Google: Fundamentals Will Catch Up With Stock Price

| About: Alphabet Inc. (GOOG)

Google Inc. (NASDAQ:GOOG) has a problem with its growing cash hoard. For the past five years, it has grown its cash balance from $14 billion in 2007 to $44 billion in 2011. During this period, operating cash flow reached a total of $48.5 billion and capital spending $13 billion. This leaves us with free cash flow of around $35 billion for the same period. Google will still be sitting on this pile of cash even if we include all the acquisitions it has made in the past five years. One of the biggest acquisitions it made recently was Motorola Mobility for $12.5 billion. The majority of the smaller ticket acquisitions were valued at less than $1 billion.

While it is not really a problem to have a growing cash hoard, Google has restricted itself to US Treasuries and high quality corporate bonds. If you look at the current yields, the 1-year Treasury bond is yielding at near zero rates. This will translate to interest income of around $100 million a year from its cash balances. The company has not distributed dividends. It has bought back a total of $416 million in the last five years.

Incidentally, Apple (NASDAQ:AAPL) also has the same problem. It announced that it will spend nearly half of its $100 billion cash hoard to pay dividends to investors and buy back shares of the company. But, Apple has said that it will still continue to invest in the business. I believe that both Apple and Google's cash hoard is to take advantage of opportunities in the technology space, as well as allocate resources for innovation. Berkshire Hathaway (NYSE:BRK.A) has no trouble staying with cash. Berkshire CEO Warren Buffett said that the default strategy is to stay with cash if it there are no value-accretive acquisitions.

At this point, there is no problem with Google's cash hoard. I see that this figure will exceed $60 billion in the coming years as average free cash flow of $10 billion a year. I believe that Google's management has done a superb job allocating its capital. The best strategy is to reinvest the proceeds as incremental returns on capital is at 21%. This is definitely higher than the company's average cost of funding of around 10%. This shows us that the company is indeed increasing its shareholder wealth, rather than destroying it. Since cash flow exceeds its reinvestment needs, it is wise to save money for future needs.

The good news is that Google has found a place to park its excess cash. It has recently invested some of its money into asset-backed securities tied to automobile loans and consumer credit-card payments. The recent purchases include investment grade debt of auto makers such as Honda (NYSE:HMC) and Hyundai. These securities have average yields of more than 2%. This will definitely boost its interest income in the coming years. Apple and Berkshire could learn from Google's handling of excess cash.

Anatomy of a Google Acquisition

Prior to the return of CEO Larry Page, the market perceived Google as technology, as a mere collector of small businesses. The market has accused the company of employing a "one-size-fits-all" approach to acquisition. This resulted in the company's lack of focus. Some investors feared that Google could be turning into Yahoo! (NASDAQ:YHOO). Yahoo!'s problems stemmed from its previous acquisitions that did not contribute to its overall profitability. Thus, there are calls for the company to break-up into pieces.

All of this changed when Page assumed the CEO role. Page mandated that Google will focus on seven key businesses areas for potential Google acquisitions. The seven areas include search, advertising, networking, social, Android, Chrome, Youtube and local mobile commerce. Page is also focused on profitability, expecting reports from its acquisitions team on how the purchased companies are performing. Every acquisition needs to be justified and should be directly aligned with its business model. For example, Google purchased Next New Networks, a video production company, in order to find new premium content for YouTube. It also spent $700 million to buy out ITA, a travel software firm, so it could have a better travel search platform. Finally, it bought Motorola to improve its Android platform.

Page also shut down projects that were not aligned with the company's core focus. Despite this extremely focused attitude, Page has not slowed down Google's buying binge. Surprisingly, it has bought more companies than Apple and Facebook (NASDAQ:FB). It bought at least twenty five companies in 2011, compared to Apple's acquisitions of three companies and Facebook's six buy-outs.

Clearly, these acquisitions have fared well, leading to sustained growth rates. Over the last five years, revenues have grown by an average of 29% per year. This has yielded in current operating margins of 31% and net income growth of 25%. These figures are higher than most of its peers. Yahoo! experienced a decline of 4% from its revenues for the same period. This translates into operating margins of 16% and net income growth of 6%. Another tech giant, Microsoft (NASDAQ:MSFT), reported five year annual revenue growth of 7% and operating margins of 30%. Its net income grew by 3% per year during the same period.


Google is currently valued at 18.9 times earnings. It also trades at 13.3 times cash flow. Adjusting for cash, the stock should trade at 16 times earnings. Its average 5-year price earnings ratio is at 30 times earnings.

On the other hand, Microsoft trades at 15.1 times earnings and 8.1 times cash flow. It also carries a dividend yield of 2.5%. This is higher than its five-year average price earnings ratio of 13.8 times. Yahoo! is valued at 18.3 times earnings and 14.4 times cash flow. Yahoo! has a five-year average price earnings ratio of 33 times.

Google's valuations are not dirt cheap, but do seem reasonable. In the long run, its fundamentals will eventually catch up with its stock price. Given management's A-plus capital allocation abilities, shareholders will be rewarded in the future. With that said, investors should slowly accumulate Google's shares on dips.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.