Google's Q3 Provides Some Long-Awaited Answers

Oct.16.11 | About: Alphabet Inc. (GOOG)

The Q3 2011 earnings call kicked off with Larry Page, Google's (NASDAQ:GOOG) co-founder and CEO categorizing it as a "gangbuster quarter". The year-over-year numbers are phenomenal for such a huge company with 33% revenue growth and 24% GAAP earnings growth. The sequential growth of over 8% is evidence that the growth pace of this giant company can put many a startup to shame. Google is also on a hiring frenzy - the headcount increased by a whopping 2585, comparable to the number from the last quarter.

However, from a long-term investor's perspective, Google has been a source of disappointment, with the stock returning just 38% in the last five years and flat YTD. Earnings, which more than doubled in those five years, have only confused the investors further. Five years ago, Google was trading at a PE-ratio of around 40 and the relatively flat profile of the company since then has caused the PE ratio based on GAAP earnings (trading twelve months) to dip to about 20.

Numerous factors contributed to holding the investors in check:

  1. Threats to Google's search dominance: Search within media other than text (video, images, etc), platform choices (mobile), international (China), and competition (primarily Microsoft) were all issues that questioned Google's ability to continue to dominate.
  2. Expenses: Google has a reputation for reckless spending in areas other than search, with some investments becoming duds (Answers, Sidewiki) and a few becoming successful (YouTube, Android). While this pattern only indicates a company willing to take risks, investors were concerned with Google spending the windfall from Search unwisely.
  3. Perception of paying a premium for acquisitions: YouTube was acquired in a deal valued at around $1.65B in 2006. Google was estimated to have grossly overpaid to get YouTube, a company with very little revenue at the time. Later, CEO Eric Schmidt confided the premium paid was around a billion.
  4. Image of a one-trick pony: Until recently, Google's revenue was almost entirely based on keyword based text advertising. All the acquisitions and R&D spending could not provide clues on the company's next (if any) business line.

The third quarter report provides answers to some of these concerns:

  1. It is estimated that over 90% of mobile searches use Google's technology, alleviating some of the platform concerns. International growth is also trending marginally upwards compared to US growth rates. In the earnings call, Nikesh Arora, the Chief Business Officer stated growth in emerging markets driven by Japan, Australia, India, and Brazil to be great.
  2. The outstanding earnings growth in the face of big expansion is an indication of Google soundly managing its expenses. Making the earnings growth especially impressive is the fact that it coincided with the period when the outcome of an across-the-board 10% pay hike was taking effect. The traffic acquisition costs were also up 5%, although that was below consensus.
  3. Google made a huge acquisition on Aug-2011 by agreeing to purchase Motorola Mobility (NYSE:MMI), the mobile spin-off of Motorola Solutions (NYSE:MSI) in a $12.5B cash transaction. Part of the reasoning behind the acquisition is that the intellectual property could help protect Android - the unit has 14,600 patents and 6,700 pending applications. The unanswered questions are what Google will do with the devices and what impact the acquisition will have on the margin? Investors will have to wait till next year to witness how effectively Google can wrap its arms around MMI. Projections are for the margins to drop from the mid-40's level to low-30s.
  4. Google's latest numbers indicate almost 70% of the total revenue coming from Display advertising and related business in the Google Network area comprise 26%. This leaves room for only 4% of the total revenue to come from other sources. It confirms Google's lot as a one-trick pony, although they are making noise in both the mobile and social areas. Investors have to look past the reported numbers and pore over certain intangibles to appreciate what Google has accomplished with respect to developing other businesses: Android accounts for half of all smart phones in the world, although Apple (NASDAQ:AAPL) pockets almost all the money made in the arena. Microsoft (NASDAQ:MSFT), Nokia (NYSE:NOK), and Research in Motion (RIMM) are other significant players, though none of them pose a direct threat to Google's plans. Google+, a major initiative, should pay dividends as the company shifts the branding to a "Google Everything" concept.

Below is a look at Fair Value Estimates based on the latest earnings report (click for an understanding of the formulas used in the spreadsheet):

Click to enlarge

We based the numbers in the spreadsheet on conservative estimates.

  • Trailing 12-months EPS figure of $29.33 is from the GAAP earnings-per-share from the last four quarters.
  • The current growth rate of 19.13% was derived by taking the GAAP earnings from the last four quarters, comparing them to the prior four quarters ($24.62), and getting the actual growth achieved.
  • The 5-year and 7-to-10 year earnings growth rate projections were estimated at 15% and 10% respectively - sizable discounts to what the company achieved looking backward.
  • The long-term growth rate is taken as 2% which is historically the average growth rate for USA as a whole.

The Fair Value Estimates using different models are described below:

  • The PEG model shows a Fair Value Estimate of $561.08 which is a little lower compared to the current stock price. The value is skewed because the formula uses dividends as a proxy to value companies that are maturing.
  • The Benjamin Graham Model gives a Fair Value Estimate of $921.80. The major variable here is the 7-to-10 year projected earnings growth rate which was assumed to be 10%. Varying that number between 5% and 15% will give Fair Value Estimates between $598.36 and $1245.24.
  • The DCF Based Model indicates a Fair Value Estimate of $778.05. The major variable here is the 5-year projected earnings growth rate which was assumed to be 15%. Varying that number between 10% and 20% will give Fair Value Estimates between $637.59 and $943.56.

Overall, the Fair Value Estimates shows some undervaluation of Google shares in the market.

Disclosure: I am long GOOG, NOK.