Google (GOOG) is the prime beneficiary of the secular shift towards online (Internet) advertisement. We are of the opinion that Google's stock is currently trading at a discount to the industry and has a significant upside potential. In our view, Google should trade at a multiple of above 15x, which translates into a share price in north of $650. We recommend that investors buy the stock.
Stock Price Drivers :
- Internet Advertising Industry Growth
Growth in the Internet Advertising Industry plays a key role in consistent gains for Internet search companies, such as Google, Yahoo (YHOO), and Baidu (BIDU), which derive their revenues primarily from advertising. An upturn or downturn in advertiser spending has a direct impact on the revenues of these companies.
- Aggregate Paid Clicks and Cost per Clicks
Aggregate Paid Clicks and Cost per Clicks are key performance metrics for Internet search companies. Aggregate Paid Clicks growth demonstrates user engagement. Improving Aggregate Paid Clicks indicates growing user interest in advertisements. It also signifies the quality, relevance and usefulness of advertisements to users. Cost per Click points to revenue being generated for each Paid Click and signifies the monetization ability of the company for each advertisement.
- Total Acquisition, R&D and Human Resource Costs
Costs, in addition to revenues, are important for the bottom line growth of Internet search companies. Total acquisition costs are a prime part of expenses for Internet search companies. TAC indicates the costs paid to rent out cyber space for advertisements on third party Websites. R&D is necessary to come up with new ideas, products and services to sustain/improve earnings growth. HR expenses are also important as Internet companies spend large sums to attract quality developers. Reduction in TAC paired with improvement in revenues is a positive sign, as it indicates the company's ability to generate more earnings over the same costs. However, reductions in HR and R&D need to be carefully monitored as it has a long term impact.
- Market Share
Market dominance is another key metric to analyze the performance of Internet search companies. Companies, such as Google and Baidu, which largely dominate regional markets, are better positioned for growth.
Upcoming Catalysts :
- Geographic Expansion
In future, the growth of Internet search engine companies will largely depend on their expansion in new geographic markets in Asia, Latin America, and Africa. Search engine companies have penetrated the developed markets of North America and Europe; hence, in order to sustain growth, it is necessary for these companies to find new advertisers. These companies will find new consumers in developing and underdeveloped economies, as Internet penetration further improves globally.
However, one important point to note is that the paying ability of advertisers in developing and undeveloped markets is less than advertisers in developed economies. Therefore, search engine companies may experience surging advertiser numbers and Paid Clicks in future, but Costs per Clicks are expected to fall. As a result, overall growth is expected to continue, but at a decreasing rate as these companies expand geographically.
- Consumer Shift to Mobile Devices
Mobile devices, and recently smartphones, have revolutionized our lifestyles. More and more users are switching to smart devices for browsing the Internet. As a result, time spent for browsing on PCs is falling gradually. These changing consumer dynamics are directly affecting Internet search companies' revenue mix. Internet search companies solely earn Paid Clicks revenues from PCs. However, in case of Paid Clicks from mobile devices, the revenue is being shared with OEMs and Carriers. Thus, a change in consumer shift to mobile devices is going to slice the advertising revenue pie available to search engine companies, which can affect the earnings growth of these companies in the near future.
Internet Advertising Industry
The Internet Advertising Industry is booming with record revenues of $8.4 billion in 1Q2012, according to IAB and PwC. Internet advertising revenues posted a 15% YOY upside in 1Q2012, as the number of Internet users grew worldwide and marketers continued their efforts to reach a wider audience. Marketers are increasingly realizing the immense potential of marketing and advertising activities on the Internet. In addition, growth in e-commerce has further pushed companies to expand their Internet marketing budgets, as more and more consumers place shopping orders online.
(Click to enlarge)
ComScore reports that Internet advertising is expected to cross $35 billion by 2012, a 17% YOY growth.
(Click to enlarge)
Search engine companies, Google, Yahoo, and Baidu, are the prime beneficiaries of growth in Internet advertising, which is the primary source of revenues for these companies.
The Company
In a growing Internet Advertising Industry, Google has excellently placed itself among search companies. The company earns more than 96% of its revenues from advertising services. Google has been successfully able to exploit a large part of the Internet Advertising Industry growth as a result of its popular search engine. ComScore reported that as of May 2012, Google has a commanding search engines share of 66.5%.
Market Performance
(Click to enlarge)
Baidu has remained investors' favorite over the past year as it continuously outperformed analysts' consensus expectations over the previous five quarters. Google displayed a mix performance trend in the same period with surpassing analyst expectations thrice. Also, the three year average sales and EPS growth rate for Baidu is higher than Google. Baidu had an average three-year sales growth rate of 65.51% compared to 20.26% for Google. Although, Yahoo exhibited negative average growth of 11.57% in the same three-year period. Based on its 52-weeks performance, Google is up 17%.
Financial Review
Led by strong 39% YOY growth in Paid per Clicks and global expansion of distribution network, Google posted a 24% YOY growth in 1Q2012 revenues. Though, some of the growth in revenues was offset by a 12% decline in Cost per Clicks and a 23% rise in Total Acquisition Costs . Still, the Mountain-View based company was able to post a strong bottom line growth because of a small headcount increase, and cost improvements in R&D, sales, and marketing expenses. The increase in CPC was attributed to the strengthening dollar against other currencies and a change in revenue mix.
Google is experiencing a gradual shift of consumers from PCs to mobile phones. Furthermore, a change in the geographic mix is increasing the proportion of revenues outside the United States. Both factors: 1) consumer shift to mobile, and 2) change in geographic mix, are going to impact Google's growth in the long term.
Increased usage of mobile phones is going to put a downward effect on revenues as mobile advertising revenue is shared with OEMs and carriers.
Also, a change in the geographic mix will slow growth in future, as Google becomes more dependent on developing economies for revenue generation.
Valuation
We believe that the stock is currently trading at a discount to the industry and has significant upside potential. In our view, Google should trade at a multiple of above 15x, translating into a price of $650.
1Q2012 | ||||
Net Revenue Growth YOY | EBITDA Margin | P/S (2012E) | P/E (2012E) | |
24.40% | 22.80% | 5.26 | 13.19 | |
Yahoo | 0.57% | 28.32% | 4.22 | 15.97 |
Baidu | 74% | 58% | 12.03 | 26.44 |
Source: Reuters | ||||
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
