This weekend's Barron's has article by Jacqueline Doherty titled "Google's Next Stop: Below 350?" The main thesis of the article is that analysts have not reduced earnings estimates for Google (NASDAQ:GOOG) to account for the expected reduction in clicks and corporate ad spending. The article recommends staying clear of the stock until Wall Street recognizes that Google's revenues will be hurt by an economic slowdown and management starts cutting expenditure in non-core areas.
To be fair the author acknowledges that Barron's (specifically she) has been consistently wrong about Google in the past; others have called her out for her hand-waving articles. Further her assertion that Wall Street have not come down is incorrect. Yahoo! Finance shows that earnings estimates for the current quarter have fallen from $4.86/share to $4.65 over the past 90 days. Estimates for FY08 have fallen from $20.69 to $19.98.
I feel that one big challenge which Google faces is that they have consistently spurned Wall Street. Google's IPO was not managed by the big banks that lost out on the massive underwriting fees big IPOs generate. They do not provide earnings guidance to make the job of analysts easy. Wall Street is forced to follow Google because of its performance; not because Google reaches out to them.
Similarly the financial press is not too enamored of Google. Google represents the biggest threat to Madison Avenue and traditional media advertising. As a result whether it is raising privacy concerns or questioning their future growth, it has a tendency to put a negative spin on Google.
In an earlier post I had wondered whether Wall Street properly values the brand loyalty which Google inspires. Barron's comment's on spending in non-core areas seems to highlight that the financial press and Wall Street continues to refuse to see the forest for the trees. In this article I will try and translate Google speak into Wall Street speak to help them understand a few things.
Non-Core Expenditure: A quantitative look
I felt it was prudent to dig into the size of the non-core expenditure which Wall Street is so disgruntled about.
Google's press release says the following:
In 2008, Google expects to spend tens of millions on research and development and related investments in renewable energy. As part of its capital planning process, the company also anticipates investing hundreds of millions of dollars in breakthrough renewable energy projects which generate positive returns.
For the sake of discussion, let me assume that Google will spend $50M in the energy initiative (tens of millions) in 2008. In 2007 Google had a net profit of $4.20B and $16.59B. So $50M is about 1.2% of Google's profits and 0.3% of its total revenue in 2007.
A Game of Scale
Imran Khan, an analyst from JP Morgan, once noted that the dirty little secret of the search business is that scale matters a lot. The amount of data available on the web continues to grow exponentially. As the emerging markets come on line, this growth will not see any significant slowdown. The number of search queries also continues to grow. In order to handle this growth, search providers will continue to build and operate huge server farms which consume a lot of energy. As early as 2005, Google engineers had warned that the energy costs will outstrip the cost of the servers. And the cost of energy will continue to increase as demand in emerging market gallops ahead.
Google's last earnings release also had the following comments:
Other Cost of Revenues - Other cost of revenues, which is comprised primarily of data center operational expenses, credit card processing charges as well as content acquisition costs, increased to $516 million, or 11% of revenues, in the fourth quarter of 2007, compared to $441 million, or 10% of revenues, in the third quarter of 2007
Incidentally this expense was 8% of total revenue in Q3-2006. Clearly data-center operational expenses are increasing. If Google is even moderately successful in its efforts to find lower cost sources of energy, the effect on its bottom-line will be direct and visible.
Many firms often spend a lot more in so-called restructuring charges, which Wall Street very conveniently ignores. However, Google is being skewered in the financial media for trying to improve its long term profitability.
Wall Street should view this as an investment in efficiency and cost-reduction, not as a speculative pie in the sky dream. Most high-tech companies have in house investment arms which fund promising start-ups. Think of the growth in the market cap of SunPower and Cypress over the past few years.
Renewable Energy at a lower cost than coal
Translation into Wall Street Speak:
Operational Efficiency (reduced energy costs)
Start-up Fund (SunPower)
The Google X Lunar-Prize
I often wonder what Google itself spends on advertizing and brand-building exercises. I do not recall seeing any paid advertisement by Google; I do remember the yodel in the Yahoo! jingle on TV. I do not have the exact statistics available, but Google does not seem to spend anywhere close to other major corporations with similar revenues.
Jeff Macke on Fast Money has been taking swipes at Google's space-program. The Google X-Prize has a total commitment of $30M, assuming someone is able to meet the challenge. It generates a lot of free press and publicity for Google. Further it captures the imagination of the younger generation all over the world; many of these countries value science and technology a lot more than the US and the US media.
Incidentally, many Wall Street execs make more than that in a year; the same firms spend a lot more in brand-building advertisements in different media. Many studies have suggested that Google is a lot more popular among the younger and wealthier portion of the population; clearly something which bodes well for Google.
Google X Lunar Prize
Translation to Wall Street Speak:
Inexpensive Brand Building Campaign
The Positives about Google
Google is a metrics driven company. Any new idea gets a chance to appear on the internet. It is estimated that at least 10% of web-impressions produced by Google have some kind of experiment and measurement metric embedded in them. Google is unique in having both the ability and the inclination to measure the real-time performance of its new efforts.
To give you an example, Microsoft Live Search tries to measure the efficiency and the quality of its search result by asking a question 'Is this useful?' next to the search results. Google instead studies whether user clicks on the link to measure the usefulness. There lies the difference. Microsoft seems to be stuck in using the traditional method of a survey (which have their own biases) while Google studies user-behavior to measure the same.
Stickiness as a measure of ROI
The metric driven approach gives Google the ability to try and measure the effectiveness of new ideas and projects. It allows them to invest in projects which provide the greater ROI and cut the under-performers.
What Wall Street perhaps fails to understand is that Google does not necessarily measure ROI by how directly the feature translates to dollars. The cool features which Wall Street cannot see Google monetizing provide Google with the brand loyalty needed to preserve their status as the web's #1 destination.
Over the past few months I have made Microsoft Live Search as the default search engine for my browser. However more often than not I am forced to repeat the search on Google to get the results I want. There is a difference and Google's increasing search market share speaks for it.
The end-user stickiness is critical in a domain where it takes just a mouse-click to switch loyalties.
Customer Satisfaction as a measure of ROI
Google has been making changes to improve the quality of results it offers to advertisers. This article has a nice discussion the changes which Google is making. All these changes are going to provide a short-term blip in the growth Google's revenues. However, they are all designed to make advertisers more loyal to Google by providing them with greater confidence in the value of their investments. As the online advertising industry consolidates, making sure that the people who pay the bills are happy is a laudable goal. It again comes to down to increasing the stickiness of people who use Google.
YouTube: Driving the next wave of online advertising
There is a lot of fear about Google not being able to monetize their other big investment, YouTube. Perhaps Google is a victim of its own success here since it is the benchmark used to compare monetization on the web, Yahoo! being the classic underperformer.
I think it is prudent to step back a bit. Google had its own video service but they realized that YouTube was gaining traction and brand recognition at a pace where it was better for them to overbid than risk losing the pole position in the next big wave. Google paid $1.65B, about 10% of its 2007 revenues to buy YouTube.
Since then they have been clearing up the copyright hurdles surrounding YouTube, building partnerships with content providers (YouTube channels) and distributers (iPhone). And by not cluttering the videos with pre-roll or post-roll advertisement, YouTube has consolidated its position as the number one destination for online video content. The contrast is obvious to see. Yahoo! and cnn.com use pre-roll and post-roll ads where I am forced to see 15 seconds of Roger Riney (CEO of Scottrade) in his helicopter after every 1 minute clip!
The statistics from Alexa are mind-boggling. About 20% of all web-surfers visit YouTube; they view 15.5 pages per visit (they hang around the site), and the site is the web's #2 destination for the past 3 months!
The monetization will follow in a variety of ways. Google is experimenting with picture in picture kind of ads (InVideo) where the user can chose to see the entire ad if they like the small preview. AdSense video ads are coming into general Beta. Content providers can become YouTube partners to distribute content.
As high speed internet and wireless access becomes ubiquitous video ads are going to be the next big wave. Advertisers are already lining up to pull their traditional TV based advertising and move on to internet based video ads. I cannot think of another company which is better positioned to profit from this wave than Google. If you do, do point it out to me.
Where is Google's stock heading?
According to Jeff Macke of Fast Money, Google is a broken stock. Google's technical indicators are pathetic. It broke through the $500 support level I had referred to my earlier post and then has fallen to make new 52 week lows.
Conflicting reports from ComScore about falling clicks and uncertainty about business spending on advertising and consumer spending at the retail level have frozen buy-side interest in Google. Money managers are waiting to hear from Google to see what exactly is happening with their business; they do not have any historical data to fall back on to determine how Google will perform in a major economic slowdown. In the meantime the stock has been taken over by traders. Since we are in a bear market, the traders will try and take the stock down even further.
Earnings Estimates: Lowest and Consensus
As I had pointed earlier, Barron's is incorrect in saying that Google's estimates have not come down. The lowest analyst estimate for the Q1-2008 is $4.23 versus a consensus of $4.65. Even the lowest estimate shows 14.94% growth verses Q1-2007; the consensus growth estimate is 26.4%. On a year to year basis, the lowest estimate ($18.06) shows a 15.84% earnings growth; the consensus growth estimate is 28.2%.
On a trailing twelve month basis, Google has a P/E of 32.60. Assuming Google suffers from a slowdown and next year's earnings are half-way between the lowest estimate and the consensus estimate, Google will earn $19.02/share and grow at around 22.0%. This gives it a forward P/E of around 23, and a PEG of about 1.05.
According to Karen Finerman of Fast Money, Google is fast approaching the value stock territory. I do not have any reason to disagree with her. Given the short term uncertainty using LEAPS to go long Google during dips may offer good long term returns.
Efficient Frontier is saying that Google had phenomenal growth in ad spending Europe in February 2008. UK, responsible for 14% of total revenue, was up 69%; Europe total was up 100%. Even US with its battered economy was up 20% in January and 19% in February excluding mortgage industry advertising. Note that as the rate cuts take effect, credit markets stabilize, and refinancing picks up, mortgage industry spending will also pick up. This might take a few months but is going to come.