When Google (GOOG) reports its earnings at the close of trading on April 18th, markets will pause to listen. After all, Google, much like other technology bellwethers such as Apple (AAPL), Microsoft (MSFT) and Amazon (AMZN), resonates with all investors and, considering the run-up in the major indices this year and the recent uncertainty introduced by the events in Boston, markets will be looking for direction.
Google has had a solid, if unspectacular, run in the year thus far, rising 10.5% -- around 1.7% better than the return of the S&P 500 during the same period. Google is actually coming off a rebound quarter - it beat analyst estimates by 1.6% in 4Q2012 after underperforming estimates by over 15% in 3Q2012.
Consequently, it's not surprising that looking back six months, Google's performance trails that of the S&P 500, as the chart below shows:
Google vs. S&P500 (6 Months % Change)
In fact, recent price action suggests that investors have been wary of Google of late, with the price decline of Mountain View's finest having been much steeper than the S&P 500's since peaking in early March. That could be because Google's earnings growth is slowing.
In fact, the mean analyst estimate calls for a 6% rise in earnings from the same period a year earlier. This represents a significant drop from the 24.7% earnings growth that Google registered in the first quarter of 2012 compared with the same quarter in 2011. What's more, Google is expected to see earnings growth of just 14.3% this year - compared with 20.6% EPS growth in the previous five years. The next five years are forecasted to see growth along a similar level at 14.58% per annum.
As can be seen from the fate of Apple's stock, slowing growth rates or the loss of earnings velocity is a recipe for underperformance.
Does this mean that current Google investors should take profits or that putative investors should remain on the sidelines? We take a look at three areas:
1. An Advertising Story. Despite the headlines that Google's Android OS continues to generate, it only makes up a small portion of Google's revenues - even if we assume that the majority of Google's "other revenues" are Android-related (Google does not provide a breakdown with its earnings release) -- no more than 6% of its total revenues come from it. Google's is still very much an advertising company, with ads contributing 83% of its aggregate revenues as recently as its last reporting quarter.
That's interesting for a variety of reasons but two in particular. First, if one considers Google a broad Internet company, then forward revenues look a bit slim - the average revenue growth for other Internet search companies such as Tencent (TCEHY.PK) or Baidu (BIDU) has been around 19.3% and these companies are in relatively earlier stages of their revenue cycle than Google is. Moreover, these companies have less in common with Google - Google has grown so large in the search market that its only "credible" rivals are companies in China where the market is different.
Second, with over 80% of its revenues coming from advertising, then wouldn't it be right to consider Google an advertising company? Let's compare the estimates between Google and the advertising industry's larger players (i.e., its "Big Four"):
Comparing the Big Four to Google
Source: Bloomberg, Thomson Reuters
As can be seen from the above chart, while Google's current year's growth would be middle-of-the-pack among the advertising industry's largest players and would trail the industry's growth substantially in 2013, its forward growth is expected to be double the industry's growth rate and at least 27% higher than any of the Big Four advertising firms.
In fact, Google's annual revenues from advertising alone would make it the world's largest advertising firm, beating the combined annual revenues of the Big Four by 10%.
What makes Google such a compelling advertising story is this - and this is where Android's dominance in the smartphone should eventually come into play: which of the Big Four players actually has a ready medium - that they control - on which to distribute their ads?
To be fair, mobile advertising is still a relatively small portion of the advertising business; in fact, Google still earns the majority of its online ad revenue from traditional desktop search, but it is expected to grow over 250% over the next two years. Moreover, it's worth noting that Google has not yet adequately monetized Android's revenue streams; Apple still earns the majority of dollars from this niche.
In our view, this represents Google's greatest challenge - clawing back online revenue share from Apple. Indeed, we believe that Google maintaining stand-alone applications on iOS (such as Gmail, Maps, YouTube) will rebound to its benefit in the long run - Google is able to earn more from these services as standalone applications rather than being restricted to licensing sees.
However, this is only the start; we believe that Google will eventually leverage its large R&D pipeline to come up with new distribution channels for its core services.
2. With a Dash of Technology. While we believe that Google is an incredible advertising play, it is also a technology play. In fact, the company has spent over $15 billion on Research & Development (equivalent to over 1-1/2 times 2012's net income) over the past 3 years alone, growing by an average of 34% in each year. Currently, it has projects ranging from wearable technology to self-driving cars, to name a couple of high-profile ones.
This puts the company at the top of S&P 500 in terms of focusing on R&D: over the past 10 years, Google has grown its R&D spending by more than any other S&P 500 company.
In our view, this should enable Google to remain competitive going forward - both Google Glass and its self-driving vehicles could be ready to market in 5 years, with the former probably two years away from mass commercial distribution. As these products come to market, they are likely to serve as distribution channels for Google's various services, in much the same way that Android does. They are likely to open up new revenue channels, such as virtual concierge services and emergency taxi services, to name a couple.
This contrasts with the R&D spending of a company like Apple, which seems to be focused more on developing additional technologies to complement or provide incremental improvement to its existing iDevice platforms rather than introducing any paradigm-shifting technologies.
To reiterate, we believe that these new products will only serve to reinforce Google's dominance in its core business of earning revenues from the users of its products following strategically (or even granularly) targeted advertising.
3. Solid Financials. All of this would not be possible if Google did not have the solid balance sheet it has. For example, its cash ratios -- both quick and current - are three times higher than the average for an S&P 500 company, and surpass that of either advertising or technology firms.
Google's level of debt is practically negligible, implying that there are few artificial limits set on its operations by financial institutions or loan covenants.
This can only help Google maintain its high EBITDA margins, which are superior to the margins typically earned by either technology or advertising firms.
Investors would do well to note that there is an element of recursive dynamics involved: Google would not be able to innovate to the extent that it has without its balance sheet and cash levels being at the level that they are at and, to the extent that this serves the company well, we believe that company management should resist any calls for the payment of a dividend, at least in the next three years.
Taken all together, this means that any valuation of Google strictly on the basis of the speed at which it is growing its revenues because of arbitrary labels such as an "Internet" or "tech" company ignores the reality that Google is mainly an advertising company - in fact, it's the world biggest advertising company - with an R&D unit attached to it.
Moreover, considering that the industry's revenues are only expected to grow by 7% a year over the next five years and that Google is at twice this rate, we believe that any premium valuation assigned to Google is justified.
We would therefore use any pullback in Google's stock to average down or establish a new position. In terms of upside, we believe that Google could see its price rise to $900 per share within the next 12 months.