Seeking Alpha
Growth at reasonable price, research analyst, newsletter provider, long/short equity
Profile| Send Message| ()  

Ticker: Google Inc. (GOOG)

Rating: Maintain at Hold

Thesis:

2012 was a great year for Google, but how will the stock progress in 2013? Concerns over regulations, rising competition, and valuation fill up the typical conversation. Yet, there is something much more important to watch with GOOG. For us, Google is a great company with strong products and lots of future growth. It should be a core holding in nearly any portfolio with technology exposure, but the ability for GOOG to see tremendous upside for 2013 seems limited to us as a significant amount of future growth appears to be priced into the stock at this time.

As shown below, we have priced into our model around 100% growth in operating income through 2017, which is definitely an aggressive model. The reason we see such strong growth comes from a number of reasons. First, GOOG looks ready to bring on new clients in their move to further the company's enterprise revenue. The company ramped up enterprise in 2012 with Google Drive, which allows users to store any type of document on the cloud network. Further, the company has shown success with its Apps program for businesses. Google now has e-mail, calendar services, word processing services, and much more. The company wants to compete with Microsoft (MSFT) for its enterprise business and believes it can take 90% of the market. The development of this business as a solid revenue model could help build the company's business tremendously.

The company, additionally, is attractive to us due to its fundamental strength in its business model over other tech competitors like Apple (AAPL) and Samsung. The reason is that the company does not have to deal with fickle consumers and consumer trends - one of the main reasons we think it's a great core holding. The company received over 90% of it revenue from advertisements in 2011, and it sees up and down movement on revenue/earnings based on competition for search and other Google products (Google +, Offers, Gmail, etc) rather than consumer trends. The advantage, in that respect, for GOOG is that its barriers to entry are strong. It's very hard to build a dominant search engine and overthrow Google. Just ask Yahoo (YHOO) or Bing. Google's dominance remains. In the latest results from comScore, GOOG still holds 67% of the search market in the USA. It started the year at 66%, so the company has actually increased its dominance despite efforts by Bing and Yahoo to regain traction.

Yet, we have seen GOOG continuing to diversify its business to deal with a move to mobile and shift to social networks. The company is finally taking its Motorola patents it acquired to develop a phone that it believes can compete with Samsung and Apple. The company is developing the X-Phone, the first company phone where the hardware and software will both come from GOOG. The company already has taken the first step with featuring its Android service, so the next step into hardware is a small step. The acquisition of Motorola patents had to be to move into this area. There are not a ton of details about exactly what the phone will look like or offer, but the phone will definitely be a great way for the company to further its Android line as well as allow it to continue to develop its mobile ad revenue. Further, the company is moving into the internet market with Google Fiber, which will be fast-paced internet at home to power all those devices that help GOOG acquire ads. The company will be dealing with barriers to entry with such dominance of Comcast (CMCSA) and AT&T (ATT) services, but if it's a superior product, GOOG could be on to something.

The key for Google is to look at its businesses and say can this increase the revenue from the ad business because at the end of the day...its the bread and butter of GOOG's business. Monetizing other products like mobile software, internet, hardware, and enterprise definitely helps. Those products all lead to advertising revenue, and if they do not, they present a problem in our ideology. For example, the company's ability to have its Maps software downloadable on Apple apps now allows them to be able to feature advertising. When it was preinstalled, it could not. The move for Apple to boot Google was a great one for GOOG in the end. The company makes much more money every time you call a company through maps on the phone. Barclays, for example, said that the app could generate $2B - $4B by 2016. This growth is an example of a great move for GOOG that focuses in on high margin ads. On the other hand, we question a move like Google Offers and Google + as long-term cash cows. Both had barriers to entry like Groupon (GRPN) and Facebook, and can it create long-lasting ad revenue? It's still to be seen.

So why not go out and buy a truckload of GOOG? The company has great economic moats, solid business lines, and has been growing solidly. Well, there is something we call valuation. Is the stock worth more than it should be? Is the stock pricing in a lot of future growth already? In the case of Google we believe so. We would argue for buying the stock if you do not hold it on any sizeable dips, but if you are not already an owner, we believe there is better upside in many other companies in technology. The problem for GOOG is it currently sits with a 23 PE and 15 future PE. Not a ton for a company with strong growth, but as we see below, the company's equity value is held back by several factors. First, the company has a strong weighted average cost of capital (WACC) that holds back shares as well as high amounts of capital expenditures and increases in working capital. Those high levels are due to acquisitions mostly, which still are a high priority of GOOG.

The company continues to dedicate a lot of money to new ventures that are not paying off. How do we know? The argument we are making above about increasing capex and working capital can be seen in the company's decreasing ROA and ROIC. The company has seen ROIC come down from 23.7 to just under 16 in the TTM from 2005 to present. Return on assets have also decreased in the same timeframe from 21.6 to 13.3. Both declining measures of profitability show that assets are growing much faster than profits. The decline in profits is shown in our model as well as continued strong working capital increases as those assets continue to grow. What we are getting at for GOOG is that its business has added to the business (assets) but it has not been paying off (profits).

What's the issue?

We have previously noted that Motorola is definitely going to weigh on the bottom line for some time. Google + as well we believe is a drag on the company. Motorola could turn out to be something very profitable if the company can make money off the patents in the way of exciting hardware, but that is a big question mark. Another sign that Google+ may be struggling is that the company is now funneling people to have a Google+ when they sign up for Google account. The force of people to use the product is not a positive. The company sees Google+ as a necessary defense to Facebook, who does create a threat with its social networking business.

What we are getting at is that maybe the so-called ironclad ad revenue is not so ironclad. Sure, the company is dominating search, but people are finding other ways of using its time on the internet - using its phones, Facebooking, and even using Linkedin (LNKD). The move into Motorola and Google+ are definitely defensive measures as it sees FB and the move onto mobile as trends that will last, but it has not mastered these businesses the way Google has mastered search. Thus, we see the decline in profitability. We do not see that changing in the next couple years, and therefore, we are holding back our price target.

The company, additionally, may see some issue with a recent development in the EU that will not allow search engines to direct search results to the company's products. That decision will most likely be a pin prick for the company, but the precedent may be an issue. The FTC recently did not come up with anything on the antitrust issue for GOOG, which is a sigh of relief. All in all, the regulatory market tends to not curb stock prices in the market overall, but a shift towards regulating the market could be an issue that we have not priced into the stock.

Price Target:

Ticker

New Price Target

Old Price Target

New Rating

Old Rating

New Buy/Sell Range

GOOG

$692

$690

Hold

Hold

$550/$775

The following price target was configured through a 5-year projected discounted cash flow analysis. The model projects operating income, taxes, depreciation, capital expenditures, and changes in working capital. Using that information, we can project what the company is worth. We can then use that projection and compare it to current prices.

Here is how to calculate price targets using discounted cash flow analysis:

(all figures in millions)

Step 1.

Project operating income, taxes, depreciation, capex, and working capital for five years. Calculate cash flow available by taking operating income - taxes + depreciation - capital expenditures - working capital.

 

 

 

2013 Projections

2014

Projections

2015 Projections

2016

Projections

2017 Projections

Operating Income

12130

14000

16000

18400

22000

Taxes

2426

2800

3200

3680

4400

Depreciation

2512

2700

2900

3100

3200

Capital Expendit.

-2800

-3000

-3200

-3500

-4000

Working Capital

4857

4857

4857

4857

4857

Available Cash Flow

4559

6043

7643

9463

11943

Step 2.

Calculate present value of available cash flow (PV factor of WACC * available cash flow). You can calculate WACC, but we have given this number to you. The PV factor of WACC is calculated by taking 1 / [(1 + WACC)^# of FY years away from current]. For example, 2016 would be 1 / [(1 + WACC)^4 (2016-2012).

WACC for GOOG: 9.29%

 

2013

2014

2015

2016

2017

PV Factor of WACC

0.9149

0.8372

0.7661

0.7009

*

PV of Available Cash Flow

4171

5059

5855

6633

*

* For 2016, we are going to calculate a residual calculation, as we believe that the market tends to value companies with around a five-year projection of where business will be. This is the common projection for discounted cash flow analyses.

Step 3.

For the fifth year, we calculate a residual calculation. This number is calculated by taking the fifth year available cash flow and dividing by the cap rate, which is calculated by taking WACC and subtracting out residual growth rate. Residual growth rate is typically between 2-6%. 4% is average growth for industry. Companies with high levels of growth have higher residual growth, while companies with lower growth levels have lower residual growth. This is why higher growth companies tend to have higher PE ratios. We will give you cap rate.

Cap Rate for GOOG: 4.29%

 

2016

Available Cash Flow

11943

Divided by Cap Rate

4.29%

Residual Value

278392

Multiply by 2016 PV Factor

0.7009

PV of Residual Value

195135

Step 4.

Calculate Equity Value - add PV of residual value, available cash flow PVs, current cash, and subtract debt:

  

Sum of Available Cash Flows

21719

PV of Residual Value

195135

Cash/Cash Equivalents

16260

Interest Bearing Debt

6206

Equity Value

226907

We have added in current cash/cash equivalents as of the latest fiscal quarter along with debt levels.

Step 5.

Divide equity value by shares outstanding:

  

Equity Value

226907

Shares Outstanding

328.59

Price Target

$692

In the end, we have found that GOOG is worth around $692, which we believe accurately reflects the company's five-year projections.

Profitability:

 

Q1-Q3 2012

Q1 - Q3 2011

Operating Margin

27.9%

30.1%

Gross Margin

53.5%

65.2%

Return on Equity

11.5%

12.1%

The margin drop in Google is what we were talking about previously in the article. Profitability is dropping, and we believe that this issue is holding back share prices. How does Google compare to other computer software and hardware companies?

IBM's (IBM) operating margin currently stands at 17%, gross margin at 47%, and return on equity is worth 50%. Equinix (EQIX) is looking at 22% operating margin, 50% gross margin, and 2% return on equity. Akamai (AKAM) has 22% operating margin, 95% gross margin, and 6% return no equity. Finally, LNKD has operating margin at 5%, gross margin at 71%, and ROE at 1%. GOOG leads all operating margin, in the middle of gross margin, and one of the top return on equity. The company is still a profits leader, but these are shrinking.

Value:

 

Current

Industry Average

P/E

22.1

27.9

Future P/E

15.2

N/A

Value is decent for GOOG. We look for sub-20 PE and sub-15 future PE for value, but with the growth, the shares look cheap. The issue though is what we have highlighted for the company's value above. How does this compare?

LNKD has a PE of 715 and future PE at 87. AKAM has a PE of 38 and future PE of 20. EQIX has a PE of 84 and future PE of 64. IBM has a PE of 14 and future PE at 10. GOOG lags some similar companies, but the others are younger, growing companies.

Conclusion

Google is looking a bit concerning with a tough return on asset and equity drop that is due to profitability coming under question as of late. We believe the company will be relegated to this development until they either abandon unprofitable ventures like Google + / Motorola or turn them into cash cows. Until we see those signs, we are keeping our targets in check.

Good Investing!

Source: Google Not A Buy, Suffering From Declining Return On Assets