Google: Buy And Hold As Seeds Begin To Sprout - Update

Jul.23.12 | About: Alphabet Inc. (GOOG)

Last week Google Inc. (NASDAQ:GOOG) reported very strong revenue growth, which does not seem to be reflected in the current share price. The quarter had a lot of activity, which makes projections more labor intensive, including the closing of the Motorola Mobility acquisition on May 22, 2012, and the introduction of the Nexus 7 tablet. Currently I believe that Google is being priced at a discount to the value of its Search, Display Ads, and YouTube businesses, and is getting no credit for its Android, Chrome, or other pipeline businesses that aren't generating meaningful revenue numbers at this stage. Moving forward as Google continues to post substantial revenue and earnings growth the stock should rally just to keep pace with the current multiple, and multiple expansion seems very likely if the overall market resolves some of the uncertainties that are restraining investor confidence and constricting valuations.

Because the acquisition closed in the middle of the quarter the consolidated figures only include Motorola's numbers since the transaction closed, therefore they don't adequately exhibit full-quarter numbers. As a standalone company Google grew revenue by 21% year over year to $10.96 billion, and on a consolidated basis revenue was $12.21 billion for the 2nd quarter, an increase of 35% compared with the 2nd quarter of 2011. Traffic acquisition costs totaled $2.6 billion or 25% of advertising revenue, which was up slightly from 24% a year ago. Because traffic acquisition costs represent payments made to Google's network members to help drive traffic, I believe that the benefits Google offers these partners increases the overall "moat" of the company. No other company can offer the scale or breadth of Google, therefore it is an essential partner for both large and small companies looking to increase their brand awareness. Specifically Google-owned sites generated revenue of $7.54 billion or 69% of Google's revenue. Google's network revenue was $2.98 billion in the quarter and both groups posted YOY growth of about 20%.

GAAP net income in the 2nd quarter of 2012 was $2.79 billion or $8.42 a share, compared with $2.51 billion and $7.68 per share in Q2 2011. Non-GAAP EPS, which will be somewhat insightful moving forward to account for the acquisition costs, were up to $10.12 per share from $8.74 in the 2nd quarter of 2012 and 2011 respectively. Google's non-GAAP numbers exclude the expenses related to stock-based compensation, and severance and benefit agreements in connection with the Motorola acquisition. These figures are significant and real costs, particularly due to the fact that Google estimates stock-based compensation for 2012 to be a whopping $2.6 billion. Google generates about 54% of revenue from outside the United States, and due to the dramatic strengthening of the U.S. dollar Google's revenue was about $350MM less than it would have been if FX was constant from 2011.

Google has put in a tremendous amount of work to increase both transparency and return on investment for advertisers. This is essential for the company to focus on long-term value creation as opposed to juicing up cost-per-click numbers to make quarterly earnings. Aggregate paid clicks increased 42% YOY and 1% from the 1st quarter. Cost-per-click decreased 16% YOY and increased 1% from the 1st quarter. Operating expenses other than the cost of revenue are extremely important to track because Google has invested in so many different businesses that aren't central to search advertising, which generates the vast majority of revenue and income. In Q2 2012, these expenses were $4.0 billion versus $2.97 billion last year, and in both years these numbers reflected 33% of revenue. Net cash provided by operating activities was up to $4.25 billion from $3.52 billion a year ago. In Q2 2012 capital expenditures were $774MM, therefore free cash flow was $3.48 billion.

When I've written about Google before, I mentioned that I view Google's non-core businesses similar to a biotech pipeline. While monetization beyond the cost of capital is not assured there are some exceptionally exciting prospects. Google+ already has 250MM people signed up for it and while it may not be as active as Facebook is, Google's integration with mobile, desktop, and tablet devices at least enhances the potential value of this business. There are a staggering 400MM Android devices now activated, and 1MM are being activated per day. Google compares mobile with the internet in 1999 before it became clear how eyeballs would translate to profits. By Google taking the painful yet necessary steps to build a leading market position in mobile, the company is parlaying dominance in desktops to the next hyper growth market. The same arguments against mobile are those that were made against digital advertising a decade ago, and as mobile phone technology improves such as with Google's click-to-call innovation, the benefits to advertisers will make mobile a staple in just about every advertising budget. Chrome has 310MM users, up from 160MM last May. More than 20 billion apps have been downloaded from Google Play, making it a leader in the lucrative emerging app market.

At the end of the quarter Google had $34.83 billion in net cash or cash-long term liabilities. This represents about 17.6% of the company's $197 billion market capitalization, so the enterprise value of Google's wonderful franchises is roughly $162 billion. I believe that next year Google could earn about $48 per share or close to $16 billion on 326MM shares. Free cash flow is usually higher than net income, therefore unlevered Google's forward free cash flow yield is about 10%. That is exceptionally high for a company that is growing revenue by greater than 20%, and while I do believe Google had a real opportunity to improve operating margins to 30% or greater, this likelihood has been diminished due to the lower margin Motorola business. I've read other analysts talk about the vulnerability of Google's search business to a better algorithm and I think they are missing the obvious. Microsoft Corp. (NASDAQ:MSFT) has thrown billions into Bing and all it has managed to do is take market share from Yahoo! Inc (NASDAQ:YHOO), which they have a partnership with anyways. This is one of the clearest case studies of a technology company building a moat, and I see no signs that Google isn't likely to build upon it into the future.

If Google really believes it needs to keep this much cash on hand, I think it would be very beneficial for the company to issue debt at record low yields and buy back stock aggressively. Google generated $12.5 billion in free cash flow over the last 12 months without using debt to achieve it. The company is going to continue to produce cash faster than it can spend it in tuck in acquisitions, therefore the weight of record low interest weights will only hurt shareholders. By issuing debt at what would likely be a sub-3% interest rate, Google would be enhancing shareholder value dramatically by purchasing its own stock at a 10% forward free cash flow yield. Using current cash to accomplish this task would be just as good if not better since it would reduce the risks of a damaging large acquisition.

Google's stock has run up a bit since earnings and our last research report but it still looks attractive. I'd suggest selling an at-the-money or out-of-the-money put expiring in January 13 to reduce your cost basis. The $605 January 13 puts are going for about $42. This would produce about a 7.5% in 179 days or greater than 15% annualized assuming the stock is above $605 at expiration. If the stock is below $605 at expiration your breakeven price would be $563, enabling you substantial potential for upside. This lower risk strategy offers an excellent way of generating income, and reducing the risk of a permanent loss of capital by providing greater discipline in purchase price.

Disclosure: I am long GOOG, MSFT.