Google: Reaching New Heights

Feb. 4.14 | About: Alphabet Inc. (GOOG)

Google's (NASDAQ:GOOG) earnings were once again unimpressive last week with Q4 EPS 2% below the Street's expectation. But the market reaction was rather positive, for two main reasons in our view.

First, the earnings shortfall was due to Motorola, which will be a discontinued operation going forward.

Second, consensus expectations have been reset in 2012-13 to take into account the rising weight of lower margin contributors (YouTube, devices…) and the declining cost-per-click (mobile ads come with a weaker pricing). Consequently, investors were not worried about the steepening decline in CPCs (-11% vs. -8% in Q3) and gross margin pressure in Q4, and paid much more attention to metrics suggesting that Google is strengthening its leadership in Internet advertising: websites revenues accelerated to +22% vs. +21% in Q3, and paid click volume growth accelerated to +31% vs. +26% in Q3.

Investors are betting, and so are we, that the short term is about collecting as much data as possible (at the expense of CPC) and that Google will have the opportunity to better monetize its mobile ads in the future when its leadership is secured.

Against this backdrop, we view the risk/reward as attractive.

1) The downside risk is clearly limited in the near term as the core business is healthy, as lower margin activities and lower CPCs have been factored in forecasts and as the valuation is, at least, fair. The stock is trading at 22x 2014 EPS and is expected to deliver an earnings growth CAGR in the high teens, suggesting a PEG (Price Earnings / Growth) slightly above 1x (see Bloomberg data below).

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Source: Bloomberg

2) While the upside risk is huge in our view, driven by several potential positives. In the short term, we would expect improving advertising spending in Europe in relation with better macro on the continent. In the mid-term, we are confident that CPCs will pick up as Google's strong position in mobile advertising and improving technologies and mobile devices enable Google to raise prices. Also, it is likely that Google will adopt a shareholder return policy in the future given the size of its net cash position, around $50bn currently and expected to increase each year as the business is highly cash generative.

But more importantly, we would expect Google to deliver on its expansion opportunities:

- YouTube could be the next big thing as it is evolving towards a live events and original content model. This could make YouTube a "super" TV channel and increase its ability to capture TV ad budgets in the U.S. and abroad

- Google Apps and Cloud could gain share in the corporate world

- Google glasses, Nest, self-driving cars, etc: the rising number of connected devices and the Internet of Things (expected by IDC to become an $8.9 trillion industry by 2020) could make Google become ubiquitous. It is unclear how Google will monetize these different opportunities but we assume the company will license its technology and/or will gather data to sell ads

It's difficult to put a value on Google's numerous opportunities but in our view, the value of the option is low and not well reflected in the current stock's P/E of 22x. As we said above, this assumes solid growth going forward, but not a major hit on the Internet of Things for instance.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in GOOG over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.