It is a sign of the times that a company that has executed so well over the last decade, and has the potential to continue generating well above average growth over the next decade is trading at a market multiple. Google Inc. (GOOG) is the company that new tech titans such as Facebook Inc. (FB) aspire to be like. Founders Sergey Brin and Larry Page have built an advertising and technology behemoth with extremely strong competitive advantages in some of the most attractive businesses to be in moving forward. They accomplished this by taking on huge, risky projects, and executing better than anybody but them could have expected. As Google continues to garner a larger percentage of advertising budgets, I expect to see strong revenue growth and improving margins. Coupled with more shareholder friendly capital allocation over time, Google is likely to generate extremely solid shareholder returns moving forward with a lower risk profile than most technology concerns.
Tackling Google as an investment can be somewhat daunting because the company has such a wide breadth of innovative products with very uncertain futures, but make no mistake at its core Google is an advertising company. Advertising generates 96% of Google's revenue (prior to incorporating the impact of the acquisition of Motorola Mobility) through the company's various market leading platforms. Google is in the right markets at the right time and even though the company is massive, in Q1 2012 Google was able to grow revenue by 24% year over year to $10.6 billion, and this was up 1% quarter over quarter. Revenues have grown from $23.6 billion in 2009 to $37.9 billion in 2011, and net income has grown from $6.5 billion to $9.73 billion in the same period. Even better free cash flow grew from $8.5 billion to $11.1 billion during the same period, allowing Google to have ample capital allocation opportunities.
Google is following in the path of other tech titans such as Intel Corp. (INTC) and Microsoft Corp. (NASDAQ:MSFT) by investing heavily in R&D, and using the company's unparalleled financial strength to increase the "moat" around the company's operations. In 2011 R&D expenses were a massive $5.2 billion, or 13.6% of revenue, which is only slightly higher than the previous two years spending. These long-term investments have firmly entrenched Google's dominance in the search business, where they control in excess of 65% of the market, and have also laid the seeds for the next decade's growth.
On April 11th 2011 Larry Page assumed day to day operations as CEO. He has worked to refine Google's long-term strategy by focusing on the core projects, and shelving others that can be more of a capital drain and distraction. Google understands that for it to be successful over time the company has to benefit its users, advertisers, and partners. To accomplish this goal Page is focusing on improved ad formats, making it easier for users to find more relevant and actionable advertisements. An example of innovation in this arena is the "+1 button" which allows users to find businesses recommended by their friends. Page's pet project is Google+ which, launched in June 2011, already has 250 million users as of June 2012. This compares quite reasonably with Facebook, which at the same time had 900 million users, and boasts a market capitalization of nearly $70 billion.
I believe that at the current valuation Google is not getting proper credit for the company's emerging dominance in mobile advertising. 850,000 Android devices are activated every day and it is estimated that Android has about 61% market share in smartphones. Mobile advertising is having transformative impacts on both Google and the advertising as a whole. Through innovations such as click-to-call, search by voice, sight, and location, along with locally targeted advertising, Google is positioning itself to parlay its desktop dominance to mobile. For other companies to compete with Google at scale in mobile, it will take enormous amounts of capital investment which only a few companies could muster. In the 1st quarter of 2012 a lot of attention was paid to Google's declining costs-per-click which were down 12% year over year, and 6% quarter over quarter. The transition to mobile and tablets from desktops, along with different costs and exchange issues between emerging markets and developed markets were strong contributors to this decline. Even more important to advertisers however is Google's willingness to adjust their model so that the ad quality continues to improve, ensuring that advertising dollars are being given the best opportunities to earn the highest ROI possible. Short-term margin issues in developing robust and exciting markets such as mobile are the fodder for market timing analysts, but have very little impact on the long-term value of Google.
Google's $1.6 billion acquisition of YouTube in November 2006 seemed expensive at the time, but the company has grown to have 800 million monthly users that are uploading over an hour of video per second. YouTube provides new and exciting advertising formats for companies obsessed with creating that viral ad that can generate explosive growth and brand expansion. Because the company doesn't provide revenue or earnings breakdowns specifically for YouTube it is difficult to fundamentally analyze, but the value of the business is likely to be multiples above Google's purchase price. Google has hit a home run with its Chrome product which has over 200 million users, and now the company is integrating the desktop version with the mobile, creating a seamless integration between devices. Google has planted seeds with products such as GoogleTV and Google Wallet, among countless others which I look at as a pipeline portfolio similar to a biotech company, as it is likely that some will hit but most will miss and only time will tell what the return on investment actually is.
Google recently closed its $12.5 billion acquisition of Motorola Mobility. Initially it was suggested that Google made this purchase to insulate itself from patent wars which are afflicting much of the tech industry. While the patents certainly added to the value, Google also seems to be interested in controlling equipment development so that it integrates properly with the software, and so that the company can make rapid changes when needed to keep up with industry trends. The Motorola acquisition will certainly hurt Google's robust returns on invested capital, but it is the type of long-term acquisition that allows Google to build on its lead in essential markets such as mobile.
From a valuation perspective Google is extremely cheap trading around $586 per share, which is in the middle of its 52 week range. We expect Google to earn about $48 per share in 2013 putting the forward P/E ratio at just above 12. If you back out Google's net cash position of $44 billion the forward P/E ratio contracts to 9.4. Because free cash flow is currently about $3 billion per quarter the cash balance should continue to grow and solid capital allocation will be essential. I think it would be very beneficial for the company to buy back stock at these accretive prices, and I think if they were to do this the earnings multiple would expand greatly. Google boasts a return on invested capital of 18%, a return on assets of 15.8%, and a return on equity of 20%. I believe profit margins of 27% are likely to increase over time as the R&D expenses as a percentage of revenue decline. Margins of 30-32% wouldn't surprise me over the course of a cycle, and revenue growth of 10-13% over the next 5 years seems possible. While some might compare Google to a Microsoft, Cisco Systems Inc.(CSCO) or Intel in 2000 when they were at the height of their stock market dominance, I believe they are making a huge mistake because Google is trading at a run of the mill valuation unlike those companies which had Facebook like P/E ratios.
Assuming Google trades at 15 times next year's earnings of $48 per share the stock should be worth $720 per share. This represents nearly 23% upside and I think the stock could go far beyond that as their seeds start to sprout. I applaud Google's investments and track record, but a reasonable dividend and buyback announcement similar to Apple's would really benefit shareholders. For those willing to utilize options selling the January 13 $640 call for $25.00, in addition to owning 100 shares of the stock might be a good option. This strategy would provide a 4.5% cash return on the maximum risk, and the only downside to it would be that it caps your upside potential to a still solid 14.1%, or 26.66% on an annualized basis.
Disclosure: I am long GOOG.