Google: More Downside Up Ahead

CEO  Eric Scmidt is confident, maybe too confident. His  recent comment that Google (GOOG) was isolated from any impact of a "poor economy" might come back to haunt him.

It is certainly plausible that enterprises could pull back the reins of their internet advertising budgets. He needs to temper his enthusiasm a bit, and take more of an, "under promise, over deliver" approach to prevent expectations from  getting too out of hand. 

The law of larger numbers: GOOG has gotten big, very fast. This phenomenon makes it harder and harder to show a continued upward growth rate because your baseline for comparison keeps getting larger.

 

The company confirmed this in their second quarter 10Q filing, signifying that itss revenue growth rate is slated to decline, creating downward pressures on operating margins. The analysts earnings consensus for the fourth quarter is $5.30 which equates to a sequential earnings gain of only 10% over third quarter estimates of $4.82,  lower than the prior year's growth rate.

 

Digging into second quarter earnings: GOOG's gross margin increased only  20 basis points from 59.8% to 60%, despite a revenue gain of nearly 39%. It is indeed disappointing that a sales increase of that magnitude didn't  expand margins at a much higher clip.

 

GOOG also was aided by some non operational factors such as a decrease in its income tax rate and additional interest income. Its interest income  rocketed 136% from $58 million to $137 million, contributing an additional 25 cents to earnings in comparison to second quarter of 2007.

 

The search mammoth's income tax rate also dropped 180 basis points from 25.5% to 23.7% saving the company almost $29 million or about 9 cents in earnings.  The search leader was effective at maintaining its R&D and keeping sales and marketing costs in check, however they certainly laid an egg in controlling their G&A cost , as this component advanced more than 6% from 8.2%  to 8.8% of sales. 

Potential pitfalls:  (1) More  than 52% of GOOG's revenues are derived from international sources. The US dollar's recent rise could have a negative impact on earnings due to less favorable currency exchange rates  (when GOOG  ultimately exchanges yen or euro for dollars, it could end up with fewer dollars) .  (2) Microsoft (MSFT) and Yahoo (YHOO) could begin to gain market share  (though I wouldn't hold your breath on this one)  (3) The distressed economy could adversely affect online advertising budgets. 

Absence of guidance: GOOG's refusal to offer earnings guidance is a problem. It creates more risk than potential reward, as a disappointment typically creates  more potential downside pressure to the shares than good news offers to the upside (fear  seems to have more influence than elation). It would be prudent for Management to contemplate offering earnings guidance in the future, as investors certainly do not like being in the dark.

 

Bottom Line: Although the shares have fallen almost 40% from their highs, there is still ample risk at this juncture, and  the distinct possibility that the shares will revisit their 52 week lows near the $400 area. The expectations for third quarter earnings could be too high at $4.82, with a top line of $4.1 billion.

 

GOOG in the past, has had to beat expectations handily just to maintain its share price, as so many players tend to buy the rumor and sell the news. Wild cards such as an unfavorable currency exchange rate or an income tax rate increase certainly exist, and could negatively impact the bottom line.

 

It might be advantageous to entertain opening a short position at this juncture, especially after  the shares rallied $35 just in the last two trading sessions. The earnings results could provide an opportunity to cover your short position with a reasonable profit, and then the chance to go long.

 

Disclosure: short

Comments

[georgesconi:]

What a disgusting, lame, baseless attempt to grab at straws. I am not a GOOG shareholder but looking to become one.I have read seceral 'short' arguments for stocks...But yours is so empty and factless,you even grasp at MSFT /YHOO gaining share...And shareholders have gotten used to GOOG lack of guidance...ANd the currency issue, and the softening economy is OLD news....FACT is GOOG is still gainig market share and when people do advertise it must be with GOOG.ANd this talk of advertising slowdown is garbage...Then lets fold up althe newspapers, internet is the new medium...it is going NOWHERE...stop trying to scare people and if you do try ,do it with some merit. Yawn Yawn Yawn,you guys are tiring

2008 Sep 22 10:58 AM

[andyn:]

Please short it...I will be happy to buy it from you at $440.
It has a fwd P/E of under 20 and a PEG ratio of 0.78, even with the growth rate slowing.
In this market, nobody looks at fundamentals, everyone is a technician.
But for the longer term investors, this is a great opportunity to get in.
I see this stock above $520 before the year end, a return of 10+% with little risk to the downside.

2008 Sep 22 11:17 AM

[I_Spanked_Y...:]

Earnings guidance from Google wouldn't be much more than a guess. It is the web. They get paid on the amount of clicks. How is Google management suppose to know how many clicks they will get in the future? Their guess will be as good as yours.

You suck.

2008 Sep 22 12:24 PM

[JSMV:]

It never surprises me how defensive people get whenever an analyst downgrades a stock or suggests shorting it...

2008 Sep 22 03:32 PM

[Bob'29:]

Lets watch the Android announcement tomorrow, Tuesday. GOOG may never look back

2008 Sep 22 09:38 PM

[Sanibel:]

I plan on buying one of the Android phones because of its open operating system. Eventually the amount of software available will exceed what is available for any competitor including Apple.

2008 Sep 23 10:29 AM

[Crayon G.:]

These writers at Seeking Alpha suck. I don't hold GOOG, but this article is way off base and without solid facts. Fact: Google is becoming an 8,000 pound Internet Gorilla in the hilarious chaos of Yahoo and Microsoft through cloud computing apps (Chrome, Picasa, Reader, iGoogle, Blogger, Desktop...), gobbling up everything in sight like a giant morphing amoeba, all the while being viewed as the "Good Guys", vs. Microsoft's image of being a corporate raiding villain. Fact: MSFT is scared sh*tless of GOOG, as evidenced this past year. Google is aiming for MSFT's prized jewels of internet and office apps, and it seems like they have quite a good chance of harpooning Ballmer's dinosaur and, with help from Apple and Salesforce, taking it down for the count.

2008 Sep 28 11:59 PM