Google: Strong Results; Maintain Buy
• We rate shares of Google Buy with a $500 target price, up from $435 per share prior to the results. Our target valuation is based on 40x 2007 cash EPS or a 1X PEG ratio on a conservative 40% rate of growth.
• To us, the most interesting metric in the quarter was the breakdown of domestic vs. international growth. On a sequential basis, gross revenue grew by 17% with 30% growth in international markets and 9.5% in the U.S. In 4Q05, the growth was 22% of which international was 19% and domestic was 24%. Our guess is that the company both corrected the issues it was having in the UK in 4Q05 and also had very strong monetization improvements generally in international markets.
• Google's net revenues of $2.25 billion, above our estimate of $2.14 billion. Diluted cash EPS of $2.29 came in above our $1.90 estimate.
• Gross margins improved slightly to 60.0%, up from 59.6% last quarter. Net margin was sharply up sequentially from 28.9% to 38.7%. Google's effective tax rate of 27% was slightly below expectations of 30%.
• Our 2006 cash EPS estimate is $9.43, up from our previous estimate of $8.57, and our 2007 cash EPS estimate has been raised to $12.63. Our 2006 and 2007 revenue ex-TAC estimates are $6.88 billion and $9.71 billion, respectively.
As we look at our updated financial model, we notice that we are expecting Google to now generate more than $14 billion in gross revenue in 2007. This is a business that in 2003 generated less than $1.5 billion in gross revenue. The numbers, honestly, are at times unfathomable for us. If the acquisition cost of a customer through Google is 7%, this means that Google will indirectly facilitate more than $200 billion in commerce online and offline in 2007. Globally, commerce on the Internet amounts to more than $350 billion. We are well aware that those receiving traffic are not always interested in an immediate transaction and this is most relevant with traditional retailers who have an incentive to drive traffic to a Web site which may turn into an online transaction. We know that the U.S. advertising market approaches $300 billion and globally the number is between $700 billion - $800 billion, suffice it to say that the market opportunity is quite significant. The question we have constantly struggled with in Google is, "how big can this thing get?" We do not have a good answer for the question but what we do know is that in the just reported quarter the company reported net revenue growth of 93% YOY, gross profit margin of 88%, EBITDA margin of 65%, and a cash operating margin of 58%. The company will generate more than $4.3 billion in EBITDA in 2006 and more than $2.5 billion in free cash flow. On 2007 estimates, Google now trades for 32x cash earnings while we expect free cash flow growth over the next three years to exceed 40%. We try to be conservative with our expectations for Google's non-search business but the current growth includes very little monetization from new areas such as video, local, wi-fi, mobile, etc. There may be a day when the previously stated question needs to be answered but it is not today and, as such, we are reiterating our Buy rating and raising our target price to $500 or 40x 2007 cash earnings.
To us, the most interesting metric in the quarter was the breakdown of domestic vs. international growth. On a sequential basis, gross revenue grew by 17% with 30% growth in international markets and 9.5% in the U.S. In 4Q05, the growth was 22% of which international was 19% and domestic was 24%. Our guess is that the company both corrected the issues it was having in the UK in 4Q05 and also had very strong monetization improvements generally in international markets. Separately, from this data, we believe that Yahoo! had a very strong quarter versus Google in the U.S. market while Google continues to dominate markets outside the U.S. Given that the monetization of users has historically been much lower outside the U.S., we believe there is continued opportunity for Google in that area.
Google reported 1Q06 gross revenues of $2.25 billion with growth of 79% year/year and 17% sequentially, and $1.52 billion on a net basis. TAC accounted for $723 million during the quarter and represented 32% of advertising revenues. We had estimated gross revenues of $2.14 billion and net revenues of $1.41 billion. The effective tax rate in the quarter was 27%, slightly below management's previously announced expectation of 30%. GAAP EPS for the quarter were $1.95, or $2.29 on a cash basis. We had estimated $1.90 in GAAP EPS for the quarter and $1.68 on a cash basis.
Income from operations on a GAAP basis was $743 million.. Adjusted EBITDA in 1Q06 increased 24% sequentially to $998.6 million and amounted to 44% of revenues. Net Income on a GAAP basis was $592 million and was $697 million on a cash basis. Ex-TAC profit margin was 88.3%, down about 40 basis points sequentially. In the first quarter, the charge related to stock-based compensation was $115 million as compared to $58 million in the fourth quarter. As a percentage of revenue, sales and marketing decreased from 8.1% in 4Q to 7.8% in 1Q. Other cost of revenues, which is comprised primarily of data center costs, operational expenses including depreciation expense as well as credit card processing charges, increased to $181 million or roughly 8% of revenues. Other expenses include a charge of $30 million related to management's estimate of plaintiffs' attorneys' fees expected to pay to settle the Lane's Gifts class-action suit, which was excluded from non-GAAP results.
Revenue from international operations was $936 million, an increase of 38% over the prior quarter. International revenues contributed 42% of total revenues, compared to 38% in the fourth quarter of 2005 and 39% in the first quarter of 2005. Foreign exchange rates had an immaterial impact on sequential international revenue growth.
Google-owned sites generated $1.3 billion, or 58% of total revenues, and increased 18% sequentially. Google also benefited from favorable traffic trends during 1Q, as well as continued gains in monetization. Google network revenues, generated through the AdSense program, contributed $928 million, or 41% of revenues, and increased 16% sequentially and were also correlated with increased traffic and gains in monetization. International revenue accounted for 42% of total revenues. Revenues from the UK were $343 million or 15% of revenue, up from 14% in 4Q. According to management, the UK, France, the Netherlands and the Nordic region all exhibited particular strength in both traffic and monetization. The UK also benefited from an expected rebound in the travel and finance verticals in the quarter.
Operating cash flow in 1Q was $825 million and capital expenditures for the quarter was approximately $345 million. Free cash flow increased by about 24% year/year to $480 million.
Cash and equivalents at the end of the quarter was approximately $8.43 billion. This amount does not include the $1 billion investment in AOL in early April 2006, nor does it reflect the $2.07 billion raised in the offering that closed in early April as well.
Other highlights during the quarter include:
• Days outstanding were 34, up from 33 last quarter
• G&A increased sequentially to 8%
• R&D spending as a percentage of revenue increased slightly to 11% from 10% in the prior quarter
• Employed 6,790 full time employees as of March 31, 2006, up from 5,680 as of the end of last quarter
Outlook and Conclusion
Although management does not give guidance, they mentioned that the effective tax rate for full year 2006 should be approximately 30%. For the full year, management expects stock-based compensation charges for grants to employees prior to April 1st of 2006 to be roughly $370 million. In addition, management noted that Google has historically encountered seasonality, and as such, 2Q and 3Q typically have slower revenue growth. This trend is expected to continue.
Our 2Q06 cash EPS estimate is $2.14, with net revenues of $1.6 billion. We expect a 2Q net margin of 36.2% and an ex-TAC profit margin of 87.4%. Our 2006 cash EPS estimate is $9.43, up from our previous estimate of $8.57, and our 2007 cash EPS estimate has been raised to $12.63. Our 2006 and 2007 revenue ex-TAC estimates are $6.88 billion and $9.71 billion, respectively.