After surpassing $800 last week, Google (GOOG) certainly appears limitless. It's stock market performance has certainly ousted Apple (AAPL), as Google has rallied nearly 30% in the last year alone, while Apple is currently fighting off the bears.
This is actually where it's time for a reality check, as optimism carrying a stock is never sustainable. Google needs a driver, something that can fuel its recent growth level or at least sustain it.
Founders Sergey Brin and Larry Page have built an advertising and technology empire with a colossal moat in nearly all aspects of its extensive business model. Young tech companies such as Facebook (FB) aspire to achieve Google's excellence. As Google continues to garner a larger percentage of advertising budgets, I expect to see strong revenue growth and improving margins. Matched with increased effectiveness in capital allocation, Google is likely to continuously provide above par returns to shareholders. Right now, the sky appears to be the limit for Google, as its growth has been unmatched by most big tech on the street. This growth however, requires catalysts to fuel growth. Despite Google's core search business remaining strong, current growth rates must be supplemented by secondary businesses for stability. Several potential catalysts that can fuel Google's recent growth include expansions in its mobile advertising business, You Tube, Motorola Mobility, and recent Project X ventures including Google Glass.
The Run At Google:
Google's Core Business Model:
Despite Google having an extensive business model, it has been exploring into many different areas, but advertising (Google's core business) generates 96% of Google's revenue (Before the Motorola Mobility acquisition). Google is in the right markets at the right time and despite being massive, in Q1 2012 Google was able to ignite revenue growth by 24% y-o-y to $10.6 billion, increasing 1% q-o-q. Revenues have grown from $23.6 billion in 2009 to $37.9 billion in 2011, and net income has grown from $6.5 billion to $9.73 billion in the same period. In addition, free cash flow leaped from $8.5 billion to $11.1 billion during the same time frame. Google is following in the path of other technology behemoths such as Intel Corp. (INTC) and Microsoft Corp. (MSFT) by investing heavily in research and development (R&D) and using the company's unmatched financial strength to increase the its durable competitive advantage in virtually all of the company's operations. In 2011 R&D expenses expressed $5.2 billion, or 13.6% of revenue, spending slightly higher than the last 2 years. Well executed investments have firmly secured Google's dominance in the search business, remaining the primary beneficiary of future growth, as it boasts a 65% market share.
Breakdown of Google's Revenue, Earnings, and Free Cash Flow:
As CEO, Larry Page has been working to improve Google's long term prospects by ensuring that future acquisitions aren't "diworsifying" its business. They have also been cutting costs in order to prevent a bloated cost structure. Google has indeed understood that long term success will be dictated by user satisfaction. To accomplish this goal, Page is focusing on improving ad formatting, making it easier for users to find more relevant ads.
Dominance In Mobile Advertising:
Google's mobile advertising segment is certainly a growth candidate, as it is growing at a tremendous pace. Around 850,000 Android devices are activated every day and it is estimated that Android has about 61% market share in smartphones. Mobile advertising has transformed impacts on both Google and advertising its entirety. Through many innovations such as click-to-call, search by voice, sight, and location, along with locally targeted advertising, Google is well positioned to extend its desktop control to the mobile field. For other companies to even compete with Google at scale in mobile, it will take enormous amounts of capital investment which only few competitors could obtain.
Android phones finally account for a larger share of smartphone Web traffic than the iPhone, according to StatCounter. This development, which was arguably inevitable in light of the huge unit share lead Android has opened up, has big implications for Google's mobile search revenue, since the company pays a much larger search revenue cut to Apple than it does to Samsung (SSNLF.PK) and other Android OEMs.
The iPad however, still has a big edge in tablet Web traffic over Android rivals. In the Q1 of 2012 Google received much attention because of declining costs per click, which were down 12% y-o-y, and 6% q-o-q. The transition to mobile and tablets from desktops, in addition to differences in costs and exchange issues between emerging markets and developed markets, were all strong contributors to this decline. Google's willingness to adjust their model so that the ad quality continues to improve caused advertisers to gravitate toward it, as it ensured that advertising dollars are being given the best opportunities to earn the highest ROI possible.
Short-term margin issues in developing robust and exciting market in mobile business segments are debated upon by market timing analysts, but have very little impact in Google's long term value. I expect increasing adoption of Internet search capable mobile phones, higher mobile Internet speeds, and increasing partnerships between search engines and mobile phone manufacturers (for e.g. think Google search on iPhone). According to a report by RBC Capital Markets, global mobile searches were around 20% of total searches in 2012. Google's open source mobile OS, the Android, should greatly benefit from this, as it uses Google search as the default search option.
The Android also has the advantage of being used by multiple manufacturers, including Samsung and HTC. Google's flagship search business also continues to dominate globally. Competitors like Yahoo, Microsoft and AOL have been consistently pushed back as Google retains market shares of around 66% and 97% in PC and mobile devices respectively. The company's superior algorithms and brand recognition have clearly found favor with users, and till date the search engine market has not boasted of a better search tool. Given the current trends, Google's dominance is expected to continue, although one cannot discount future technologies such as Apple's Siri as possible future threats.
Growing Internet Searches Per PC And Mobile Devices In Use:
As web penetration increases across emerging markets like India, users are expected to increasingly become more familiar and comfortable with using web search as the flagship tool to look for information. In addition to this, web browser development has increasingly made it easier to promptly do a web search. For example, Google Chrome obviates the need to actually open the Google homepage to do a search. These above factors should contribute significantly in growing web searches for every PC device globally. The mobile revolution would have a big role to play in the way Google search is utilized. Smartphone and tablet capabilities are improving by leaps and bounds. This includes personal usage like finding restaurants and utilizing maps and GPS (Global Positioning System), as well as professional uses such as sending/receiving e-mails and making presentations. As bandwidth increases in emerging markets, mobile device functionality is expected to come at par with PC's in the next 4-5 years. This should lead to a substantial increase in the number of mobile devices in use globally.
Future business prospects:
In contrast to search, which is more functional and commercial in nature, online video and social networking are more entertainment-focused, where ads are generally seen as a distraction. Currently, ads displayed on such platforms are graphical and static in nature, which do not drive the same recall as a moving video (e.g. television ads). As YouTube and other video sharing sites figure out better ways of displaying ads which are not intrusive and do not interfere much with the user experience (like Revision3's in-video interactive clickable ads), advertisers will be willing to pay more for such ads, driving up overall video advertising monetization. Google's $1.6 billion acquisition of YouTube in November 2006 seemed expensive to many at the time, but the company has grown to have 800 million monthly users that are uploading over an hour of video per second. YouTube has provided new and exciting advertising formats, and best of all, it benefits from the network effect. Essentially, the more people that use the service, the more valuable it becomes. I believe that Google has also done a great job monetizing Youtube, as its advertisement idea is clever. Typically, an advertisement will play for five seconds, and then the viewer has the opportunity to skip it. This results in satisfaction for both Google's audience and customers. Google has also hit a home run with its Chrome browser, noted for its remarkable speed, which has over 200 million users, and now the company is integrating desktop and mobile versions. Google has demonstrated its incredible ability to innovate, with products such as GoogleTV and Google Wallet, among countless others.
Several months ago, Google closed its $12.5 billion acquisition of Motorola Mobility. Initially, analysts believed the acquisition to be one of the ways Google could protect itself in the patent war that many tech companies have recently seen. While these patents have certainly added to net value, Google also seems to be interested in controlling equipment development in order to fully control and have the ability to coordinate its Android software with the units themselves. Due to how technology companies usually face rapid product cycles, an acquisition such as this one benefited Google tremendously, as it has the ability to quickly adapt to new cycles. The Motorola acquisition has definitely weakened Google's robust returns on invested capital, but it is the type of long term acquisition that allows Google to further extend it's reach as a mobile giant.
The Google Glass is a breakthrough innovation with the right level of consumer appeal to succeed. In addition, it's got the right name on it; that being Google, as it automatically has the cool and new factor to it. The capabilities of the Google Glass are plentiful. The Google Glass is worn on the head like a pair of glasses, and allows the user to have a visual or audio response to the sort of questions one might pose on Google search, such as "Where's the closest supermarket" or "How do I get to my house" for someone seeking directions. You can also take photos or record videos on command, and you are always at the ready to capture life's moments at a moment's notice. You can share those moments quickly as well. Plus, you can connect to your smartphone via Bluetooth. Google Glass could offer mobile phone utility value of its own if adopted and marketed properly by Google and adopted significantly by users.
However, the company's approach so far does not imply such a possibility, at least not in the near-term. If it were the case however, it would indeed be an astronomical driver for Google's growth, making its current valuation quite undervalued. Furthermore, Google Glass has received the proper media attention it needs with technology blogs such as TheVerge taking notice along with leading financial media like CNBC. It's got the wow factor to gain the attention of consumers, and I think it could someday have the follow-through in order to pull market share from competition such as Apple, Samsung, BlackBerry (BBRY), Nokia (NOK), etc. It'll be hard to manage Apps as it is now, but Google could package the Glass with an Android phone of its own I suppose. Google does not appear geared to go in that direction though, and like Microsoft, looks like it doesn't want to overstep its bounds and cannibalize its Android using partners. Yet, if it is then applicable to all phones, Glass might do just as well or better. Either way, Google wins with its innovative and patented design. If it's not a phone of its own, it's a new product category of its own, and the next best gadget for geeks of all sorts. According to Google insiders, it will be available by the end of 2013, in time for the holidays for those who can afford it.
Glass is the sort of product innovation Apple is known for, but the innovator of our age is experiencing a sort of dry spell today, and its shareholders are paying for it. Google's technology may be disruptive, but it's not going to dislocate cameras or video products made by Sony (SNE) and others, at least not at the premium price-point where it will likely be introduced. Neither is it going to severely strike into PC usage, so Dell (DELL) doesn't have to add it to the threats against the ailing hardware maker. I believe the product will speed the use of verbal commands in software applications of all sorts though, and that would make it a more competitive threat to tablets, mobile phones and everything else people are using for mobile computing today.
Valuation And Bottom Line:
Although it can be hard to call Google cheap right now, it certainly is quite easy to label it modestly priced. With analysts expecting Google to earn approximately $45 per share in 2013 signaling a forward P/E ratio at just above 19. Because free cash flow generation is at $3 billion per quarter the cash balance should continue to grow and solid capital allocation will be essential. It surely would be advantageous for management to allocate a decently sized amount of the $50 billion war chest for stock buybacks, in the event of a market correction. Google boasts a healthy return on invested capital of 18%, a return on assets of 15.8%, and a return on equity of 20%. I believe already vast profit margins of 27% will eventually continue to expand as R&D expenditures as a percentage of revenue decline. Margins around 32% are certainly achievable over the course of a cycle, and revenue growth of 10-13% over the next 5 years seems possible. Google's mobile advertising and You Tube businesses are just the catalysts Google needs. As of now, Google X remains more of a speculative play, with products such as Google Glass and the "Self Driving Car" being both secretive and quasi capitally intensive (especially in development stages). However, the segment indeed has potential to flourish in the future. In fact, many of Google's secondary business segments look semi speculative, but with Google's keen management, they have great potential to become cash cows. While some compare Google to a Microsoft, Cisco Systems Inc. (CSCO) or Intel at the peak of their great legacy 2000 (which Google has obviously recently seen), I argue that they are quite mistaken because Google is trading at an average multiple on Wall Street, compared to other tech giants when at Google's state.
Disclosure: I am long GOOG.