Google (GOOG, GOOGL) is the leader in the digital advertising space, with advertising revenues of over $50B in 2013, more than 6x compared to Facebook (NASDAQ:FB). Since 2009, Google has more than doubled its advertising business from $22.9B to $50.6B. Its content and hardware business is growing exponentially, from $0.8B in 2009 to $4.9B in 2013, excluding the impact of the Motorola Mobility acquisition. The following chart shows the breakout of Google's revenue by segment, which clearly demonstrates that advertising is still the lion's share of revenue at 91%.
Source: GOOG 10-K
Advertising revenue is broken into two components - revenue from Google websites, and network revenues from partner websites which use Google AdSense and other distribution platforms. The operating margins from network revenues are significantly lower than those from Google websites, due to traffic acquisition costs that Google pays its partners. Revenue from high-margin first-party websites has been increasing at a faster rate than third-party, which has resulted in growing operating margins for the search business. The following chart shows the relative growth in advertising revenue between Google websites and Google network sites:
Source: GOOG 10-K
To model Google's business going forward, it is important to understand the difference in gross margins between each of its business lines. Google does report its traffic acquisition costs related to its AdSense and distribution partnerships, and provides total cost of sales in its financial statements. It does not break out its cost of sales any further. However, since we expect Play Store content and hardware sales to form an increasing percentage of Google's revenues going forward, and these businesses have a significantly different margin profile compared to the advertising business, we do need to make some assumptions around margins for these businesses. Luckily, we can analyze old financial statements where other segment revenues were a negligible component of Google's business to calculate estimated gross margins for the first-party and other revenue segment. The following table shows the gross margin estimates for Google by segment:
There are a few interesting things than one can glean from the above analysis - firstly, that TAC has increased significantly as a percentage of revenue to the point where Google appears to have only a 7% gross margin ($12.25B TAC on 13.12B network revenue). This would indicate that Google is finding it increasingly harder to monetize its third-party network, potentially due to competition from Microsoft (NASDAQ:MSFT).
To estimate margins on first-party websites, I looked at financials going back to 2007, when other (content and hardware) revenue was only a small fraction of total revenue. This yields a gross margin of around 85% for the first-party website revenues - clearly the primary driver of Google's profitability. The GM seems to have moved up and down a couple of percentage points over the years, and I have assumed 85% going forward, which seems well in line with current numbers.
Finally, the GM on content and hardware is a calculated number, which reveals a decline from around 30% in 2007-2011 to the 20% range. Given Google's investments in lower-margin hardware, this appears to be a reasonable estimate. Going forward, I am assuming gross margins for the content and hardware business to be in the 20% range.
Revenue and Gross Margin Modeling
As we see from the above, first-party website revenue is the key to Google's continued profitability. This revenue has two components - the number of paid clicks (volume) and the cost per click (price). Over the years, with the increased share of ad budgets to online, the volume of paid clicks has been increasing steadily. In Q1, GOOG saw paid click volume increase 26% YoY and down only 1% quarter-on-quarter from the seasonally strong holiday Q4. With the increase in Google's addressable (and increasingly mobile) end points driven by smartphone and tablet penetration, I model paid clicks to grow 25% for the next two years, and 20% thereafter out to 2020. Cost per click, however, has been declining steadily over the past three years, though Q1 saw stabilization from the Q4 of 2013. In my model, I have assumed cost per click declining 5% every year through 2020. Though the transition to mobile devices does increase the volume of paid clicks, it decreases the cost per click, since advertising rates on mobile are still a fraction of desktop rates. Moreover, as developed markets reach maturity and a higher proportion of the paid click growth comes from emerging markets, cost per click rates will come under pressure due to the lower monetization in those markets.
I model network advertising revenues growing 4% per year in line with Q1 2014 performance, at a gross margin (post-TAC) of 7%. Due to the high TAC, the performance of this segment is relatively insignificant to Google's overall valuation.
Other revenues from content and hardware are expected to continue strong growth - I am modeling 35% growth for 2014, which could have some upside, since this segment grew 48% in Q1. With increased market share on higher-end tablets and smartphones, as well as with the launch of products such as the Chromecast, this segment could reach revenues of $17B by 2020. I have assumed a gross margin of 20% for this segment due to high content acquisition costs and developer revenue share.
Google invests 14% of its sales into R&D and 13% in sales and marketing, and I have modeled it to continue to invest at these levels. On G&A expenses, I am modeling some operating leverage, with expenses declining from 8.6% to 7.5% of sales by 2020. I believe there is some upside here, as G&A expenses do not scale one-to-one with revenue. Taxes are modeled at 20% of operating income, consistent with prior years.
In my valuation model, I use a discount rate of 10% and a terminal value growth rate of 4%; as well as annual dilution of 1.5%. With these assumptions, I get to a fair market value (FMV) of $672, which represents 26% upside to Friday's closing price. This suggests that Google is a very attractive buy at this price, even while discounting all the other investments the company is making (Google Glass, Google Fiber, driverless cars, to name just a few). The complete valuation model is below:
Risks and opportunities
The major risk to Google is that it still monetizes best on traditional desktop and notebook computers. Here is an extract from the 2013 10-K:
The margins on advertising revenues from mobile phones and other newer advertising formats are generally lower than those from desktop computers and tablets. We expect this trend to continue to pressure our margins, particularly if we fail to realize the opportunities we anticipate with the transition to a dynamic multi-screen environment.
As the traditional PC market declines, this ironically puts pressure on Google's high-margin business. Google is taking aggressive steps to combat this by introducing Chromebooks to address the low-end of the notebook markets, and these have seen some success primarily in the U.S. However, the trend is clear, and Google needs to use its assets such as Street Maps to demonstrate value of new business models, such as location-aware advertising to advertisers. This is potentially a huge opportunity, if it can nail these scenarios.
Google continues to execute strongly on the core areas of its business. It is building a moat around its search business through its market leadership in tablets and smartphones. Internet advertising is still in its infancy in several large markets, and the secular trends in the industry as well as in computing devices favor Google. It is also investing in many seemingly unconnected areas, and any one of these investments, if successful, has the potential to disrupt existing industries. My analysis shows that there is significant upside to the existing business, even without quantifying any impact of these incremental investments. Google is a company that is prepared to invest heavily for the long term. As investors, we would be wise to follow suit and pick up some shares now.
Disclosure: I am long GOOG. 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.
Additional disclosure: I am short GOOGL puts.