With all of the hysteria surrounding the decline of Apple's (AAPL) stock price, there has been slightly less media attention regarding the continued ascension of Google's (GOOG) stock price. Google's stock has staged a nearly 51% climb from its 52 week low of $556.52, to a recent high of $840.15.
We profiled the stock bullishly on two occasions near the lows, because the market clearly wasn't appreciating Google's durable competitive advantages that are likely to lead to a reasonably long runway of above-average revenue and earnings growth. Google to me is the preeminent advertising company in the world, leveraging its role as the primary focus of corporate advertising budgets to leverage incredible technological innovation on a scale that has little precedence. The biggest risk to the company's moat occurred on the transition to mobile advertising, but the company was a first-mover in that market, willing to lose money over the short-term to build incredible value over the long-term. For these reasons Google is the technology business that I'd most love to own for future profits, but I'd only suggest holding the stock at current prices if you are a true buy and hold investor, willing to endure a potential 30-40% sell-off. To be clear I am not forecasting this type of decline for Google, but investors buying at these prices are likely to be momentum investors that tend to jump off the bandwagon based on price movement, as opposed to changes in the fundamentals.
While it is easy to get lost in all of Google's innovations, it is essential to understand that at its core, Google is the dominant advertising medium. In 2012, $43.586 billion of Google's $46.039 billion of ex-Motorola revenues came from advertising. Total advertising revenues have grown in excess of 20%, in each of the last 3 years. Advertising on Google's websites constituted 68% of Google revenues, while Google's network members' websites represented 27%. Both grew by about 20% in 2012 and have the potential to grow by a similar rate in 2013. Google is dominant in both internet search advertising and mobile, and has the best display ad business in the world. Internet and mobile advertising should grow between 10-15% per annum over the next 5 years, and it would be shocking if Google's advertising revenues did not grow in excess to the market rate. Display advertising should grow by double digits over the next 5 years as well, and Google has been picking up market share consistently there. YouTube was an extremely expensive investment at the time, which has been nothing short of a grand slam homerun. The ability for advertisers to be able to reach their target market across so many mediums is extremely difficult to compete with. For large and small advertisers, Google on average will likely account for the largest percentage of their respective advertising budgets. This is an incredible moat that Google is building upon every single day, and it brings the attack directly to its competitors' doorsteps.
One example of this is Google Plus, which I believe could eventually be a hybrid between Facebook (FB) and LinkedIn (LNKD). Many analysts' have downplayed the impact of Google Plus and I believe they are making a mistake. The Communities feature, which allows for groups to form around particular interests, seems highly desirable for work or school collaboration. Hangouts is another innovation that is unique to Google plus, which is very attractive to companies that are interested in collaborating with a designated group online, perhaps to inform them about a new product launch etc. Google has consistently been at the forefront of the next wave in advertising since it took over as the dominant Search provider. Google plus doesn't need to surpass Facebook or LinkedIn, but instead it adds another social component from which advertisers can connect with their target market. The most recent foray is in Google Voice where users can obtain pertinent information about nearby gas stations, stores, restaurants etc. with the use of their voice. Having recently relocated from California to Miami, I've relied extensively on Google to assist with the transition. It is like having a friend in a new city that can save a lot of time and energy in finding the things you need, and I think that we take this critical role Google plays in our lives for granted. Think of former hugely entrenched businesses such as phonebooks, magazines and newspapers that dominated the U.S. display advertising market for generations. Google is a digitized and global version of all these mediums, with video and social kickers, as well.
Amazingly, I've made it this far without really getting into the huge successes such as Chrome, Android, Maps and Google Play. All three of these technologies broaden Google's reach involving interactions with users, which ultimately lead to monetization opportunities. Google has beaten Microsoft (MSFT) at its own game on mobile, and the company has the potential to pressure Microsoft on the desktop space. We are long Microsoft so clearly we are comfortable with its position and valuation, but to ignore the threat that Google poses would be the definition of naive. Google's leadership has been overwhelmingly strong and while the company's valuation might have been previously depressed due to concerns about potentially excessive spending on "non-core" initiatives like Android, there is no question that Google has gotten a strong return on its investments through the enhancements to its competitive position that has been attained despite the disruptive shift to mobile, which left many tech heavyweights scrambling to the surface just to breathe. Even some things that for a technologically average individual like me would normally seem silly, Google Glasses and automatically driven cars seem like seeds that could sprout profitably in the future. Now because of our deep value investment style, we aren't willing to assign a high multiple on these prospective type technologies, but I certainly assign a higher probability of success than I would to some far-fetched idea from the likes of a Steve Ballmer or Ron Johnson. When Google traded at a below market multiple in the middle of 2012, the investor was getting all of these ancillary projects for free in my estimation. Now the math is a little different and the implied expectations are rightfully high.
Google ended the 4th quarter of 2012, with 334.977MM diluted shares outstanding. At a recent price of $832.80, the market capitalization is roughly $279 billion. Factoring in the company's $48.088 billion in cash and investments, in addition to the $2.988 billion in long-term debt, Google's enterprise value is roughly $234 billion. The net cash position is equivalent to about $134.60 per share, but of course much of the cash is held overseas and would be subjected to taxation upon repatriation. For the full year 2012, Google generated $10.737 billion in net income, or $32.31 per diluted share outstanding. The trailing twelve month P/E ratio is just under 26, but the company can very likely grow revenue in excess of15-20% per annum, and should be able to increase earnings per share by 15-20% over the next couple of years in my estimation. The table below takes Google's 2012 earnings per share of $32.31 and shows what the potential EPS of the company is assuming 10, 15, 20 and 25% growth rates. Part of these EPS growth rates will be determined through the capital allocation strategy the company embarks on. Clearly, share buybacks well in excess of the dilutive stock options would have been very beneficial to shareholders. With that said, I wouldn't bet on an aggressive buyback program happening in the near future and I think that is a bit of a shame. Because Google generates so much free cash flow ($13.3 billion in 2012) the company could afford to reduce shares outstanding when the stock trades below intrinsic value like it did last year. The reality is that even just adding 3-5% to the annual EPS growth rate, an incredible amount of shareholder value would be created over the long-term. Obviously the fact that Google uses stock options aggressively like its competitors do, this compounding effect tends to work negatively against long-term investors due to dilution.
Projecting 10 years out for a technology company is scary, but I feel a little more comfortable with my view of Google as predominantly being an advertising company. I believe Google is roughly fairly valued if the company compounds earnings per share by about 15% per annum. I don't care about adjusted earnings per share because stock options sure as heck matter to me if I'm a long-term shareholder, regardless of the way charlatans like Marc Benioff portray their financial results to a brain-washed analyst community. If Google can grow in excess of this, I believe the stock offers an extremely compelling opportunity. The decision on whether to take that chance resides in the investor's confidence in the business and management, and the opportunity in other areas of the market. I feel that there is a higher degree of certainty in other concentrated investments that we are making so we've made the decision to divest our stake in Google, but we'd be anxious to buy at lower prices. One thing I will guarantee is that long-term growth rate expectations will vary considerably over the next decade, so the investor speculating on the most favorable outcomes better be willing to stick it out, or they will likely end up like those who bought Apple at $650 only to sell at $450 despite only slight differences in the fundamentals.
There is no doubt in my mind that the revenue growth rate for Google will continue to slow, but I believe it will not fall off completely whatsoever. There is a long run way of growth in the markets that Google operates in, which are still transitioning from some of the more traditional advertising mediums. Google's durable competitive advantages ensure that the company will likely increase its wallet share in excess of its competition. Google's management invests heavily in R&D, and there are only a handful of companies that can spend anything near what Google does to continue upon its innovation path. Google is not reliant on short-cycle gadgets, which were destined to become more and more commoditized, repeating the same consumer electronic patterns that we have seen for generations. The acquisition of Motorola is much more of a play on being able to create innovative form-factors, which can help increase the utilization of Google's many products and services. Management understands that like computers, the actual device will be far less important than the software, advertising and application dollars that are spent on the device. Hopefully this analysis provides a reasonable and fair framework to evaluate the future of the stock from a value investor's perspective.