A consistent business with 27% growth does not sell without a premium often. Especially considering that both Google's owned sites are growing at a 32% rate while Ad-Sense, the highly coveted ad serving application, grew at just 19%. These numbers come from the recent 1Q report which caused a 8.5% drop in share price. The most important statistic to me from the entire report was the "Cost-Per-Click" (NYSE:CPC) growth of 8% year-over-year. Although there would seem to be some concern about a 1% decrease in average CPC from 4Q 2010 to 1Q 2011, I believe the decrease is more associated with a greater demand for advertising in general during the 4Q for any year as opposed to any other quarter. A trend in CPC growth quarter-over-quarter confirms my suspicion which would seem natural due to the Christmas Season.
When reviewing the fundamentals we notice a few things immediately:
- They have $36.7B in cash and marketable securities!
- Google seems to be able to generate $7.5-10B in FCF while expanding at 20%+. This estimated range considers the annual performance over the last 3 years, margins for those years, and revenue growth. In the end it is only an approximation.
- They own a commanding market share in online advertising that provides large return on equity well above average and huge pricing power. Number 3 will become very important in times of inflation when Google earns real returns on equity and inflation becomes rapid share appreciation.
One thing I like to confirm is that Retained Earnings are growing at roughly the same rate as FCF. In this case, FCF is $2.3B and Retained earnings growth is $2.3B for the 1Q. This means that the FCF is a trust worthy statistic. $2.3B in FCF annualized becomes $9.2B and fits nicely in the range described. This consistent FCF is one of the main things Warren Buffett (and all value investors) look for. Coupled with CPC growth of 8% year-over-year when inflation is approximately 1-2% is very impressive. Warren Buffett once stated that he bought Coca Cola for 16x earnings (which he believed to be undervalued) because they were consistent earnings with growth potential (emerging markets for Google has lots of room for growth). He also stated that Coca Cola can raise prices every year by 6% which is higher than the average rate of inflation for the past century and a half in America. Google is raising prices by 8% and they have been raising them anywhere from 7-11% for years (outside of 2009). Number 1 states the cash balance of $36.7B which is staggering in comparison to just $11.7B in total liabilities. A current market cap of $170B gives an Enterprise Value of $145B. Therefore Google is yielding 9.2/145 = 6.34%. I use a Discounted Cash Flow model for 20 years which is too long of a time period for me to feel comfortable giving a 20%+ growth assumption. I used a discount rate of 10% so for the following growth rates I got the corresponding present values
8% - $575 (8% appreciation)
10% - $627 (18%)
12% - $687 (29%)
15% - $791 (49%)
20% - $1014 (91%)
Currently the market is projecting 6% growth compounded annually with a 10% discount rate (30-year Tresuries). The growth projections become exceedingly worse when you use discount rates that better approximate the current 30-year Treasury. I believe a 12% growth rate is very probably for Google considering the multitude of sources they have to grow additional revenue on top of their AdWords juggernaut. A 12% growth rate discounted at 10% just so happens to provide a 25% margin of safety on the purchase (better than the 15% Warren Buffett got on Coca Cola) and is the reason I have decided to write this article.
How safe are these cash flows? If Google loses their large market share in search (likely to Bing of all current search engines) then their cash flows will no longer be safe nor as robust. I believe standard internet searching should include Google for the forseeible future. Mobile search and the rise of applications likely constitutes the main risks for Google moving forward. Luckily, Android has already turned into a $1B+ revenue stream annually. All Andoid systems default search with Google and use a pleathera of Google apps (such as maps, books, compare shopping, and every imaginable app). As of July, 2010 there was over 100,000 apps on the Android and I can only imagine the number has increased significantly since. I believe investments in android, google docs, and a number of other "free" services cannot be valued in dollars. They are the depth and width of the "moat" we call Google Search. The more information that individuals seek through Google's network the greater profits will be. Some current projects that I believe have potential for large profits in the future include Google: Android, Books, docs, alternative energy, and software that helps cars drive themselves (think Irobot), among literally hundreds of other pet projects. None of these projects cost a significant amount of capital (people or dollars) and in my opinion improve on the corporate atmosphere with potential to support the bottom line.
All stats are flawed as they generally only show a portion of the whole picture (usually the portion that supports your case). Nevertheless, I see the following as supporting the stance of future growth of the current moat which is Google.
Traffic Aquisition Costs (revenue shares with partners) is increasing at a slower rate then revenue growth. Google spends 25% of revenue on TAC (generally companies on AdSense with split revenues with Google) as opposed to TAC being 26% of revenues just a year ago. As mentioned, I believe CPC increasing at 8% is impressive and should be watched over the next few quarters and years to see if this increase can keep pace with GDP growth as well as inflation growth. If Google can earn real increases in CPC then an investment in Google equity today will grow fantastically. Finally, Google has hired 2000 people in the last 3 months! Companies hiring now at hiring from a larger pool of perspective employees than normal while the cost is likely below expected cost due to a high supply of labor. This is purely subjective but I believe Google will experience significant growth due to policies like these.
I have yet to purchase but I believe Google remains a great purchase at or below $530 ($171B market cap).
After purchasing Google my portfolio will include:
I have no intentions of selling any of the previously mentioned.
Disclosure: I am long GOOG.