A Close Look At Google's Earnings

Google reported net revenue growth of 20% in the Q to $2.23B (EPS $3.29, excluding $133 million tax benefits EPS is $3.18), higher than Street estimates in spite of an approximate 200 basis points increase in traffic acquisition costs as a percent of revenue (see the conference call transcript). Details and color:

* Google's incremental cash flow margin in the quarter was 60.8%, down 100 basis points from Q3. Lower gross margin also impacted operating margin, which came in at 47.6% vs 49.9% reported in Q3. R&D expense was slightly higher than Street estimate and was offset by lower sales & marketing spend. On a pro-forma basis, operating margin was 53.6% in Q4 vs. 55.3% last Q.

* Investors should however expect margins to continue trending down, as Google invests aggressively in new growth opportunities (international, video, media partnerships and mobile etc).

* I heard on CNBC that Google grew 3x faster sequentially than YHOO Search did on a YoY basis. When I researched (you shouldn't just take 'em for their word), I came across a Goldman's analyst who said:

GOOG’s 19%+ QoQ growth reflected a ~1700 bps spread over Yahoo!’s normalized 3% QoQ search growth rate compared to the average 1,400 bps spread historically seen in the 4Q as Google continues to drive superior monetization of its commanding search market share both domestically and internationally.

* Google-owned sites revenue was $1.98 billion, 80% YoY, representing 62% of gross revenues. Revenues from Google’s network of affiliate sites was $1.2 billion, 50% YoY representing 37% of gross revenues.

* International revenue was $1.41 billion, +93% YoY growth, which represented 44% of total revenues. US sales were also strong coming in at $1.8 billion, growing at a clip of 51% YoY. Management pointed to contributions from Australia, Latin America, Ireland, and Brazil. Furthermore, management explicitly indicated several times on the call (you should hear them or read transcripts too! ;) that growth in the US remains solid.

* I believe Google still represents the best of breed when it comes to Internet ad revenue growth. While growth is slowing, it is occurring at a much slower than anticipated rate while the much discussed decline in margins has been slow to materialize. A year ago, consensus expectations for 07 revenues and EPS were $9.0B & $11.63. Since then they have risen to $10.8B & $13.92, while Google’s stock has risen only 15%.

* In my opinion, GOOG is undervalued. Why? With shares trading at 28x 08 EPS, and EPS growing over 35% in the next 3-5 years. Furthermore, Google shows no signs of slowing down its investments or partnership activity, and higher revenue sharing, Checkout subsidies etc are likely to help it accelerate, even though margin pressure will exist.

Comments

[AnandKrishnaswamy]

Yaser,

What is your response to the bear case on Google in the long term (>=5 years).

Company is already $150B in market cap
Organic Growth cannot continue at this torrid pace. (Sure everyone agrees on this one, even the bulls)
Management refuses to issue dividends or buyback shares (This is the most concerning)

All of these could lead to a P/E contraction in GOOG in the long run, since eventually, growth will slow.

Granted, these are some of the smartest brains in the planet, but their refusal to buyback shares/issue dividends/split the shares is concerning.

Thoughts?

Anand

PS: In spite of these concerns, I still continue to hold GOOG.

[sufiy sufiy]

Yaser,

Company growth is slowing, free cash flow is flat for the year, margins are down, market cap to free cash flow ratio is 95 (yahoo is 28). Don't you think that it is pure Bubble with completly unjustified expectations build into the stock price?
sufiy.blogspot.com/200...

Regards,

Sufiy.

[Yaser Anwar]

Anand-

For every company PE eventually contracts. However, GOOG has lots of growth. Just read their conf. call and you'll see management talking about possibilities in BRIC and more. They are spending lots of money to gain exposure in all key markets, especially India and China, which still have TONS of growth left.

Why would you want them to buyback? Buybacks are for companies who don't have growth! For google that wouldn't be an effective utilization of cash! No way! They sell at 28ish times earnings and according to the leading internet research firm online advertising can easily growth 30% for the next five years! Google is undervalued my friend. I have 20 shares since it was 200, I'm not going to sell! Each time it goes up 50, I buy 20 more. :) You should too.

Sufiy-

Again, FCF and margins are falling because they are spending lots to growth the company. That should be expected, however, they still have good margins and more importantly the market share! MSN Live and Panorama won't be much of a dent in their growth since they are very innovative and I don't see why fund managers won't pay up to 35 times in 08 earnings at least.

Hope this was helpful! Thanks for reading!

Yaser

[AnandKrishnaswamy]

Yaser,

Your response suggests that they DO have lots of opportunities to invest their capital. I dont disagree on that point, but am cautiously optimistic - ie wait and watch.

Also your 28ish PE for GOOG means it will earn 480/28=approx $17 this year? Is that your estimate? How do you arrive at that number? Just wanted to pick your brain on the rationale.

Thanks and keep em articles coming!
-Anand

[sufiy sufiy]

Yaser,

Have you noticed that actual Cash flow from operations declined by 9% in Q4 over Q3, I believe they was Push to reduce CAPEX in Q4 to 366 mil from 492 and it is not a good sign as Henry Blodget has put it but JUST MANAGING FCF in order to keep it above the water:

sufiy.blogspot.com/200...

Regards,

Sufiy.

[sufiy sufiy]

Yaser,

I have already wrote about Slowing Growth, MC/FCF=95 against Yahoo!'s 28.9, falling Operational cash flow by 9% in Q4 over Q3, saturation point in traffic with Down Trend, Technical Damage, trimming of CAPEX to save Free Cash Flow which is barely flat, but everybody was exited about Earnings and how they "beat" the street. Another surprise here: 13% "Efficient Tax rate" was very handy this Q they have reported EPS 3.29. If we will read ER we will find out that Income before income tax was 1184733, we will apply stated by Google 26% Tax (which is also rather interesting rate) and so normalise tax rate within the year without One Time Benefit due to deal with IRS (they call it "APA" :"Our effective tax rate will be greater in 2007 under the APA than it would have been without it." Surprise, Never Sacrify Party for Tomorrow's Morning.) In plane English if this One Time benefit would not happen now Earnings will be ONLY 1184733*(1-0.26)=876.7... mln USD against 313459 mln shares with Q4 EPS=2.80! way below Street expectations.

sufiy.blogspot.com/200...