Seeking Alpha
Long only, special situations, event-driven
Profile| Send Message|
( followers)  

Background and Thesis

We believe that at these levels, Google (NASDAQ:GOOG) is fairly priced and unless we see a marked improvement in Return On Invested Capital in the short term, the stock will struggle to move higher. This is not because earnings will not grow (they will), but the multiple you are paying right now is still a little stretched.

In the chart below, we can observe a weakening in the growth rates of Google's Search Engine Advertising Revenues (the majority of its revenues).


(Click to enlarge)

This is being compensated to some degree by the positive trend in other revenue growth (such as licensing).


(Click to enlarge)

This is not necessarily a cause for alarm, but at 31x the average of EPS from the last 7 years (multiple adjusted for net cash per share), the valuation seems risky to us.

Company Overview

A long-term cash flow generator...


(Click to enlarge)

Aggressive investments in growth. Will it pay off?...


(Click to enlarge)

Below one can see how cash is deployed. Not so shareholder friendly. 34% of cash generated is banked...


(Click to enlarge)

Growing levels of invested capital...


(Click to enlarge)

Revenues/Invested Capital in a downtrend...


(Click to enlarge)

Margins are at 5-year lows. Will they stabilize here?...


(Click to enlarge)

ROIC trending down...


(Click to enlarge)

Fair Value

The stock is right now trading at its 5-year average relative P/E to the market. Paying this relative multiple is fine in so far as an average 50% premium to the market remains justified. We do not believe that anyone can really be sure if this premium remains justified, so it is prudent to try and buy the stock below its average, like in October of last year.


(Click to enlarge)

Using Google's maximum, minimum and average historical Returns On Invested Capital, we have calculated based on the historical levels of invested capital possible ranges for where NOPAT could be (see below). Right now, NOPAT is slightly above minimum historical ROIC levels. Please note that this is based on current levels of invested capital and we expect invested capital to continue to grow going forward that should result in an even higher NOPAT.


(Click to enlarge)

Historically, Google has traded on an average relative P/E of 1.60 to the S&P 500. Applying this to the current market multiple of 15.47 gives us 24.69x earnings. We have multiplied the current P/E of 23.09x by the historical NOPAT levels (derived from minimum, average and maximum ROIC levels) to get a sense of where the market cap for the company can trade. In the chart below you can see the actual market cap of Google plotted against the market capitalization calculated using NOPAT derived from the minimum, average and maximum historical ROIC. We can see that right now the market cap of Google is at its minimum fair value level. The problem with this is it assumes that Google can keep its current ROIC and its current market multiple premium.


(Click to enlarge)

If ROIC does continue to fall, it is extremely likely we would see multiple contraction. The chart below shows the actual market cap of Google plotted against the market capitalization calculated using NOPAT derived from minimum, average and maximum historical ROIC, multiplied by the market P/E. Given that Google is currently achieving near historical low Returns On Invested Capital, within the context of a deteriorating ROIC trend, it would seem ill-advised to pay a current market value based on average historical ROIC.


(Click to enlarge)

Source: Be Careful With Google