Don't Ignore These Red Flags For Google

| About: Alphabet Inc. (GOOG)

Google (NASDAQ:GOOG) had a nice run this year. At current levels, it is trading at a multiyear high since hitting $700 in 2007. It is currently up by 29% for the year. It's obvious that the market is enthusiastic regarding Google's prospects over the next few years.

I believe that the historical financial performance of the company has a lot to do with this. For the last five years revenues have grown by 23% a year. This translates to five-year average pretax margins of 31.5% for the same period. This is effectively higher than the previous years' average of around 25% to 30% operating margins. If you look at closely at the company's cash flows, free cash flows have also grown from $2.14 billion in 2004 to $34.10 billion in 2011. This is an increase of 298% a year for the seven-year period. This also translates to massive wealth creation for its shareholders. This equates to average return on investment of around 24%. While this is quite high for any U.S.-listed company, the downward trend of its returns is visible.

Competition Will Dampen Future Returns

The biggest driver of Google for the coming years will be its mobile revenues. It is currently in the process of creating an ecosystem that will match Apple (NASDAQ:AAPL). Moving forward, I expect to see Google and Apple dominate the mobile industry. As of now, this ecosystem is already present with the Android platform. But Google's main driver will be its advertising revenues rather than its hardware sales. I believe this is the reason for the market's optimism in Google as it moves to increase its revenue per search.

Based on the forecasts of research firm Cowen, mobile revenues grew from 3% of total revenues in 2010 to 7% of total revenues in 2011. It estimates that this percentage of revenues will double to 13% this year. These estimates are based on the surge in smartphones and tablets for the year. Over the long term, Cowen predicts that the mobile market will be a $20 billion business for Google, which already represents 26% of its total revenues.

In my view, there are some obstacles to these assumptions. Apple has won a U.S. case against Samsung, which resulted in an outright ban on sales of key Samsung products and will cement Apple's dominance in the mobile market. Given that Samsung is the largest Android partner, this will put a dent in its future plans. The result will be customers either buying iPhones or Microsoft (NASDAQ:MSFT) Windows-based phones. Also, Amazon (NASDAQ:AMZN) has recently announced that Microsoft's Bing will be the default search engine for its Kindle Fire tablets. This will boost Bing's presence as a search engine for mobile as consumers will recognize that Google's superiority in the search engine space is based on familiarity rather than search quality. Having said that, I believe the markets expectations of Google's mobile revenues appear too optimistic. It is true that the Android ecosystem will be a dominant player in the mobile industry in the future. Despite this, the market needs to discount potential factors that will drive Google's mobile revenues lower.

Google's PC search revenues are still expected to produce steady cash flows. However, the increased usage of smartphones and tablets will result in lower PC search revenues in the long run. Google is also facing real competition from social media giant Facebook (NASDAQ:FB). In a recent Businessweek article, it said that Facebook is doing a better job than Google based on the Triggit report. It noted that Facebook Exchange generates four times as much return on the ad dollar than other real-time bidding platforms. Facebook introduced real-time bidding in June as it competes with advertising giants like Google and Yahoo (NASDAQ:YHOO). The Facebook bidding platform is expected to lure advertisers away from its competitors.

Another firm, Adroll, said that advertisers are getting $16 for every $1 they spend from the Facebook Exchange. This will definitely create a boost for Facebook. The market is concerned about the company's ability to generate sales from its massive number of users who are active on smartphones and mobiles. Moving forward, this could have an impact on Google's overall profit growth, although it may take a few years to show a significant impact.

Meanwhile, other Google products and offerings are also seeing increased competition. For instance, Gmail could see lower growth in the future as Microsoft and AOL (NYSE:AOL) attempt to attract more users through an interface redesign. Also, YouTube is facing increased competition from Vimeo, a new entrant in the uploaded video space.

Overall, these factors will contribute to lower return on investment for Google. It should be noted that its returns in the recent years have slowed down. This suggests that the technology giant is facing increased competition on its core products.

Rally Should Take a Breather

The stock is currently trading at 21 times earnings, lower than its five-year average 30 times earnings. It also trades at 3.6 times book and 14.7 times cash flow value. On a price-over-growth ratio basis, the company trades at 1.1 times. This seems low as the market has optimistically forecast Google on double-digit growth.

In contrast, Yahoo trades at 12.6 times earnings and 1.5 times book value. In my view, this appears high as Yahoo is facing significant headwinds from strong competition. It also lacks clear direction on how it will position itself for the next five to 10 years. Moving forward, Yahoo's earnings multiple is expected to compress.

Facebook is valued higher at 34.5 times and 3.5 times book. On a price-over-growth ratio basis, it trades at 1 times. This implies that the current valuation of Facebook appears reasonable. But it should convince investors that it has solid plan on its mobile revenues and could catch up with Google's market share.

At current Google stock prices, it implies an earnings growth of 15% a year. This is in line with consensus five-year earnings estimates. Thus, it is safe to assume that the market has fairly valued Google at these levels. The downside is that the market has yet to capture these negative factors that will result in lower valuations in the future.

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.