Google's Mobile Strategy And Valuation Consequences

Dec.12.12 | About: Alphabet Inc. (GOOG)

Overview

Google (NASDAQ:GOOG) is one of the most successful internet companies that has ever existed and has earned its $226B valuation. Google enjoys a dominant market share in search and is present and substantial in many other markets. As Google continues to work towards maintaining and growing its domination in mobile search and expanding its ecosystem, mobile users will be at the forefront of the battle. Google is no doubt aware of this as they have aggressively moved into several markets that are not necessarily core to their search business. This article will take a look at Google's mobile strategy and its impact on the shares' valuation.

Their recent acquisition of money-losing Motorola Mobility was expensive in my view but I understand they are trying to cement their position as king in the world of mobile devices in order to grow their ecosystem of products and services. This acquisition proves Google management understands that desktop computing is slowly bleeding out while mobile computing (including smartphones) is exploding and they want to be on the forefront of the movement. Management is hoping the Google ecosystem will challenge Apple's (NASDAQ:AAPL) in the coming years and are making the investments necessary now in order to reap the benefits.

I am not suggesting that Google's bread and butter desktop search business is in danger of disappearing but as more and more consumers and businesses shift to mobile computing for their data needs, Google will need to control the mobile arena as well. Their move into selling smartphones and tablets has been extremely well received in the marketplace and are serving to grow Google's brand beyond just search. While some of these hardware businesses are loss leaders in order to compete, Google's strategy to grow its ecosystem user base in the hopes of future payoff is sound. This is akin to a manufacturer building its factory base and supply chain in order to receive the future benefits. Of course, this is on top of their ubiquitous Android OS for mobile devices that is proving to be wildly popular worldwide.

Stock Analysis

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GOOG has fallen about 11% since hitting its high of 774 in early October but has rallied 6% off of its November low of about 640. The question is does GOOG deserve your capital at these levels? To answer this, we will start by taking a look at some valuation metrics.

Google is extremely well capitalized, with current assets of $56.8B and current liabilities of only $14.4B. In addition, they are trading at about 3.3 times book value and have only about 12.5% of their assets financed by debt. Considering those facts and that they generated $14.57B of operating cash flow last year, it is safe to say that Google has excellent liquidity and self-financing ability. Strengthening this position, they do not pay a dividend so all free cash flow is available to grow the business.

Google does have some debt, about $3B in long term obligations, but in light of Google's dominant position in their industry and immense profitability, this is on the verge of not worth mentioning. Google's shift away from simply being a search company is evident in their 9/30/2012 balance sheet as you can see goodwill has increased by almost half YoY and intangible assets increased roughly fivefold from the previous year due to acquisition activity. In addition, Google's 3Q 2011 inventory of $35M is now $618M (!) reflecting MMI assets and their shift towards hardware. Lastly, Google's accounts payable quadruples YoY, no doubt reflecting payment obligations to suppliers for MMI. While none of these numbers are troubling as they are relatively small, a handset business as large as MMI's can get out of control quickly if not properly managed. It will be interesting to see going forward how efficiently Google can manage their hardware business. Execution in this arena is the principal risk to the stock, in my view.

Some troubling notes on the analyst front - 90 days ago, Google's FY2012 earnings estimate was $42.54/share but that number has come down to $39.79. While this is bad enough, the risk is that Google will come in light even relative to that number. In addition, Google's FY2013 per share earnings estimate was over $49 two months ago but is now $46.37. While downward earnings revisions are never good, these are relatively minor and are priced in already. However, the reasons behind the downward revisions are what is important and should be watched carefully if you are long.

Valuation

To take a look at valuation, we will use a discounted cash flow model to derive a present value for GOOG shares. As with any DCF analysis, some assumptions must be made and here they are:

  1. Discount rate-10% (my estimate)
  2. Earnings growth for 2013-16.5% (Yahoo! Finance analysts estimate)
  3. Earnings growth for 2014-2018-13.5% (Yahoo! Finance analysts estimate)
  4. Perpetual earnings growth-5% (my estimate)
  5. WACC-10% = equity risk premium as Google has some debt but doesn't report interest expense

Without further ado, here is the valuation.

2012

2013

2014

2015

2016

2017

2018

Earnings Forecast

Reported earnings per share

$39.79

$46.37

$52.63

$59.74

$67.80

$76.95

x(1+Forecasted earnings growth)

16.54%

13.50%

13.50%

13.50%

13.50%

13.50%

=Forecasted earnings per share

$46.37

$52.63

$59.74

$67.80

$76.95

$87.34

Equity Book Value Forecasts

Equity book value at beginning of year

$207.03

$253.40

$306.03

$365.77

$433.57

$510.52

Earnings per share

$46.37

$52.63

$59.74

$67.80

$76.95

$87.34

-Dividends per share

$0.00

$0.00

$0.00

$0.00

$0.00

$0.00

=Equity book value at end of year

$207.03

$253.40

$306.03

$365.77

$433.57

$510.52

$597.87

Abnormal earnings

Equity book value at begin of year

$207.03

$253.40

$306.03

$365.77

$433.57

$510.52

x Equity cost of capital

10.00%

10.00%

10.00%

10.00%

10.00%

10.00%

=Normal earnings

$20.70

$25.34

$30.60

$36.58

$43.36

$51.05

Forecasted EPS

$46.37

$52.63

$59.74

$67.80

$76.95

$87.34

-Normal earnings

$20.70

$25.34

$30.60

$36.58

$43.36

$51.05

=Abnormal earnings

$25.67

$27.29

$29.13

$31.22

$33.60

$36.29

Valuation

Future abnormal earnings

$25.67

$27.29

$29.13

$31.22

$33.60

$36.29

x discount factor (10%)

0.909

0.826

0.751

0.683

0.621

0.564

=Abnormal earnings disc to present

$23.33

$22.55

$21.89

$21.33

$20.86

$20.49

Abnormal earnings in year +6

$36.29

Assumed long-term growth rate

5.00%

Value of terminal year

$725.81

Estimated share price

Sum of discounted AE over horizon

$109.97

+PV of terminal year AE

$409.70

=PV of all AE

$519.67

+Current equity book value

$207.03

=Estimated current share price

$726.70

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As you can see, Google is expected to earn something like $77 per share in 2018 at current growth projections. Given the current forward multiple, this implies a roughly $1,150 price target for GOOG shares in 2018. The trick is we are discounting GOOG's cash flows to account for the time value of money, a fair return on our money, and some degree of uncertainty between now and 2018. As a result, the fair value of GOOG today based on my assumptions and the estimates provided is $726.70 per share. This represents only about a 4% margin of safety from today's price and as such, I believe Google is fairly valued presently.

As seen in this chart, Google's TTM PE ratio has decreased substantially since going public but has stabilized around the 20 area. I don't think Google will be facing any multiple compression any time soon so this is a positive for the stock.

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GOOG PE Ratio TTM data by YCharts

One small negative for the stock is that Google does not pay a common stock dividend. This will scare away income investors and some institutional money managers. However, Google has proven their ability to reinvest their cash quite profitably so I don't think this will necessarily negatively impact the price since it is well known they aren't going to pay a dividend. And for the bulls, a future Google dividend declaration would be a huge positive catalyst as all the managers I mentioned will be free to accumulate the shares.

One last chart, this is the reason to buy Google if you want to get long. This chart depicts Google's net income since it went public. While this trajectory can't last forever, it is showing no signs of stopping anytime soon. Particularly with Google getting into so many new markets other than search, they are no doubt cooking up new ways to make this graph continue towards the upper right.

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GOOG Gross Profit TTM data by YCharts

Conclusion

Google is obviously the dominant player in its industry and its valuation is well deserved. They are an extremely well-run company and I don't expect any of that to change in the near future. Based on my valuation, you could certainly buy Google here around $700 and probably get a fair return on your money. However, I would ideally wait for the shares to come in some, perhaps back to the $650 level before adding aggressively. There is a tremendous amount of uncertainty as the efficacy of all the new markets Google has entered, namely smartphones and tablets, and if Google executes, shareholders will be handsomely rewarded and my estimate of fair value will no doubt prove to be conservative. To hedge against this uncertainty, wait for GOOG to pull back before adding shares to your portfolio.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.