The Fundamental Case To Sell Google

| About: Alphabet Inc. (GOOG)

Last week I removed the last shares of Google (NASDAQ:GOOG) from my portfolio. I was happy to do it. As things are now, I doubt I will ever be buying again. It's important to own up to one's mistakes as an investor and acknowledge when the situation has changed and is no longer tenable. In my case with Google it no longer is.

The success of Google as a business is not the question of this article, nor should it be. The question is how shareholders will fare going forward. Judging from the last couple of years, I don't think they will fare very well.

Chart by Fastgraphs

This is a ten year chart. We can see that Google's stock price has decoupled from its earnings trajectory for the last five years. This isn't merely "the foibles of Mr. Market." It's a long-term trend that reflects a permanent shift in sentiment. The focus of this article is why this decoupling has occurred.

There are quantifiable reasons for this, to be sure, but before we look at them I want to share a very telling exchange between an analyst and the co-founder and reappointed CEO Larry Page from the most recent earnings call.

The analyst asked about mobile search versus desktop, citing that mobile growth was very strong but he was wondering if higher-margin search on desktop computers had flatlined yet. To which Page's response was, exactly, "I feel like you're asking the wrong question, a little bit."

Page went on to explain that we are entering a time of multi-platform online advertising, but clearly danced around the question and provided no color on desktop search as part of the business. Small exchanges like this, and there have been more than one, really illustrate how management sees itself above taking criticism and that requests for detail can be wholly inappropriate.

Since day one Google's share structure has given control of the company to its founders and stripped ordinary shareholders of much voting power. It's one thing to say that being a shareholder means putting absolute faith in the founder's vision. Its quite another for management to sit arrogantly in an ivory tower and discount any semblance of accountability to those shareholders. Since Larry Page took the reigns of CEO, it seems that's exactly what has been happening.

Profitability Metrics Are Deteriorating

Coming back into the realm of the empirical, we see that Google's revenue growth bounced back since 2008 and all accounts show it chugging along at a healthy rate above 20% for this year, too.

Data by Morningstar, chart created by author

Larry Page points to metrics like revenue growth to imply that Google is going back to its good old days. Unfortunately, as we will see, this growth is becoming less profitable and more expensive to achieve as the years go on. Sure enough, the Asset Turnover ratio, where revenue is the numerator, shows this pretty clearly.

Data by Morningstar, chart created by author

The Asset Turnover ratio has declined in every full year since 2005. I go back this far to show that the trend is a long-term one. The trailing twelve month number may look promising for now, but the overall trend of declining revenue efficiency is undeniable.

Not to belabor the point, but I think it's important to look at two other key profitability metrics, Return on Assets (ROA) and Return on Invested Capital (R.O.I.C.).

Data by Morningstar, chart created by author

Data by Morningstar, chart created by author

In both ROA and ROIC, net profit is the numerator with assets and invested capital the respective denominator. Although Google had a time of recovery from the Great Recession, if we remove that entirely we see a definite downward trend in both of these important profitability metrics. This shows that net income is growing slower than assets. Looking at the above graphs, we should expect to have a deceleration in profit despite accelerating revenue growth. And we do.

Data by Morningstar, chart created by author

Net income shows a clear deceleration. In 2011 profits increased by less than 15%, and in 2012 all accounts show it will be comparatively lower. Google is becoming a low-growth company.

Left In The Dark

Since Google limits its disclosure on metrics, we simply don't know what projects and business units are dragging these metrics down. There have been several obvious dark spots, however:

  • Newly acquired Motorola recently posted a loss and its new phones minted under Google have thus far been a "total dud." Considering that Motorola has been unprofitable from 14 of the last 16 quaters, it's doubtful that they will be profitable anytime soon, if ever.
  • While Android and Chrome may add little, if any, to the bottom line, they could both be seen, however, as a defensive strategy to entrench search.
  • Google+, while it may have a number of users, is not making monetization a priority.
  • Cost Per Click declines weigh heavily on the numbers, too. The shift to mobile has disrupted internet advertising. Management isn't to blame for this one, but it does create a lot of uncertainty and is doubtlessly a big factor in the above declines.
  • Finally, there are the "pet" projects you may have heard about: Green energy investments, self-driving cars, a space program and the like. While exciting and interesting, projects like these will not help the bottom line in the short term or long.

Because Google is such a well covered, oft written about company, I'll leave discussion of Google's individual business units to those more knowledgeable than myself.

What I will say is that profitability metrics are declining across the board. The money Google is spending on capital projects is getting progressively less mileage and top-line growth is decelerating along with it. For growth investors, that's a serious problem.

No "Adult Supervision"

So, could Google clean out some of its non-performing projects to increase returns and restore some of its margins? Maybe a minimal Internal Rate of Return? Paying a dividend would instill capital discipline in that the possibility of returning money to shareholders could compete with new projects for capital. These things have all been done before in companies that have "matured," and shareholders have often benefited.

Data by Morningstar, chart created by author

No excuse not to pay a dividend.

Unfortunately, with the stock structure as it is, there's no realistic chance of this happening. The company is firmly in the control of Larry Page and Sergey Brim. In the past, Eric Schmidt's presence as CEO was believed to make sure that some of the "wackier" projects didn't see the light of day. Not so anymore, and we're seeing the results.

The rationale for keeping outsiders from influencing decisions was to shelter the company from Wall Street and its tendency to see only 90-days out. These problems and trends, however, are long term, and nobody at Google seems willing to put on the brakes or reward investors for their patience.

Listening to a recent earnings call or Google presentation, we can really sense that management seek to bring the company back to the time when they revolutionized Search by revolutionizing other ways in which we live.

Unfortunately for them, history is not on their side. Genius tends to be spontaneous. It rarely comes from entrenched entities. By throwing ever larger sums of money into various projects in an increasingly desperate effort for the next big thing, Larry and Sergey are attempting a sort of corporate alchemy. It is the shareholders who will be ultimately singed by the experiments they are concocting.

Conclusion: Time to Hop Off

Those concerned about the corporate governance issue, decelerating growth and diminishing returns should know that now is a fine time to get off the Google bandwagon. They could hardly be blamed. Take a look at the five year price chart with the price and trailing twelve-month P/E ratio:

What stands out here is the PE ratio. It's over 23, and near its twelve-month high. Considering the issues mentioned above, it does seem awfully frothy. With top line growth possibly hovering around 10%, no dividend in sight and no plan to better profitability, now is a great time to book gains and look for more shareholder-friendly pastures.

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.