Google (GOOG) has dramatically underperformed the market over the last year owing to disappointing revenue growth in early 2019, as well as regulatory fears keeping a lid on the stock. While an FTC investigation appears far reaching and intense, the story with owning Google is simple: even if regulators add huge fines and force a breakup of the company, there is substantial upside to the share price. Furthermore, as governments around the world continue to regulate Google’s businesses, they unwittingly create an even larger moat for GOOG, keeping smaller competitors at bay. Google is a dominant force in search, with years of growth potential ahead of it.
Recently I have screened through roughly 5000 companies, looking for the best of the best, the top 2% of stocks worth owning. These are earnings compounders, names with high free cash flow margins, solid management teams, good balance sheets and a healthy margin of safety. Google fits perfectly into this bucket, particularly given its recent underperformance and its phenomenal track record. Indeed, the stock is flat in the past year (even after its recent run), versus the S&P’s 10% total return. This is true despite Google’s impressive earnings per share growth of 26% last quarter.
Below I examine each of Google’s businesses and argue why either the break-up value or the consolidated value of GOOG is worth upwards to $1500 - $2000 per share.
Source: Author spreadsheet
Note: Google reported Q2 earnings just as I was writing this up. I used a $1200 per share stock price. The Class A shares (GOOGL) have one vote per share and the C shares (GOOG) have no vote. They trade quite close together.
Everyone is familiar with Google’s core businesses. In that space, few can argue that Google isn’t the best. Per the company, Google’s core business includes the following:
- Android – operating systems for mobile devices, with an installed base of 2.5BB smartphones.
- Chrome – Internet browser with 5BB downloads and 54% worldwide internet browser market share.
- Google Drive – online storage business with over 1BB users.
- Google Maps – a free app with tremendous potential.
- Google Play – online app store for Android with over 1.5mm applications available.
- Search – advertising revenue generated from either clicks or simply brand advertising.
- YouTube – an incredible business that even Netflix’s Reed Hastings envies.
- Others such as Google Assistant, Google Lens, Google Cloud Platform (including such tools as Google Docs which alone has 500mm users), and Google Photos.
Apart from the core Google businesses, there are also the (sometimes controversial) Other Bets. These are startup/emerging businesses that haven’t become cash flow generators yet. While many deem these as “pet” projects of the management team, there unquestionably is value here.
Waymo, the self-driving car business is probably the best known Other Bet. Nest and Verily also fit in this bucket. Verily raised a cool $1BB late last year from Silver Lake. Google booked a huge gain last quarter from its Lyft stake, so there likely is intelligent investing at work here.
While many view Google as a technology company, the business model is really advertising driven, with over 85% of 2018 revenue driven by ads. Perhaps surprising to some, online advertising is anticipated to finally eclipse traditional advertising in 2019. According to emarketer.com, digital ads will grow 19% in 2019, making up 54% of total US advertising spending. Google controlled 38.2% of digital share last year, with Facebook in second at 21.8% share in 2018.
The 3 year projections looks equally impressive (link):
That equates to 17% growth per year from 2018 through 2021, and cumulatively 59% growth in 3 years. I expect Google to at least maintain market share, which has been the case the past couple of years.
Sum of the Parts
To cut to the chase here, while Google’s core advertising/search business will likely grow at these type growth rates, the YouTube business is just starting to become monetized (via YouTube TV and advertising within videos). Just a few key notes on YouTube:
- 2 BILLION monthly users
- 500 hours of content uploaded EVERY minute
- Most downloaded app last year
- A BILLION hours of content viewed per day
- YouTube alone reaches more US consumers a week than all of the cable companies COMBINED.
Revenue has never been broken out by Google, and with the recent launch of their premium service, it’s too early to really gauge much. But with 1mm users, and growing at 60% according to this, it is fair to say that a Netflix type multiple of revenue is a minimum value. Here is more reading on what a handful of analysts think YouTube is worth.
If revenue is approaching $15BB, then a 6-9x multiple (Netflix is 8.5x), seems quite reasonable. From a profitability perspective, again Google doesn’t break out revenue or EBITDA/profits. But generally speaking there are more costs on the YouTube platform than in the core search business. Royalty costs (50% of revenue is paid to those who upload content), huge bandwidth and storage costs also eat up margin.
With overall company EBITDA margins around 30%, it is probably safe to assume that YouTube runs in the 20% range or lower. Below we assume that level of margin, and back that out of core business cash flow.
So gives us 4 components of value: Cash on the balance sheet, YouTube, Core Search, and Other Bets.
To figure out the Core Search cash flow, I backed out YouTube estimated cash flow, as well as Other Bets cash flow.
These are runrate figures from their June 2019 quarter.
This $41.81 is essentially my estimate of GOOG’s EPS from its core search business excluding YouTube. I think using D&A as a proxy for maintenance capex is fair. Total capital spending looks like $22BB on a trailing twelve month basis, which I assume is for a variety of growth projects (to add capacity for YouTube, Other Bets, Core Search). Management suggests about 30% of capex is related to property growth, and 70% related to technical infrastructure (computer, storage and networking equipment).
Net net, though, Google is a fantastic free cash flow machine. They generate 30% plus EBITDA margins and operate a diversified array of wide moat businesses that appears infinitely scalable with limited incremental capital.
There is a reason they have over $100BB on the balance sheet today, a mind boggling figure.
Here is a view of the sum of the parts, and how it can grow dramatically over the next 2-3 years.
With any patience whatsoever, this stock looks like one with minimum downside. In fact, should numbers fall, my downside scenario is roughly $1000 per share.
On the plus side, using these figures I get a valuation range of up to $1800 per share in 2021, upside of over 50% in a couple of years.
Not to sound like a Ronco TV commercial, but wait, there’s more!
Waymo, the self driving car business, could be worth anywhere from $25 to $125BB according to UBS. Morgan Stanley suggests a $40BB valuation (link). That’s another $35 to $175 of per share value.
Even more interesting are the hidden assets of Android/Mobile Apps and Google Maps. Android has incredible market share, with 88% of smartphones running it. Of the 1.56BB smartphones sold in 2018, indeed 86% were equipped with Android. Given the European ruling last year, Google will begin charging European phone companies for the use of Android/The Play Store and other applications.
The only catch: GOOG will have to separate out Google as the default search engine on these new phones. But my bet is that users will continue to use Google Search regardless. There is no other search engine that can compare. (When I get stuck on my Apple with a Yahoo search, I can tell immediately, and switch back to Google).
In any case, should GOOG eventually charge say $10 per user to license Android and its apps, (a small amount compared to the several hundred dollar phone price tag), then an incremental $13BB in FCF could flow into the company. Assuming some lost search revenue of $3BB, that still equates to $10BB of incremental annual cash flow. These are speculative numbers no doubt, but I am convinced management at some point intends to monetize Android.
At a simple market multiple (17x), that is a$170BB of incremental value, or $240 per share. Adding Waymo (say $50) and Android (say $150), and our $1800 per share value would total $2000 looking out to 2021/2022.
Using 2020 numbers for the shorter term holders out there, still gets me:
Finally, Google Maps also has advertising potential. Small ads placed on a map for gasoline stations or food could also be a huge source of revenue. The technology for Maps is quite amazing, with the company adding features such as bus/train delay information, navigation warnings and enhanced traffic updates.
Regulatory Concerns / FTC Antitrust Review
Certainly US politicians seem to have found their latest populist whipping boy. While my view is that Google probably has done more for education and the democratization of information than any other company in the world, politicians are clearly eager to regulate it and perhaps even break it up.
The FTC has recently launched an anti-trust investigation of Google, and likely to subpoena the company about its business practices. Here is a link to documents filed to date.
First of all, anti-competitive concerns seem hard to gauge. Android was free. Google searches are free. So are Google Docs and Gmail and billions of hours of TV programming. Advertisers have plenty of ways to buy ads. Searchers have multiple other means of searching the web. While in theory Google can manipulate search results to show their own shopping sites first, Google has already in many ways addressed these concerns (ads are highlighted, Google sites separated).
But the government is essentially the mafia. They can and will do whatever they want. Break-up worries are a non-issue in my book. As I outlined above, the sum of the parts here is quite high. Should they force Google to break up and send YouTube and Android packing? There might be some overhead costs that would be incremental to the story, but selling YouTube ad space probably is quite easy to do independently from Google. A breakup scenario is a positive, perhaps even a home run.
The more likely outcome is that Google will face fines of some kind, as well as incremental compliance costs and monitoring costs on uploaded YouTube videos (that may contain hate speech or extreme violence). Search results likely will have to exclude Google Store or other Google managed sites. Seems fair to allow competitive ecommerce sites a fair search result.
In the end it probably will be a long drawn out litigation, with an end similar to Microsoft. Microsoft was sued by the Department of Justice and 20 state attorneys general in 2001. Bundling Office and their Internet Explorer was deemed anti-competitive. Remember Netscape? While the original judgment ordered a breakup of Microsoft, on appeal they settled so as to keep their businesses together. Office today includes Explorer, but other browsers are readily downloadable. In the end, I think it was the right outcome.
With Google, the bundling of Chrome/Search with Android seems the only real corollary. The European Commission has already filed two separate anti-competitive claims against Google: one in 2010 that ended up with Euro 3.9BB in fines, and another with Euro 4.3BB of fines imposed in 2018. There were accusations of placing Google store ads too high in search results. Search results now exclude Google sites/stores.
The total European fines, approximately $10BB, were incurred over 8 years. It probably will be higher in the US, so I assumed $15BB in our analysis. Importantly, I see little real impact to their fundamental story.
Perhaps a bigger risk to the story is multiple compression and disappointing financials. In the March quarter revenue “only” grew by 17%, or 19% excluding currency impacts. Given several quarters above 20% topline growth, and coupled with privacy concerns, the stock sold off dramatically.
The June quarter was solid; however, the second half is in question as worldwide economies slow and margins face pressure as the company intends to ramp up hiring. YouTube and Google Web Services were quite strong and helped growth in Q2, but at some point any maturing business will see growth moderate.
In any case, the long term story is still very intact even if growth drops 5 percentage points, or into the mid teens. Google search and YouTube are fantastic businesses that throw off piles of free cash flow. Management has quietly built an empire of assets unrivaled. Don’t forget, Larry Page and Sergey Brin bought YouTube for $1.65BB in 2006, a paltry sum considering its worth today. They prefer to stay behind the scenes, and given their success, I hope they can continue to be quiet but smart allocators of resources.
And finally, Google’s earnings track record is also quite incredible. EPS has compounded at 20.7% over 10 years, and 19.3% over the last 5 years.
Below is a graph of their EPS since 2006.
Source: Author spreadsheet and Street estimates for 2019-2022
And to simplify the story, if investors simply believe that consolidated EPS of $75 per share is doable in 2021, just a mere two years away, then excluding the cash, you are buying Google today at 12.2x earnings. Should it continue to garner a 20x multiple (one of the lowest among the FAANGs), then adding in cash gets me a valuation of $1738 per share, upside of 45% in 2 years.
The downside case, with a little patience, seems pretty conservative (assuming only 5% EPS growth for 2 years), at a market multiple. The math is below:
Source: Author spreadsheet and estimates
The company recently put in place a $25BB stock buyback program. While many argue that buybacks are some kind of artificial financial engineering, the reality is that, when a company’s shares are cheap, buybacks can be an intelligent means of allocating capital.
Competition. Facebook and Amazon are fierce competitors. Other search engines (e.g. Bing, Yahoo) could also develop better or newer search algorithms. YouTube competes with dozens of broadcasters, cable companies and streaming services from Hulu to Netfix to Comcast and Disney.
Regulatory Oversight, Fines. I have factored in a range of regulatory fines. Other impacts however could include additional compliance costs, artificial intelligence development costs, or monitoring costs that could impact margins.
Recession. Ad spending is cyclical, and while Google posted solid growth throughout the Great Recession, given its more mature business model a slowdown is more likely this time around.
Stock Based Comp. Google pays a large amount of compensation in the form of equity to its employees, to the tune of $10BB on a trailing twelve month basis. That’s about $10 on a per share basis after tax.
Other Bets / Hardware. These businesses make little money today, and will likely continue to burn cash. Ruth Porat hired in 2015 however is an excellent CFO, and keeps a careful eye on this segment.
Currency. Most of Google’s costs are in US dollars. With 54% of revenue generated overseas, movements in foreign currencies can translate into less revenue and lower margins on a USD basis. It has been a 2-3% revenue point headwind for several quarters.
Lack of Disclosure. The company does not disclose segment data apart from Google and Other Bets. Our estimates for YouTube are based on primarily on analyst estimates and news stories and other estimates linked in this article.
I’m planning to launch a Marketplace service soon, entitled Free Cash Flow Compounders: The Best Stocks in the World. This service will utilize my 25 years of professional investing experience and is the result of my screening of over 5000 stocks in search of the highest quality investment opportunities at the best entry points possible. These are high return on equity, high free cash flow stocks with a proven track record in compounding earnings at higher than market rates. Keep your eyes open for that and direct message me if you’re interested!
Disclosure: I am/we are long GOOG. 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.