continue improving search.  To catch up with Google one would need 20 years of search data and tens of billions of dollars, and by then Google would have 40 years of search data and many tens of billions more dollars behind them.

 

On the Porter forces Google Search scores well:

·        Supplier (users who click on ads) power is high in that users make a daily decision to use Google and it would be frictionless to switch.  However, Google’s search data, algorithm and personalization is superior to replacements.  By choosing to use Google, users make Google better because it’s a learning machine.  The network effect is strong.  There’s no economic incentive to switch.  There are billions of undifferentiated suppliers so the power of any one supplier is very low.

·        Buyer power is low insomuch as there are many of them.  And Google’s audience is larger than anyone else’s, and ad delivery is probably more effective than competing search engines. 

·        Substitutes include other search engines which are few in number and inferior.  Other substitutes include applications that organize information on narrow subjects but don’t compete on a broad basis with search engines.  It’s impractical to have applications that serve many of your topical information needs.

·        The threat of new entrants is very low.  Microsoft has spent over $10 billion to get a foothold in search and has yet to do so profitably. 

·        Competitive rivalry is low.  The product (information) is a commodity.  Still, the industry is very concentrated.  Google differentiates itself with its reputation for trustworthiness.

 

Google’s culture makes them a powerful force.  Their culture manifests most tangibly in one primary way: their refusal to extract excess value.  Google refuses to take excess pricing on search ads.  Every search term is auctioned, and rather than accepting the highest bid, the winning bidder is given the term at second best bid plus $.01.  And the most relevant ads are given the best placement on the page rather than the highest-paying.  Also, Google ruthlessly drives out superfluous ad inventory with each algorithm update.  Google is constantly pushing low quality content down in their search results.  These low quality results have a disproportionate amount of text ads and display ads on them, which hugely penalizes Google Network revenues, but satisfies users and advertisers.  YouTube only charges their advertisers when their ad is viewed in its entirety – name one other media company that can make the same claim.  Google treats their advertisers extremely fairly, and carefully protects their viewers’ experience, at great expense to themselves.  I don’t know of a company that is more aggressively bent on constant improvement, besides maybe the 3G companies.  And I don’t know of another company that is more willing to disintermediate themselves, except maybe Amazon.

 

I believe the runway to expand the range of businesses that buy search ads even within the U.S. is long.  It used to be that a local business’ first dollar of ad spend would be in the yellow pages.  I don’t know why some day in the future that first dollar shouldn’t go to search, especially when all the local newspaper readers are gone, all the terrestrial radio listeners are gone, and the local television viewers have gone over the top.  And search ads are still cheaper, and more measureable than other media formats.  I think search is still under-utilized by small businesses.  I also think there is a long runway in developed markets to improve the value of a paid click to advertisers, with improved georelational abilities and results tailoring.  And then of course, the quantity and value of paid clicks in the emerging world will rise for a long time.  These are all problems that Google has some of the smartest people on Earth working on and has a massive lead versus competitors in almost every country. 

 

In Q1 paid clicks grew 25% on Google sites.  On the Q1 ’15 call management explained for the first time that the decline in cost per click (CPC) is entirely due to the rapid and accelerating growth of YouTube ad views.  Advertisers are willing to pay less for a video ad on YouTube because it’s usually earlier in the sales process than an actionable/measureable search ad which often leads to an immediate purchase.  Without the YouTube drag on CPC, management explained that CPCs are growing, even with a headwind from mobile mix shift and even with Rest of World growing faster than the U.S. and U.K.

 

YouTube

YouTube is a valuable media property with no substantial competition in the user-generated content space.  It benefits from powerful network effects.  It’s not as psychologically rewarding to broadcast cat videos as it is to broadcast the Super Bowl, but cat videos can still be a great business.  When you want to watch cat videos where else do you go?  And you might even watch an ad before it, if the ad is interesting to you.  For ten years YouTube has accumulated its video library and built its brand through goodwill.  YouTube has become as synonymous with online video as Google has with search.  And because YouTube generates many times more traffic and revenue as its competitors, YouTube can pay content creators exponentially more than the competition. 

 

Consider that Netflix spent about $60 million per season to produce House of Cards for what some have estimated to be 2.5 million viewers.  YouTube spends about $8 million per year to produce PewDiePie’s channel for 37 million viewers with quantifiable revenue uplift.  YouTube’s economics are superior to other media models in a few ways: 1) they don’t risk money upfront on content, 2) YouTube doesn’t spend money on content that no one watches, 3) their content evolves organically from millions of unpaid producers so YouTube doesn’t have to put any thought into figuring out what the audience wants, 4) YouTube is global, which very few media platforms can accomplish. 

 

Ad views are growing at least 40% YOY.  I can’t think of another world class media property growing that rapidly.  YouTube might be 15-20% of Google’s ad revenue in a few years, but I believe it deserves a valuation multiple substantially higher than Search, which might make YouTube 20-40% of Google’s value.  Because YouTube isn’t profitable, I think most analysts are implicitly assigning it no value.  Even my target price below assumes no margin improvement which likely gives YouTube little to no value since it’s at or near breakeven today.

 

Google Cloud Platform

In Q1 Amazon began reporting AWS revenue and EBIT.  Today AWS has about 20% EBIT margins (EBIT allows for the monstrous capital costs).  I think a standalone AWS would get a very high earnings multiple.  I also believe that Google Cloud Platform is growing much faster than AWS (possibly near triple digits), but with lower pricing and so almost certainly lower margins.  This is a business that enjoys massive scale benefits, and benefits from Amazon’s and Google’s expertise at efficiently running huge data centers and writing great hosting applications.  I can’t quantify much about this business due to lack of disclosure, but I know that it’s a very valuable business that’s rapidly getting more valuable.  Like YouTube, due to its small contribution to earnings today, it’s likely that the market (and me) are giving Google Cloud Platform little to no value.

 

New CFO

Patrick Pichette, while extremely Googley, probably wasn’t very greedy.  Hiring Ruth Porat can only be an improvement for shareholders, the only unknown is how much of an improvement.  In Eric Schmidt’s new book, How Google Works, the best that Eric could say about Patrick was that he visited a lot of mobile stores to understand how Android was being received, which in my opinion is a terrible use of a CFO’s attention.  Ruth is receiving $65 million of restricted stock ($25 million already and $40 million priced in early 2016).  I believe Ruth will want to maximize her stock’s value like any self-respecting investment banker.  Whether she’ll be allowed to is another (valid) question, but it’s interesting to me that Larry would hire an investment banker at all.  I read through all of Ruth’s comments in the Morgan Stanley conference calls and presentations to find out how much of a finance guy she is, and curated the most interesting comments below:

 

·        "...the importance of transparency and clarity for stakeholders. As you know, that has been core to our work with you during my years as CFO."

·        "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 client activity and areas that are most accretive to the overall franchise."

·        "the process of going over the last couple of years 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."

·        "we have a very systematic and clinical approach, really, to optimizing returns within each of our businesses. It's a focus on revenues, expenses, and capital."

 

In my view, Google’s biggest shortcomings are in transparency, dead weight capital, and (possibly, but we have no way of knowing) expense discipline.  Ruth spoke frequently about all three while at Morgan Stanley.  They have a lot of projects which produce losses but have good option value, but we have no way of knowing how much Search value those projects are concealing with their losses because disclosure of moonshot and emerging product R&D is non-existent.

 

The problems that plague Google investors reminds me a lot of the problems that plagued Japanese investors pre-2013 – poor capital allocation strategy and poor focus on profitability.  I confess to passing on Japanese investments because I viewed Japan’s corporate governance problems as too intractable.  Similar to Japan, Google’s behavior could begin to change overnight.  The difference is that there’s only one highly intelligent, rational person with his finger on the capital return button, and now he’ll have an investment banker trying to reason with him for the good of her net worth.  Maximizing the stock price is good for employee morale and good for attracting new talent.

 

Capital Allocation

Google has a fascinating acquisition track record that often produces other-worldly rates of return and a low failure rate.  Some examples:

 

Uber

Google Ventures invested $258 million at a $3.76 billion valuation in August 2013.  Uber is raising equity at a $50 billion valuation this year, less than two years after Google’s investment.  After this 2015 round, Google’s stake will be about 6.4%, meaning Google’s stake is worth about $3.2 billion, a two year 12-bagger.  One interesting thing to note about Google’s non-marketable investments is that the non-controlled ones are marked at the lower of cost or market.  Google Ventures’ Uber stake is worth almost as much as its entire portfolio is marked on the balance sheet.

 

YouTube

Google paid $1.65 billion for YouTube in November 2006.  I think YouTube is conservatively worth $30 billion today ($6 billion of revenue x 5).  That’s a nine year 18-bagger, a 40% CAGR.  The gain on YouTube alone is roughly 3x the net amount Google has spent on all acquisitions since 2006.

 

Android

Google paid $50 million for Android in July 2005.  This was an absurdly small price for what is now the largest installed base OS on Earth.  Based on statements Google has made about the payments it has made to developers over the last 12 months, I think Android is generating over $3 billion per year of app revenue.  Android also helps secure search traffic for Google, especially since they have 80% share of mobile devices.  At 5x app revenue, Android would be worth at least $15 billion today.

 

One common pattern is that investors are usually skeptical of Google’s acquisitions at the time they close, but they usually seem obvious in hindsight.  But it’s also true that Google can continue to do these acquisitions and still do lots of buybacks.  To call Larry Page a bad capital allocator is a half truth at best.  On the one hand I’ve never seen acquisitions with returns as high as Google’s, but on the other hand there’s clearly room for more capital deployment even if it’s into buybacks with returns that aren’t as transformational as YouTube.  In almost every case historically Google has bought startups, and has never spent more than $2.5 billion net of disposals and tax attributes on a single acquisition.  I don’t think it’s in Google’s DNA to acquire un-innovative mature companies that would cost a lot.  I just don’t think Google needs $150 billion of cash sitting around in 2018 when they’ve never spent 1/50th of that much on an acquisition.  Having that much cash would be more indicative of mental illness than strategy.  Ruth may try to reason with Larry that Google can continue doing all the great projects and acquisitions they want and still do some buybacks.

 

Model

I prefer to add back stock based compensation expense to earnings because the result of this expense tells you that Google gives away 20% of the company in perpetuity.  The economic reality is that Google gives away 1.5% of the company per year.  So I prefer to look at diluted adjusted EPS and just grow the future share count by the number of RSU grants, since that is the economic reality.  But that’s just, like, my opinion.

 

I’m using (and buying) the class C share price (ticker GOOG) because they have the same economic rights as class A shares.  Class C shares have no voting rights, but since the class B shares have 65% of the voting rights I think the voting rights are worthless in this case.  I don’t know why the market pays more for class A shares, maybe they think it’s like grades of meat.

 

Today’s price on future diluted cash EPS:

 

 

2018

2017

2016

2015

 Price

          525

          525

          525

          525

 Cash per Share

          231

          187

          145

          107

 EV/Share

          294

          338

          380

          418

 Diluted Cash EPS

            45

            42

            38

            34

 P/E

           6.5

           8.1

         10.0

         12.3

 

 

Without Buybacks

 

2018

2017

2016

2015

 Consensus Revenue

     92,025

     81,095

     70,212

  59,733

Consensus EBIT

     34,937

     31,383

     27,495

  23,594

Consensus EBIT Margin

38.0%

38.7%

39.2%

39.5%

+ Stock Based Comp

       4,279

       4,279

       4,279

    4,279

+ Amortization

       1,456

       1,456

       1,456

    1,456

Adj. EBIT

     40,672

     37,118

     33,230

  29,329

Taxes

       8,134

       7,424

       6,646

    5,866

Unlevered Net Income

     32,538

     29,694

     26,584

  23,463

Diluted Shares

       725.5

       713.5

       701.5

    689.5

Diluted EPS

       44.85

       41.62

       37.90

    34.03

Multiple

         25.0

         20.8

         16.5

      12.3

Enterprise Value/Share

       1,121

          864

          626

       418

Cash per Share, EOP

          231

          187

          145

       107

Equity Value per Share

       1,353

       1,051

          771

       525

 

 

Targeting $50 Billion of Cash at 12/31/18

 

2018

2017

2016

2015

 Consensus Revenue

     92,025

     81,095

     70,212

  59,733

Consensus EBIT

     34,937

     31,383

     27,495

  23,594

Consensus EBIT Margin

38.0%

38.7%

39.2%

39.5%

+ Stock Based Comp

       4,279

       4,279

       4,279

    4,279

+ Amortization

       1,456

       1,456

       1,456

    1,456

Adj. EBIT

     40,672

     37,118

     33,230

  29,329

Taxes

       8,134

       7,424

       6,646

    5,866

Unlevered Net Income

     32,538

     29,694

     26,584

  23,463

Diluted Shares

       601.5

       622.0

       650.1

    689.5

Diluted EPS

       54.10

       47.74

       40.89

    34.03

Multiple

         25.0

         20.8

         16.5

      12.3

Enterprise Value per Share

       1,352

          991

          676

       418

Cash per Share, EOP

            84

            95

          102

       107

Equity Value per Share

       1,436

       1,086

          778

       525

         

Cash, EOP

     50,395

     58,855

     66,575

  73,487

         

Buybacks

       

$

     40,997

     37,415

     33,496

 

Px

       1,261

          932

          652

 

#

            33

            40

            51

 

 

 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.

Catalyst

New CFO, potential improvement in disclosure and capital allocation.

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