Caris' Google Earnings Preview: Still Our #1 Internet Stock (GOOG)

| About: Alphabet Inc. (GOOG)

Caris & Company analyst Tim Boyd addresses clients on Google's (NASDAQ:GOOG) upcoming quarterly report, for the quarter ending June 2006. Caris believes the report will be largely positive and has modestly raised their estimates as a result. Their note to investors follows:

The company will report its June quarter results on Thursday, July 20th, after the close. We are estimating $1,677MM in net revenue and $2.20 in pro forma EPS vs. Street consensus for $1,631MM and $2.20, respectively. Note that we have modestly raised our estimates for the quarter (we were previously at $1,650MM and $2.16). Google remains our #1 recommendation among Internet stocks.

The upward revisions (and our expectations for outperformance relative to Street consensus) are based on three observations:

1. Continued share gains in both U.S. and Global query volume. According to comScore qSearch data, Google increased its share of both U.S. and Global query volume during every month of 2006 (through May; June data is not yet available, although we would expect that these share gains continued into June).

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Although there are some methodological issues that make the qSearch data less than 100% accurate, we believe that it is directionally meaningful, especially with regard to market share.

2. Acceleration in overall U.S. online advertising and Paid Search in particular. In a note published May 31st, we referenced a study performed by the Internet Advertising Bureau (IAB) and PricewaterhouseCoopers (PwC) which showed accelerating Y/Y growth in online advertising in the March 2006 quarter. Specifically, the report found that U.S. Internet advertising revenues grew 38% Y/Y to a new record of $3.9B. In 4Q05, Internet advertising revenues grew 34% Y/Y, so business is accelerating. We would emphasize that consensus expectations (as far as we can gauge them) prior to the release of this report had been for modest deceleration in 2006, making this a very bullish data point for the online ad industry.

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In terms of revenue share among the various media components of Internet advertising, the most recent data we have is from IAB’s full-year 2005 report:

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The biggest Y/Y gains came in the Lead Generation/Referrals category, which doubled its share to 6% in 2005. This category applies to fees that advertisers pay to online companies that refer qualified purchase inquiries (e.g., auto dealers which pay a fee in exchange for receiving a qualified purchase inquiry online) or provide consumer information (demographic, contact, behavioral) where the consumer opts into being contacted by a marketer (email, postal, telephone, fax). These processes are priced on a performance basis (e.g., cost-per action, -lead or -inquiry), and can include user applications (e.g., for a credit card), surveys, contests (e.g., sweepstakes) or registrations. The market share of all other categories of Internet advertising either declined or remained flat Y/Y – except Keyword Search, which continued to expand its dominant position, rising from 39% in 2004 to 41% in 2005.

This data is, of course, from 1Q06 and therefore not the most timely. In our experience, however, these IAB reports have very accurately gauged trends in online ad spending. Coupled with the qSearch data, which shows material Y/Y growth acceleration in search query volume, we believe that the unanticipated strength in 1Q06 online ad spend is likely to have continued and even improved during 2Q06. We also believe that this strength will disproportionately favor Google.

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3. Relative USD weakness during the quarter should provide a minor top-line boost. Broad-based USD strength during the March 2006 quarter cost Google $65MM in revenues on a Y/Y basis. During the June quarter, however, the dollar weakened about 3% on a weighted average basis. This should translate into a $5MM to $15MM sequential benefit and a -$5MM to flat Y/Y impact.

In terms of valuation, we continue to view GOOG shares as attractive at current levels. Although Caris & Company does not set official price targets, we do employ a P/E and EV/EBITDA-based framework to determine potential valuation ranges. We apply a 43x multiple (1.8x PEG multiplied by our long-term GAAP EPS growth assumption of 24%) to yield a potential valuation of $494. We apply a 25x multiple (1.0x PEG multiplied by our long-term EBITDA growth assumption of 25%) to yield a potential valuation of $521.

To provide some historical perspective, we present the following summary of Google’s recent quarterly results and the stock’s reaction to them.

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Despite recent strength, GOOG shares are still off 4% from their post-1Q06 earnings high and 10% off their January 2006 all-time high of $472. As our estimates indicate, we expect a strong Beat quarter on the topline and an In-Line quarter on the bottom-line. Due to Google’s increased level of capital expenditures in 2006 and our expectations for a significant jump in R&D and Marketing spend over the next year, we believe there could be some lumpiness in Google’s EPS results over the next several quarters. We also think it likely, however, that the stock will trade primarily off of Google’s top-line results during this phase of increased investment. We therefore recommend that investors buy GOOG shares ahead of the earnings report next week.

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GOOG 1-yr chart:

GOOG 1-yr