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Recent Developments/Catalyst

Google's summer season tends to be a bit slower for the company, but the company has had some interesting developments over the last couple weeks that have made us want to update our price target and rating for the company. Before today, we had a $690 price target and Hold rating. In the article, we will discuss new developments, how they affect value, and reprice the company (along with a new rating).

The major recent developments for us to discuss include Android mobile growth, Chromebook growth, the acquisition of Waze, and growth of YouTube. In our last update on GOOG, we discussed the major issue we see is the slowing return on assets for Google (NASDAQ:GOOG). We will also discuss that issue.

Android has looked strong as of late, but there are some interesting switching costs that could hinder growth from current Apple (NASDAQ:AAPL) users. Goldman Sachs (NYSE:GS) put out a note on Thursday, June 20 that the company had tested out switching costs for a customer that wants to basically all the same services on an Android phone that they have on Apple phone. The company found that when they tried to switch from an iPhone to a Galaxy S4 that the cost was $80 in actual costs to do iTunes Match and similar apps. They also reported that they lost 13% of current apps as well as lost out on synchronization between iPhone, iPad, and iMac. The combination of costs in dollars as well as cost of mental headaches was enough to breed loyalty for iOS users.

While switching may start to slow for Apple users, can GOOG gain market share?

At the end of April 2013, the company owned 52% of market share, according to ComScore. That number was down from 52.4% in January 2013. It was up from 50.8% in April of 2012. Overall, though, the gain in market share has slowed. With BlackBerry and Microsoft owning only 8% of market share left, there is not a ton of potential for Google to grow their pie piece with potential switches likely done for now. Further, a new iPhone is on the horizon and could result in some actual switchbacks.

Growth of mobile, therefore, is from general growth versus share stealing at this point. Expectations for smartphone growth in 2013, 2014, and 2015 are 19%, 15%, and 12%, respectively. We see GOOG lining up with these levels as their Android saturation may have started to peak.

Another area of growth for GOOG has been Chromebook and should continue to be. As cloud computing continues to grow and GOOG centers its operating systems on it, we believe the Chromebook will grow. GOOG's Chromebook builds itself around a cloud network, meaning the device has less HD space, is cheaper, and it is more in line with current market trends. Yet, results so far are weak. Chromebook has only about 0.02% of worldwide usage of OS. The company has seen some interest, and the idea works as the world shifts to cloud, but the business is still a very small part of what GOOG does and is not a reason to buy.

The company, additionally, made an acquisition of Waze. The company is a community-based traffic/navigation app that provides GPS directions with users able to post road info about traffic, construction, etc. The acquisition was a smart one for GOOG. The deal was valued at about $1B, but it will allow GOOG to remain the top dog in navigation. Apple has been trying to challenge the company, and this deal is a good one. The company makes a lot of money off of Google Maps. As we noted in our last article:

The company's ability to have its Maps software downloadable on Apple apps now allows them to be able to feature advertising. When it was preinstalled, it could not. The move for Apple to boot Google was a great one for GOOG in the end. The company makes much more money every time you call a company through maps on the phone. Barclays, for example, said that the app could generate $2B - $4B by 2016.

The acquisition of Waze, though, continues to show an issue that we noted in our main article. Return on assets continues to decline. In 2007, the company's ROA was 19%. At the end of 2012, ROA was 12.9%. In the Q1 of 2013, ROA had come down another 3 basis points. The issues for GOOG is that they continue to grow business, grow assets, acquire companies to compete for advertising revenue dollars. The company has built platforms like Google +, Google Offers, and acquired companies to enhance current offerings. The Waze deal, while positive, furthers this notion. Total assets grow with this acquisition of Waze but does it actually increase net income? We're unsure of exactly how GOOG uses Waze, and we are sure they will try to monetize it further. Yet, the company will get integrated into Google Maps as they do with other acquisitions. It is a concern that makes us weary of Google moving forward.

Valuations have come up since our last report as well. PE is now sitting at 26.8 and future PE at nearly 17, neither level is a value level. So, buyers of GOOG have to believe it's a growth stock, since it's not a dividend name as well. Is it?

We see GOOG growing operating income by about 15% for the next two years, but that growth rate slowing to 8-10% in 2015 and 2016 for issues noted along with a slowdown in smartphone growth along with continuing competition rise and ROA continuing to stay weak.

We are increasing operating income expectations slightly from previous model given recent results.


(Click to enlarge)

Price Target Analysis

Step 1.

Project operating income, taxes, depreciation, capex, and working capital for five years. Calculate cash flow available by taking operating income - taxes + depreciation - capital expenditures - working capital.

2013 Projections

2014 Projections

2015 Projections

2016 Projections

2017 Projections

Operating Income

14700

16500

18160

19600

20600

Taxes

2499

2805

3087

3332

3502

Depreciation

3350

3500

3750

4000

4200

Capital Expendit.

-4500

-3000

-3500

-4000

-4250

Working Capital

4850

4850

4850

4850

4850

Available Cash Flow

6201

9345

10473

11418

12198

Step 2.

Calculate present value of available cash flow (PV factor of WACC * available cash flow). You can calculate WACC, but we have given this number to you. The PV factor of WACC is calculated by taking 1 / [(1 + WACC)^# of FY years away from current]. For example, 2016 would be 1 / [(1 + WACC)^4 (2016-2012). WACC for GOOG: 9.1%

2013

2014

2015

2016

2017

PV Factor of WACC

0.9168

0.8406

0.7707

0.7066

*

PV of Available Cash Flow

5685

7855

8071

8068

*

Step 3.

For the fifth year, we calculate a residual calculation. Taking the fifth year available cash flow and dividing by the cap rate, which is calculated by WACC subtracting out residual growth rate, calculate this number. Companies with high levels of growth have higher residual growth, while companies with lower growth levels have lower residual growth. Cap Rate for GOOG: 4.1%

2017

Available Cash Flow

12198

Divided by Cap Rate

4.07%

Residual Value

299705

Multiply by 20167PV Factor

0.7066

PV of Residual Value

211774

Step 4.

Calculate Equity Value - add PV of residual value, available cash flow PVs, current cash, and subtract debt:

Sum of Available Cash Flows

29680

PV of Residual Value

211774

Cash/Cash Equivalents

14778

Interest Bearing Debt

5537

Equity Value

250695

Step 5.

Divide equity value by shares outstanding:

Equity Value

250695

Shares Outstanding

331.77

Price Target

$756

Source: Google: Now A Sell As Return On Assets Remains Main Concern