Google Looking Toppy Over Profitability Concerns

Sep. 5.12 | About: Alphabet Inc. (GOOG)

Ticker: Google (NASDAQ:GOOG)

Rating: Maintain at Hold

Price Target:

Click to enlarge

We see Google as priced fairly at this point, and that the company's ability to maintain such strong profitability levels will be limited by several aspects. First off, we believe that recent litigation surrounding the Apple (NASDAQ:AAPL)/Samsung case will be a negative for Google and Android capability to gain market share. The positives for the company is that Chrome has a strong ability to gain more market share in the tablet/PC market as well as the mobile market, but again, we see that being more hindered now than before the Apple/Samsung case.

The company recently acquired Frommer's, which will help them compete with the likes of TripAdvisor (NASDAQ:TRIP) and add more travel aspects to their business line. Additionally, we believe the company's Product Listing Ads (PLA) are the way of the future for the company and will have higher click-through rates.

Yet, we see snags for the company that are keeping our valuations in check. We do not believe that Google+ will be able to develop into a major cash cow. The company is trying to add aspects to Google+ that give it a similar feel to Salesforce (NYSE:CRM) Chatter, which is great. Yet, users remain low for +, and all these great moves mean nothing if that usership does not increase. While there are supposedly 100M members, the site is a desolate ghostland. Average posts have less than +1, and 30% of people who make a public post never make a second. These stats are according to RJ Metrics. The Motorola Mobility move does not add a large amount of profits (lack of patents, loses money). Further, the company's valuation is coming back to normalcy. Future PE is 14 and PE is 20. We see some slight value in the future PE, but our expectations are lower than most analysts for next year. For now, we still believe the company is pricing about where it should be.

Outlook:

The company did not provide any outlook in their latest quarterly earnings. We are expecting 15% growth in operating income in 2013, and we believe that the company looks well positioned for the rest of the year to meet or beat expectations. The problem we have with the company is that moving into next year, the market we believe is expecting too much for the company. Margins have been consolidating due to lower click revenue as well as Motorola acquisition. Yet, we do not believe that Motorola offers a significant income cow, and it will be a drag on margins over time.

Profitability:

Margins have declined for Google in 2012 so far, and they are even more significantly below the 2011 FY. A lot of this margin decline is due to Motorola Mobility obviously, but the question we pose is when will MMI be able to produce margins at levels that the rest of businesses are able to produce. Based on history, we do not foresee that happening with the current business model of Motorola. Therefore, we believe lower margins may be a thing of the future. Additionally, PLAs produce lower margins as well than current ads. If profitability slips, that will hurt the stock, and right now, most see it as temporary.

Value:

Google does have some value at current levels, but we believe that the market is not effectively pricing in margin declines into future PEs. Typically, the internet information provider sector is often a bit more expensive due to such high growth levels, and that sort of premium could be expected in GOOG. Though, the company may have killed that potential with such a large amount of shares outstanding. New, high growth stocks with 50M shares or less outstanding have a much higher PE than the same high growth stock with 300M+ shares outstanding. All in all, there is value here, and we do see some slight upside to fairer pricing.

Growth:

Google ranked 4th out of 12 companies for growth in the Computer Hardware/Software EquityAnalytics sector behind Apple (AAPL), Equinix (NASDAQ:EQIX), and Fusion-IO (NYSE:FIO). Google is a very strong growth stock, and that is definitely very appealing. Yet, we believe that some of the growth is going to temper with the mobile market shifting and the company betting on a lot of growth out of new ventures that are unproven like Google+ and foreign markets. If you are buying GOOG, you are buying growth for sure, but understanding growth is just one part of this company along with value, profitability, and market share is important to remember.

Financial Health:

Google ranked 3rd out of 12 for financial health, and that is another plus for this company. They have a solid balance sheet with fairly low levels of debt as compared to revenue. Their current ratio at 3.8 is very strong, and we actually see the move from 5.9 to 3.8 as good because it means the company is increasing liabilities and making investments. The problem, though, is that we are not a fan of the investment they made. The company does have a very low debt to equity ratio as well, which is positive to see.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.