Google Going The Wrong Way

Apr.25.12 | About: Alphabet Inc. (GOOG)

For those of you that have followed my writing over the past several months, you know that I have been neutral to even bearish on search giant Google (NASDAQ:GOOG). I don't have anything against the company, and in fact, I use the site several times a day, mostly searching for you guessed it, research I use for my articles on this site. However, just because a company is popular, and dominates its industry, doesn't mean it is a great investment. Google has done incredibly well in past years, in terms of both revenue and earnings growth, but the stock has lagged incredibly.

Google announced its first quarter earnings a couple of weeks ago, and I'll get into some of that later on. First, let me address the 2 for 1 "stock split" that they announced. I argued back in October that Google needed to split its stock to get it going. I said that a 5 for 1 split would work well, a 7 for 1 would put it back at its IPO price, and perhaps a 10 for 1 was a bit too much. They announced a new class of shares, which effectively works out to a 2 for 1 split.

However, it does nothing to affect the actual price of the current shares, and I think that is a big mistake. If Google split down to say $100-$200, I think it would fuel a new fire in the name. Just look what happened when Baidu (NASDAQ:BIDU), the Chinese search giant, split in 2010. It was at $650-$700 then, split 10 for 1, and has basically doubled since then (before Tuesday's after-hours drop).

So why am I so negative on Google? Well, take a look at the following chart, which goes back to the start of 2010.

Click to enlarge

(Source: Yahoo! Finance)

In just over two years, Google is down 3.6%. Yes, it actually is down since the start of 2010. Hiding money under your mattress would actually have worked out better, although I'm not suggesting that as a viable investment strategy. In fact, if you look at the Powershares QQQ (NASDAQ:QQQ), the ETF that tracks the NASDAQ 100, of which Google is currently the third largest holding, the ETF is up 44% since the start of 2010. The overall NASDAQ index is up about 30%. Google has vastly underperformed both. As a point of reference, Apple (NASDAQ:AAPL) is up 166% since then, and that doesn't include the gains after Tuesday afternoon's earnings report.

Google has remained a losing investment, but continues to be an analyst favorite. When I analyzed Google after its terrible fourth quarter results, 32 of 39 analysts covering the name had either "Buy" or "Strong Buy" recommendations, with 6 holds, and one underperform. The average price target at that time was just over $700. Today, 35 of 41 have some form of a buy rating, with 6 holds. The average price target is now $750. The targets have been raised by $50 on average, but the stock really hasn't done anything. Many of these analysts have had $700-$800 price targets on Google for the past few years, and we still have not gotten there. Will we anytime soon? I'm not so sure.

Google reported Q1 revenues that were in-line, which to me is a disappointment after last quarter's results. They needed to beat, and by a decent margin. They beat by a little on the bottom line, but not as much as in previous quarters where they beat. All in all, I found the earnings report disappointing. So why else am I down on Google? Well, just look at the following Q1 margins over the past four years.

Q1 Margins 2009 2010 2011* 2012
Gross 61.84% 63.81% 65.76% 64.41%
Operating 34.20% 36.72% 32.61% 31.84%
Profit 25.83% 28.86% 26.80% 27.15%
Click to enlarge

*In 2011, Google took a $500 million charge, with no tax benefit, regarding a Department of Justice investigation. I have backed out the $500 million when calculating 2011 margins.

As you can see, Google has seen some gross margin improvement since 2009, but the numbers were down over the prior year period. Operating margins also declined. Profit margins were up over 2011, but that was due to a huge improvement in the effective tax rate. Contrast these numbers to a company like Apple, which is constantly increasing its numbers. Apple just reported a great quarter, where their gross margins were up 6 full points over last year, operating margins were up more than 7 full points, and net margins were up more than 5 percentage points.

I know that Apple and Google are not similar companies, but this is why Apple is the best now and Google just isn't. While Apple has grown, it also has lowered its costs. Google has been mostly unable to do that, and I don't see much margin improvement in the near future.

Now, Google's growth and valuation come into play as well. If you are looking for growth, Apple is growing much faster right now, as is Chinese search giant Baidu. Even though Baidu only announced an okay quarter on Tuesday, it is still growing twice as fast as Google right now. Also, when it comes to valuation, Google is tricky. If you use Yahoo Finance for earnings estimates, you get the non-GAAP numbers. Based on those numbers, Google is trading at 13.85 times this year's earnings. But if you go by GAAP numbers, Google is trading at closer to 16 times this year's earnings.

Apple is currently trading at about 13.6 times earnings (using the last price in after-hours and the current full year estimate, which will be going up). So think about that. Google isn't growing as fast, doesn't have the margin growth, and is trading at a higher valuation. Yes, you can make the case that Apple is undervalued, but I think Google is overvalued, especially when compared to Apple.

To me, Google just does not make sense above $600, and it is a short idea at higher levels. If I were to buy a search company, I would either go with Baidu, despite Tuesday's results, or even Microsoft (NASDAQ:MSFT). Microsoft you say, you must be kidding? No, I'm not. Microsoft does have a growing search business in Bing, and they also have Xbox, Windows, Office, Skype, etc. Microsoft also offers an attractive dividend and is buying back stock. Google is doing neither of those.

Google may not be a total short at $600, but it is on the short candidate list, and if it rises a couple of percentages Wednesday thanks to Apple, it might get to levels where it makes sense to short. I keep saying that I won't be a Google bull until they split or can sustain a move above $650. They really haven't split, and any recent attempts to rally above $650 have been short lived.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in AAPL, BIDU over the next 72 hours.