Google's June Quarter -- Still Our Top Internet Pick

Jul.24.06 | About: Alphabet Inc. (GOOG)

Caris & Company analyst Tim Boyd addresses clients on Google's (NASDAQ:GOOG) recent June quarter earnings report. Excerpts follow:

Google reported a Beat June quarter – net revenue of $1,671MM and $2.49 in non-GAAP EPS were both solidly above Street consensus for $1,646MM and $2.22, respectively. Our estimates were a smidge high on the top-line ($1,677MM) but too conservative on the bottom line ($2.20). The bottom line upside was driven by stronger-than-expected non-operating income (not including the profit from Google’s sale of its Baidu stake) and a lower-than-expected tax rate (we note that had the tax rate been 30%, as we expected, there still would have been substantial upside to our and the Street’s EPS estimate).

Google posted very impressive growth across all of its business segments and geographies.

AdWords growth was up 10% sequentially, with only slight Y/Y deceleration to 94% versus 98% in the March quarter. AdSense growth was up 7% sequentially, also with very slight Y/Y deceleration to 58% from 59% in March (due to a TAC rate that was 90 bps higher Q/Q). U.S. growth was highly impressive, accelerating to 69% Y/Y from 62% last quarter. Growth in international revenue continued to be quite robust with modest deceleration from 106% Y/Y last quarter to 91%.

The 2Q06 results suggest that Google continues to take share from Yahoo! (NASDAQ:YHOO) and MSN (NASDAQ:MSFT). As we noted in our Yahoo! earnings report, it has become clear that Google has opened a substantial (and likely insurmountable) lead on its closest competitors with regard to search technology. As evidenced by a sequential O&O growth rate that seems to be substantially in excess of Yahoo!’s 2Q06 result, Google continues to grow faster than its primary competitors both in terms of query volume and monetization. We note that proliferation of the “third sponsored link” during the quarter may mean that monetization was a bigger driver of revenue growth than volume, but our guess is that both sides of the equation were strong.

“The growth rate in capital expenditures will be substantially greater than the revenue growth rate” in 2006. Thus did Google reiterate the capex plans that it first announced last quarter. The focus of the spending continues to be IT infrastructure (including servers, networking equipment and data centers) and real estate. We continue to believe that these spending plans are an important step toward the world of Virtual Computing, which Google is in a position to dominate. More importantly a propos the nearer-term, this level of investment should further insulate Google from competitive pressure.

Google has “raised its hiring bar.” Google continues to hire rapidly and globally. To wit, in 2Q06 Google added over 1,000 employees. CFO George Reyes noted that the majority of new hires have been in the U.S., but that India and Ireland (go Bragh!) are also growing quickly. He added that Google “expects to continue to hire aggressively around the world, particularly in Q3, across all functions, especially sales & marketing and R&D.” CEO Eric Schmidt added that the “hiring bar” has been raised. In our view, this is a key comment: as evidenced by their massive capex build, Google may be capacity constrained in terms of infrastructure and real estate, but the talent seems to be lining up at the door. That could be bad news for Yahoo! and Microsoft over the longer term. Google is paying for the talent, however: G&A expenses as a percentage of revenue reached an all-time high of 10.8% during the quarter.

Management comments on Google Checkout suggest that CPA is the ultimate goal.

CEO Eric Schmidt noted that Google “simply wants to make the whole process of buying quicker, more foolproof, more likely to conclude, and we think that that will ultimately translate into higher value for the advertiser, which should ultimately be reflected in our overall revenue.” This comment highlights what in our view is the #1 long-term goal of Google Checkout, namely to buttress a new cost-per-action advertising model (as we have noted previously, Google has already begun testing one). In other words, Google Checkout was not primarily designed to steamroll PayPal and others in the off-eBay e-commerce market, but to make a new pricing model more attractive to merchants that advertise with AdWords. That having been said, could Google Checkout encroach upon eBay’s most rapidly growing revenue stream? Absolutely, if it is adopted aggressively and widely by consumers world-wide. Merchants will adopt – they are being subsidized to do so. But the consumer side is a lot trickier due to privacy and security concerns (see our July 5th evaluation of Google Checkout for more details).

We are raising our 2006, 2007 and 2008 estimates as follows:

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In terms of the stock, we would be buyers at today’s open. Given Google’s strong June quarter results, we are hard-pressed to explain the rather tepid aftermarket rally in the shares. Our best guess is that the broader market is currently so risk averse that high-multiple growth stocks like GOOG are, on a relative basis, anathema right now. We estimate that GOOG shares will open at around $390, which is roughly 32x our 2007 GAAP EPS estimate and 17x our 2007 EBITDA estimate. These are, generally speaking, premium valuations relative to peers, but given the fact that Google is growing at 2x to 3x the rate of these peers, we believe a more aggressive valuation is warranted. Our P/E and EV/EBITDA framework suggests that $490 to $520 may be an appropriate valuation range for the shares.

We reiterate our 1*/Buy rating on GOOG shares – it remains our #1 pick in the Internet sector.

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GOOG 1-yr chart

GOOG's most recent quarter-ending conference call transcript.