Google Still a Buy, Despite 'Disappointing' Earnings

Brian Bolan, research analyst at Jackson Securities, sent a note to clients following Google's (GOOG) latest earnings report in which he maintained his recommendation to buy shares of the company.

Company Description

Google is an internet search and technology company that has established itself as the leader in its growing market. Free downloads of applications, tools and other products have helped to fortify the brand which has come to stand for something more than just a search engine.

Valuation and Recommendation

As a leader in a growing market, we see many opportunities for Google to grow revenue, earnings and market share. We continue to recommend investors BUY shares of Google.

Summary

All good things must come to an end, even the good thing that has been Google beating the street estimate. Google disappointed Wall Street with earnings that fell below expectations for the first time, as revenue growth slowed and expenses grew. The combination of slowing sales and growing expenses is bad no matter what business you are in.

Earnings

After the close, Google reported earnings of $3.56 per share well below our aggressive earnings estimate of $3.93 and below the consensus estimate of $3.59. Net revenues of $2.722B were above our $2.677B estimate. We should note that our estimate was among the most aggressive on Wall Street.

Google Sites Vs Network Sites

The quarter can be summed up quite easily when you look at the break out of the top line. Google Web Sites brought in $2.486B in sales, an increase of 9% from the previous quarter and 74% from the year ago quarter. Network sites, however, did not perform quite as well. $1.352B in sales was 7% lower than our estimate and essentially flat with the previous quarter. Growth of 36% from the same period a year a go is good, but will not help when the stock tries to support its lofty multiple.

We further note that licensing revenues experienced a sequential decrease. While this line item is only 1% of total revenues, the sequential decline in revenues is something that is almost completely shocking to us. At this stage of its life, Google should still be exhibiting growth in every category. The flat performance of the Network Sites and the decrease in revenue from the Licensing business is troubling to us.

Bullet points from the conference call.

Summer seasonality appears to be milder than expected

Revenue per query and CTRs are strong

Headcount will be watched very closely

Traffic growth globally contributed to the growth in GOOG sites

Seasonality for AdSense and changes to certain partners affected revenue

Adsense for content was affected by changes in policy

Market Share

Third party numbers continue to suggest that Google is dominating the competition in terms of search market share. We expect this trend to continue, but following the most recent quarter we believe investors should take this idea with a grain of salt. At the present time, we still see some space for Google to gain share, but we see even more opportunities for to loose share to the smaller players. We bring this idea to the forefront following the earnings call with eBay, in which eBay noted that they saw very good ROI’s when they shifted their advertising budget away from Google to other players for a period of 10 days. Ask.com, MSN and AOL all provided very good returns for eBay, as did Yahoo!.

eBay is a significant customer, but due to the huge number of clients and ultimately the large amount of revenue, its unlikely that the loss of eBay would cause us to lower estimates dramatically. We do believe that eBay and other larger scale buyers will continue to look for the best opportunities to increase their own businesses and that may come from sources other than Google.

Taxes…. 25.5% vs our estimate of 26%

It seems that every quarter we are writing about how the tax rate boosted earnings. It appears as though this consistent gaffe has been figured out. Our tax rate estimate of 26% compared quite favorably with the actual rate of 25.5%. We currently estimate that the company will post tax rates of 26% for the third and forth quarters of 2007, but we are wary that a tax adjustment to “true up” numbers may be coming in the third or fourth quarter. We recall that guidance had been for a tax rate of 30% for the year, and a 25.9% rate in 1Q07 and 25.5% rate in 2Q07 leaves us two quarters to see a rate well in excess of 30% if guidance is to be believed.

Key Takeaway

This quarter was really a stunner, with the key takeaway being the flat growth of Network Sites. Even as TAC continues to rise we believe that large publishers are looking for alternatives to Google. With search as its core and responsible for a majority of the revenue, we see TAC increasing in the coming quarters and a continued stagnation of Network revenues.

Looking Ahead

We know the worst is behind us, but we believe that there is still some trouble yet to come. The third quarter does get a late boost from the academic community which tends to use Google more than Yahoo!. However, we also believe that Network revenues will not move much from their present position and only a minimal growth has been modeled into our estimates.

TAC

TAC or traffic acquisition cost, continues to rise. This quarter saw another increase to 85.1% of Network revenues. This implies that the revenue sharing deals with larger publishers are beginning to meaningfully increase. The TAC number in our model has been increased yet again, to 85.8% in the third quarter and 88% in the fourth quarter of this year.

In the prior quarter we noted that the largest of advertisers may look to switch providers if their needs are not met, and we believe we saw this evidenced in the flat Network Revneues line. With TAC likely to continue to increase, we see little reason to expect a great number of large advertisers to commit more content to Google.

Error in our Model

While going through our model for 2Q07 we noticed an error that caused our estimated to be inflated by about $62.5M on the bottom line. This was due to the treatment of stock options and the related$3.73. We have corrected the error for future quarters. Valuation Our target of $560 per share and buy rating suggest that we are bullish on the stock. Our target price is derived from a multiple of 36x this years earnings estimate of $15.28. Our view on the valuation is that Google is priced at a discount compared to its peers. We recommend investors buy shares of Google.

GOOG 1-yr chart

For more on Google's latest quarter, see the company's Q2 2007 Earnings Call Transcript.