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  • The Reflexive Long Case for GOOG
    The Market Price. Going long Google is a scary proposition. At a mkt cap of $183b, it ranks as the 12th most valuable company listed in the United States, and I believe that number does not even include its Class B stock, which, bearing the same economic rights and 10x more voting power than the Class As, tacks on at least another $42b to the ethereal market valuation. The A stock’s highest ever trade was $714.87 back in Dec 2007, a 39% upside to present, while as recently as Nov 2008 it traded at $262.48, a 54% downside.


    The Underlying Trend and Prevailing Bias. But look at what has happened to earnings since then:

    Normalized since Dec 2005 (it listed in Aug 2004 at a first-day price of $109), earnings have gone up 4.5x, and they stand about 2x higher than in Dec 2007 (the high) and about 5x higher than Dec 2008 (the low). Meanwhile, P/E has descended from happy times (listing at 154.29) to the present stoicism (hitting 19.32 in Jun 2010). This isn’t exactly textbook Soros analysis: his original essay compared price per share to earnings per share, implicitly referencing P/E ratios as his “prevailing bias” (I was unable to chart this as the share price is just too high). Well, the prevailing bias is near historic lows, on a downtrend, while earnings are at historic highs, on an uptrend. This places us in either the C-D (good)  or the F-G (bad) region of Soros’ famously inscrutable analysis. Stock prices will affect earnings if there is a reflexive connection, which begs the question:

    Where is the Reflexive Connection? For a true boom and bust pattern to exist, Soros  insists that “stock prices must have some effect on the fundamentals”. Google makes cash acquisitions, and does not do stock buybacks or dividends. However, it does issue stock and options to employees, a fact of which it is very proud: “All of Google’s employees are also equityholders, with significant collective employee ownership.”  Disclaimer. I will be the first to admit that I am no accountant, but the purpose of the following examples is to illustrate the possible reflexive connection. The High Pay Effect. Stock-based compensation was at $1.1b or 4.9% of revenues in 2009, for which it received tax benefits of $264m.  This adds an average $50,000 to each employee’s total remuneration on top of its anecdotally comfortable cash salary, and that is only according to Google’s accountants. We cannot truly know the total remuneration of a Google employee as it includes the range of benefits available at the legendary Googleplex, as well as the final cost to the shareholders upon exercise of those options which may well differ from the booked cost, which reflects expected cost at the time the options were granted. The Exchange Effect. Google allowed its 2004 Stock Plan employees to essentially “trade-in” their options, at an average strike of $507.74, to receive new ones with 1 year longer expiration at a lower strike of $324.17. Up to 8.5 million shares were “traded-in” in this manner – ignoring the 1 year extension, this move was worth as much as $1.55b. Yet only $360 million of “modification charge” is to be recognized over the next 3 years for this.Conclusion – Google will continue to pay its people massively well so long as the market values their work well, and costs to shareholders will continue to be understated as long as present accounting policies continue.

    The Flaw. Quote Soros: “There is bound to be a flaw in the participants’ perception of the fundamentals… Knowing what the flaw is, how, and when it is likely to manifest itself are the keys to understanding boom/bust sequences.” Here I present two possible ideas for how the participants’ bias may be flawed. Terrible acquirers. Google recorded a $1.09b impairment charge due to its investments in AOL and Clearwire in 4Q08. That’s it, but those are just the impairments Google has seen fit to record. As the recent 10K says, “We have yet to realize significant revenue benefits from our acquisition of YouTube.” Business Sense? Google’s engineers have developed an incomprehensible mass of freemium services that go from the immeasurably useful (Gmail, Reader, Groups, Maps) to the unmonetizable (Android) to the not so successful (Checkout and orkut) to the just plain weird (Google SketchUp, Google 3D Warehouse, and Google Building Maker anyone?). Aren’t there diminishing returns to Google’s famed 20% time? Conclusion – I do not dare underestimate the ability of Googlers but the simple truth is that Google has exploited all the low hanging fruit of internet services and is increasingly having to grow by acquisition (e.g. Groupon) or face unassailable competition (e.g. Facebook). This doesn’t mean it will be unsuccessful at doing so, but it does mean it will be increasingly harder to replicate past eyeball growth. The valuation of its Groupon proposal was also questionable, and Google has not put itself past dilutive share issuance for acquisitions in the future.

    Long Google – for now. However, I do not believe earnings growth is under threat. Earnings growth is indirectly a function of eyeball growth, but is primarily moved by the ongoing “internetization” of our commercial world, of which Google remains king. Google is decades ahead of any other internet ad service in providing liquidity andprice-discovery for its ad services through its Doubleclick exchange. Operating margins are at 35.86% and rising, on revenue growth that has declined from the heady 100%s of 2004-2005 but still remains above 20% for this Internet giant. The observed fall in P/E from 154 (IPO) to 23 (now) represents a downshift of the company from growth stock to blue chip, but I would be happy to own this high-growth “blue chip” at its current 4.3% earnings yield given the low yield environment everywhere else, and the potential for the prevailing bias to recognize at least some of Google’s remarkable EPS growth. Yet, I have spent more than half of this essay detailing the cons of investing in Google, which must eventually come open in a time of reckoning – just not yet.

    Disclosure: No positions

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
    Tags: GOOG, Internet, Search
    Dec 05 4:19 AM | Link | Comment!
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