The past two weeks have been full of earning reports and, more significantly, earning surprises. While the stock market has been on a roller coaster ride, many investors have been on the sidelines, confused by Wall Street’s reaction. Traders are making merry; "buy the dips, sell the rips" seems to be working really well. In this context, I felt it was important to see how individual investors can profit from the limitations of Wall Street.
Wall Street is a bonus driven environment, where the time horizon stretches to the end of the current quarter (for management fees) and the current year (for trading bonuses). Any perspective beyond that gets little mindshare in these uncertain markets. In this article, I will focus on what is happening in the internet space, where Google (GOOG), Yahoo (YHOO) and Microsoft (MSFT) are duking it out.
Google Beats by a Mile
Google reported its financial results on April 17, handily beating the consensus earnings estimate of $4.52/share by 32cents/share (see conference call transcript). The stock reacted by making a $75 move the next day and has tacked on another few percentage points since then.
Google has risen almost 25% from its mid-March lows, though it is still about 28% below the high set late last year.
During this period, the company has not issued any statements which could have justified the massive price swings.
Private Equity Model and Wall Street Analysts
It is not too hard to figure out why Wall Street goes through such massive sentiment swings when it comes to Google. Unlike a majority of publicly traded companies, Google does not offer forward guidance about its financial results. Google sees Wall Street’s obsession with quarterly results as a distraction towards its goal of building a strong company and long term shareholder value. Similar sentiments are also shared by many private equity firms who believe that the focus on quarterly earnings artificially constrain public companies and hamper efforts to build stronger companies. Google operates under a private equity model while being a publicly traded company.
Since Google does not offer guidance, Wall Street analysts have to step out of their comfort zone when making projections about Google’s business prospects. Google's business model is unique: it is a technology company which earns its revenues from advertising. Since Google has not faced an economic slowdown, there is very little historical data which can be used to estimate its performance in the current slowdown.
However, the magnitude by which the analysts were wrong is indeed surprising, especially since there are a lot of metrics which can be used to evaluate Google’s performance.
Wall Street’s Thesis on Google’s Imminent Collapse
The financial press was gaga over Google last fall, as it raced to new highs in the 700s. Henry Blodget, a master in attracting attention with outrageous projections, said that Google might go to $2000 (the fine print said in 2020).
However, the mood turned extremely gloomy a couple of months ago. Blodget was very active this February, predicting Google’s demise, based on a warning he (incorrectly) discovered in Google’s 10K, and an anonymous industry insider’s thoughts (he meant an ad agency insider and not a Google insider) about how Google was extremely vulnerable to a slowdown in ad-spending.
To add fuel to the fire, ComScore (an internet intelligence and metrics company) reported a significant slowdown in year to year growth in paid clicks. Since paid clicks account for a bulk of Google’s revenues, this was seen as a sign of the slowdown in ad-spending striking Google. Google also missed its earnings in the results reported in January, and the Street was very receptive to any news predicting the demise of Google.
Building the Mosaic: An Analyst's Job
After Enron and the dot com bubble burst, companies could no longer leak information to their favorite analyst on Wall Street. Analysts were now required to have the same access and information as the general public. This also meant that to add value, analysts would have to dig deeper and identify trends which were not obvious at first. They are now expected to build a mosaic based on public information distributed by the company and, more importantly, from the information they gathered from third party sources and contacts. Wall Street analysts failed miserably in building this mosaic from publicly available information.
Analysts failed to account for the impact of Google’s international growth. As I have written in an earlier post, SEMs like Efficient Frontier were showing strong growth in ad spending outside the USA. They had specifically mentioned that international sales accounted for 48% of Google’s revenue and were growing at a significant faster pace. Further, lower tax rates in the rest of the world contribute more to Google’s bottom line. And unlike the US, Europe’s economy is not in a slowdown with the ECB in no mood to cut interest rates, fearing inflation.
Search Growth and Google’s Market Share Growth
Metrics about the growth of online search were suggesting that not only was online search growing at a decent clip, but Google’s market share was growing even further. Though economic slowdown does affect buying habits, consumers do not stop buying. Even with no GDP growth, the US is a huge consumer economy. The conclusion being reached that the consumers had suddenly stopped clicking on ads served by Google defied common sense. Consumer behavior, unlike Wall Street sentiment, does not reverse course in a quarter.
Google had talked about changes in the way the ads were being displayed which would reduce the chance of accidental clicks. However, they felt that the reduction in the number of clicks would be compensated by the better quality of returns that advertisers would get from the genuine clicks. This is a unique characteristic of Google’s self-correcting feedback mechanism: poor performing keywords automatically get bid lower. The feedback is almost real time and advertisers can make changes within days, instead of weeks and months as with traditional media.
In my opinion, the biggest disconnect was in ad spending. Though consumer behavior is a factor, it does not change overnight, especially since it does not cost money. Ad spending, however, can and will react to changes in economic conditions rapidly. And at the end of the day, it is the money spent by the advertisers which determines Google’s fortunes.
All data released by Search Engine Marketers showed that growth in online ad spending was great outside the USA. Within the USA, the financial services sector had cut back on spending but the rest of the market was growing as predicted. The disruption in financial services is a transient phenomenon. With the changes in confirming loan limits, and lower interest rates, I expect a massive wave of refinancing which will restore the robust ad spending by the financial services sector.
In another article, I noted that during a slowdown, companies are willing to sacrifice margins to earn revenues. Revenues allow companies to operate and make up for their fixed costs. In this environment, ad spending will focus on generating immediate revenues with a reduced emphasis on brand building campaigns. Online advertising, and especially search engine marketing, is one of the most cost-effective mechanisms for driving sales. Advertisers view it as a cost of sales and not marketing costs. Online advertising’s share of the ad budget will grow much faster during a slowdown and these changes are typically sticky.
Google’s Future: Video, Display and Mobile-Search
Google is the cusp of opening up new horizons in advertising and becoming a full-service advertising provider. The DoubleClick acquisition gives it a strong position in display advertising. Traffic on YouTube is sky-rocketing and Google is gradually monetizing the eye-balls with non-intrusive video ads.
With the arrival of Apple's (AAPL) iPhone, searches from mobile devices are exploding. The ability to pin-point a user’s exact real-time location gives advertisers the incentive to spend aggressively on location based ads, which will drive traffic to traditional brick and mortar retailers. Note that although many brick and mortar retailers have an online presence, the location based ads on mobile devices are perhaps the first real play in the click and mortar world, where a retailer without any online presence can start using online advertising. This bodes well for Google since it expands their revenue source to small retailers who do not have an online presence but would like to use online marketing tools.
Google: Creating Order in Chaos
One interesting aspect about Google is that they thrive on becoming a leader in the nebulous environment which exists when any new disruptive technology emerges. They can gather real-time feedback and provide performance metrics to their customers almost instantaneously. They are quite nimble and are able to react to changes quickly (e.g. the change in the budget allocation algorithm in February). They are quick to recognize when they are not numero uno and are willing to spend their money where it matters in the long run (e.g. the YouTube acquisition when Google-Video was a distant second).
While the rest of the world ponders, Google takes action and delivers. Google is currently trading at 22x forward earnings estimates with a PEG ratio of less than one. This is why I believe that Google is the buy of the year. Much of the uncertainty about the future is discounted and the outlook looks as rosy as ever.
Disclosures: Vikram hold equity and equity options positions (both long/short) in Google, Yahoo and Microsoft.