Bearish Analyst Upgrades Google (GOOG)

Stifel Nicolaus analyst Scott Devitt upgraded Google (GOOG) from "Hold" to "Buy" on March 24th. His reasoning is important, because Mr. Devitt has been arguably the most bearish analyst on Google over the last six months. He upgraded the stock from "Sell" to "Hold" on February 6th. Excerpts from his note to clients:

Google (GOOG, $341.89, BUY): In Google We Trust; Upgrading to Buy

Google shares are down about 30% (pre-S&P 500) in the past two months, as the company has transitioned from Wall Street and media darling to a business that now has entered a "show me" period with the same crowd. We appreciate changes in sentiment particularly when they are presented in such short time horizons with misinformation on both sides of the argument. Given the decline in the shares, we believe there is now money to be made in support of the positive thesis on Google. We are upgrading Google shares to Buy from Hold and initiating a 12-month target price of $435 per share or 37x our 2007 EPS estimate.

Below, we accentuate the positives, address the negatives, and explain why we have now become a buyer of Google shares.

Accentuating the Positives

Rapid Growth and Compelling Business Model. Google has gone from $0 in revenue to $6 billion in revenue in seven years, an achievement that took Microsoft a full decade to achieve. Google just completed a quarter in which it reported revenue of $1.92 billion, an increase of 86% compared to 4Q04 and an increase of 22% compared to 3Q05. For 2005, Google grew revenue by 93% and a 229% increase in operating profits. In 2006, we expect revenue growth of 57% and operating income growth of 52%. In 2005, Google reported gross margin (ex-TAC) of 89% and operating margin of 39%. International revenues now account for almost 40% of Google's total revenue stream.

Query Share Gains. Google accounts for 60% of global query share according to industry sources, compared to Yahoo! at 25%. Over the past year, Google has picked up 10 percentage points in search share. With each new data point, Google's share seems to look better and share leads to control of distribution, in our opinion.

Intellectual Capital. The Google mystique has allowed the company to hire attractive talent away from competitors. We believe the hiring prowess Google has shown, if it is maintained, creates an obvious long-term business advantage over competitors in the sector.

Aggregation Benefits. In our view, the aggregation of distribution allows for the commoditization of content and/or inventory. Perfect examples of distribution commoditizing inventory include Dell and Wal-Mart. In the case of content, we point toward the winner take all business of local newspapers and online auctions. Advertisers (newspapers) and merchants (eBay) had to follow the aggregator which allowed for the extraction of excess margins. Google and search is the same in that the higher the search share Google controls the higher more excess margin to be extracted and the more it can operate as a monopoly (these are good things).

Impact on advertisers. There has been a lot of interest lately in pay-per-click pricing and the notations throughout 2005 from retailers that pricing was not sustainable. Given Google's market share gains, we believe retailers have to "pay to play" or risk losing share. There are pockets of inefficiency from time-to-time but, for the most part, keywords represent the clearing price for the acquisition of a customer. It is important to pay attention when all advertisers speak in unison as it can cause near-term corrections; however, the fact that Google's query share continues to increase tell us that the options for retailers are limited. If global commerce continues to grow above 30% and Google continues to take query share, the pricing environment could modestly worsen for advertisers, which could allow Google to easily achieve a 3-year growth rate of 40%.

New Products

Google has transformed itself from "just a search company" into a global network of data aggregation and product integration. While many of Google's offerings are not by themselves profitable or, in some cases, able to be monetized, we are not concerned at the current valuation. Unlike some competitors, Google does not charge users (consumers, not businesses) for its products. That burden lies squarely with advertisers. In other words, there is nothing to hold a user on its site since there is no fee associated with its use. For this business model to work, Google would need to create a site with a multitude of content so that the user would not need to go elsewhere to look for it. It is, in essence, like reverse engineering a portal without paying a fee at the gate. Yahoo's success and dominant unique user base relies on both paid premium products and free content. Google is in the position of playing catch-up to much of Yahoo's offerings, though with a (so far) very loyal base. We posit that many of the offerings may not achieve the colossal revenue growth and profits many investors speculate about; however, incremental products have the potential to bring in additional users who also click on advertisements. We should note, as we have in the past, that the advertising market is cyclical in nature, and as such, Google's revenues will likely begin to be as well as its hyper growth recedes. A proper valuation of Google incorporates the potential slowdown in growth and cyclicality of its primary industry. Below we address certain recent events/projects as well as some that we believe are key to Google's future success.

Google Finance – recently released in beta, offers stock quotes and charts, company news and corporate data. The site does not currently carry any advertisements, though it may in the future. The site does not use editors, so all information presented is unbiased.

Google Base – recently released in beta, a site where users can submit all types of online and offline content to make it searchable online. By describing attributes, users searching the database can find content based on the relevance of submitted items. Content may also be included in the main Google search index and other Google products like Froogle, and Google Local.

Google Pack – recently released in beta, it is a downloadable file that includes several software offerings. Included in the pack are Google software products such as Google Earth, Picasa, Google Desktop and others, and includes other software such as Mozilla Firefox, Ad-Aware SE Personal, Norton Antivirus, and Adobe Reader. Option software includes Google Video Player, Google Talk and RealPlayer.

Froogle – still in beta mode, the site is Google's shopping search engine, and applies the power of Google's search technology to comparison shopping. In addition to comparing online products, consumers can also use the Google Local technology to find offline stores to purchase the product. Google does not accept payment for placement within Froogle's search results, and the advertising that appears on Froogle search results pages is always clearly identified as "Sponsored Links."

Book Search – recently released in beta, users can find a book whose content contains a match for particular search terms. Click a book title and users can see the Snippet View which, like a card catalog, shows information about the book plus a few snippets - a few sentences of the search term in context. Additionally, users may also see the Sample Pages View if the publisher or author has given Google permission or the Full Book View if the book is out of copyright. In all cases, you'll also see 'Buy this Book' links that lead directly to online bookstores.

Google Video – recently released in beta, the site allows users and publishers to upload video onto the site. This is an open online video marketplace, where users can search for, watch and even buy an ever-growing collection of TV shows, movies, music videos, documentaries, personal productions and more. Consumers can also purchase or rent premium content at the Google Video store using a Google Account.

Gmail – still in beta testing. Google' email product that offers a near unlimited amount of email storage. Users can sort emails and search through them using Googles search technology. Gmail users can also chat with anyone on the Google Talk network.

Google Local for Mobile – recently launched in beta testing, it is a free download for mobile phones combining directions, maps, and satellite imagery. The tool lets users find information on mobile devices, including detailed directions, integrated search results for businesses, movable maps and satellite imagery.

Google Desktop - It's a desktop search application that provides full text search over a user's email, files, music, photos, chats, Gmail, web pages viewed, and more. By making a computer searchable, Google Desktop eliminates the need to manually organize files, emails and bookmarks.

Acquisition of Writely (UpStartle) – An acquisition with an eye towards enabling people to handle office tasks over the Internet. This move continues to fuel the speculation that Google might be looking to compete with Microsoft's software suite, a supposition that was fueled several months ago when Google began partnering with Sun Microsystems, which has an open source product, OpenOffice.

Addressing the Negatives

Click Fraud. The issue of fake clicks has made news recently, related to both driving up costs for advertisers and driving profits for third-party affiliates. As we have written in the past, click fraud does exist but its size and potential impact to the industry remains in debate. We think click fraud has the potential to be more prevalent on small affiliate sites where the incentives to cheat are significant. Noting that 45% of Google's revenue comes through affiliates and that about 30% of the affiliate revenue is from small affiliates, we can isolate the possible problem to 14% of Google's gross revenue or 3% on a net revenue and operating income basis. We believe the problem is manageable but continue to believe the psychological impact to new advertisers remains a risk.

Revenue Diversification (hint: It is over-rated). Google has been categorized by many as a one-click pony, to which we mostly agree but we believe the 60 other products that may not be monetizable on an independent basis are creating a protective moat around the core business of serving text-based advertisements. We have historically feared the lack of customer lock-in as a significant risk to Google's business. We continue to believe the lack of natural monopoly status in the core ad business is what requires the company to remain ahead of competitors in search technology and what requires the company to invest significantly in new products to create an environment in which customers do not look for alternatives. Given Google's shares of worldwide queries which is now approaching 60%, we believe the investments in the business have mostly worked to-date.

Capital Expenditures. As noted above, the lack of lock-in requires Google to invest in the business to create a more compelling user experience. The investment comes in the form of capital expenditures, of which Google spent $838 million in 2005 and we now expect in the area of $1.1 billion in 2006. The huge ramp in capital expenditures over the past two years has pushed Google's free cash flow to levels well below its cash earnings. To us, this represents a risk to the business as investors are trusting management to appropriately allocate its capital, in this case in the form of capital outlays. We do not know the breakdown of capital at Google but do know that Google is expected to spend $500 million more than Yahoo! in 2006 and $700 million more than eBay. We believe a component of capital expenditures, namely Gmail and Gdrive storage, relates to the company's "the network is the computer" mentality which, if it works could generate huge returns but in the meantime justifies a higher risk premium than the capital outlays of either eBay or Yahoo!.

Operating Expenses. We expect cash operating expenses to grow to $2 billion in 2006 and $2.7 billion in 2007, from a base of $1.26 billion in 2004. In 2005, Google added 2,600 employees to a base of 3,000. Google's model is one in which the operating costs are back-ended loaded, both in terms of opex and capex. We believe the expense ramp could be one that is misjudged, causing earnings to be lower than even our below consensus estimates.

Lack of Transparency. We apply a 10% discount to our valuation work on Google due to management's lack of transparency with investors. Should communication change, we would adjust accordingly. We should point out that we do not believe "no guidance" in and of itself justifies a discount but the environment it has created does, such as CFO comments taken out of context and material information being made public without intent.

Conclusion

Generally, we believe that Google serves as an aggregation point for commerce and information on the Internet and that new products mostly serve as the mechanism for creating customer lock-in (possibly the missing protective competitive moat). Given the 30% pullback from peak valuation and the associated change in sentiment toward Google, we believe Google represents a compelling entry point with a long-term view. We have been waiting for a bottom in the shares with the catalyst being that consensus numbers may need to be modestly trimmed. Since we now believe the shares to be a Buy, we decided to act now rather than miss the bottom. Google is an outstanding, global brand and franchise; the company is not without its risks but we believe the risks to be more than appropriately reflected in the shares. As such, we are now buyers of Google shares with a potential 27% upside to our 12-month target price (pre-S&P500).

Related:

1. More opinion and analysis of Google Inc. and its stock
2. More opinion and analysis of Yahoo! Inc. and its stock
3. Google Finance: 6 Short, Must-Read Articles
4. Founder of MarketWatch on Impact of Google Finance
5. Full transcript of Google's most recent conference call

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