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What Game are you Playing?

|Includes: Alphabet Inc. (GOOG)

 “Always do what you are afraid to do” 

Ralph Waldo Emerson

Today I’m going to write something different. Something that I believe in. Probably I will fail. But here it goes anyway. Today, I will write about the true value and potential of Google, today and tomorrows Titan.

What is the true value of Google? How can you even put a price on Google? What does it mean to the internet? What does it mean to all of as? Can you remember the internet before Google? Can you imagine your day surfing the web and not using Google products? Can you imagine Google importance in next couple of years? One is certain, Google enjoys a strong competitive moat.

For the last few days, I have spent most of my time in a dark room, thinking about the future outcome for Google, the true potential and possibilities that lay ahead of them. I was obsessed by finding the best possible way to value their business, because I strongly believed that the old fashioned, so called common sense, won’t be enough. It was just foolish for me to think, that P/E or any other widely known and embraced valuation ratio could ever show me the real value and tell me the whole story behind Google. I needed to go beyond the plain numbers and beyond common beliefs, I needed to predict and commit an act of faith (gamble).

So, how do you put a price tag on it? The real question is how can we alter our common beliefs? We will see the whole picture only if we change our mindset, and embrace the idea to question all current assumptions and facts that are brought upon us by generations that lived before us. Remember, just because everybody else agreed upon something, and marked it as common sense that doesn’t always mean it is the universal truth and that no one should question it, or even challenge it. The only problem is that challenging common sense isn’t in our nature, we are afraid to think different from the herd, it’s far easier to go with the flow, rather than challenge everything. The world needs you to be yourself, because everyone else is already taken. 

Few reasons why I believe Google is undervalued due to the future potentials, not because the current numbers. 

We all know that Google search ads are still the main revenue driver for Google, and that works just fine for me. Significant number of people still believe that “Android” is a bad investment for Google, almost all of us “knew” that Android was a bad investment and a lost cause for Google back in the day of birth. We believed that Android won’t be able to compete with iOS. But look at it now, Android happens to be the main player in the mobile world at the moment, even surpassing Apple iOS. I have strong beliefs that the mobile platform is going to be the way of the future, which easily could be one of the main revenue drivers for Google in the years to come.

At the present moment only 14-15 percent of all mobile devices are smartphones. According to some predictions by 2014 this number will grow to 27 percent. I was fascinated by the fact that in 2009, according to New York Times, mobile ads generated less than one-third of one percent of all total ad revenue. Read it again, just to be sure, we are talking here about 0.33 percent. It appears to me, that a great deal of potential is just waiting to be unleashed. However, Google is well aware of the same potential and this can be easily confirmed by the acquisition of AdMob (they acquired AdMob for $750 million). AdMob claims to serve more than 7.1 billion mobile banners and text ads per month across mobile Web sites and handset applications. Few more possibilities to think about. It’s interesting why Samsung produced the new Nexus S. Why it wasn’t produced by HTC? HTC produced the Nexus One, and did a hell of a job, so why Google gave the Nexus S in the hands of Samsung? My opinion is that HTC is working hard on the new tablet with Google, which easily could be a game changer in the future development of the tablet market. What does all this mean? It means even more customers for Google. And more ads!

“Fasten your seatbelt Dorothy, ‘cause Kansas is going bye-bye”

So, we didn’t have faith in Android, we are still having a hard time believing that mobile platform will be grater in terms of ad revenue compared to the PC platform, and there is one more thing that makes us smile or angry or whatever, I’m talking here about the vast possibilities of “cloud computing”. People tend to be angry, or they tend to make fun of something that they don’t utterly understand, or even don’t approve.

In my case, I just can’t stop thinking about the future importance of cloud computing, and how it has the chance to change everything. Google’s CEO Eric Schmidt wrote a blog post, explaining why this is one of the most important developments of his working life. In his words: 

“We are demonstrating the real power of the computer science to transform people’s lives. It’s extraordinary how very complex platforms can produce beautiful simple solutions like Chrome and Chrome OS, which anyone can use” 

With Chrome OS, we have in development a viable third choice in desktop operating systems. Before there was no cloud computing alternative—now we have a product which is fast, robust and scalable enough to support powerful platforms. It’s something computer scientists have been dreaming about for a very, very long time. The kind of magic that we could imagine 20 years ago, but couldn’t make real because we lacked the technology. As developers start playing with our beta Cr-48 Chrome OS computer, they’ll see that while it’s still early days it works unbelievably well. You can build everything that you used to mix and match with client software—taking full advantage of the capacity of the web.”

“I am very proud of what a small team, effectively working as a start-up within Google, has achieved so quickly. In 20 years time, I’m certain that when we look back at history it will be clear that this was absolutely the right time to build these products. Because they work—and they work at scale—I’m confident that they’ll go on to great success. Welcome to the latest chapter of an epic journey in computing. Welcome to Chrome OS.”

It’s still way to early to speculate how exactly Chrome OS will effect the industry, or in what way will it change it, but I’m sure that this is the product that is going to be one of the main revenue drivers for Google in years to come. This is one more reason why I firmly believe that Google still is a wonderful business, selling for a reasonable price.

Q3 2010 Earnings Call Best moments: Listening to the earnings call I heard and remembered some of the interesting stuff they were talking about. Mobile is an annualized run rate of over $1 billion. This means that the people are accessing Google’s products and services through their mobile phones and they are adding a billion dollars annually to Google’s existing revenue streams. Google’s mobile search queries have grown five times over the last couple of years and of course a lot more of this queries are coming from Android phones, in my opinion this is the most significant part of the earnings call. Youtube has 2 billion of monetized views per week, compared to the 2 billion of total views per day. Google gives the software away for nothing, people ask how do you make money from that. The evidence they have suggest that people who use Android, search twice as much compared to anything else they are doing. Clearly, there’s more revenue associated with those searches. Google made up a number from thin air that they can get $10 profit a year per Android phone according to Eric Schmidt. It was interesting to hear the future predictions about the tablets and mobile. Eric Schmidt believes that mobile will eventually overcome PC in ads. When that happens, mobile should be a very strong revenue driver compared to a PC. Google apps are increasing rapidly, Google hopes for apps to be a billion dollar business in the next several years. Google is now activating 200.000 Android units a day and increasing fast. In May this year they were activating about 100.000 devices. Talking about strong growth. 

Conclusion and current valuation:

Like I said, I believe Google has more to it that the current numbers. People that are running Google are dreamers and they are fully capable to change everything and achieve greatness along the way. However, I will briefly discuss the current numbers anyway. 

I like to make things simple as possible, but not simpler. Looking at the balance sheet, it is hard not to notice the amount of cash&equivalents, just shy over $10 billion, when you add $14 billion in short term investments and $3 billion in accounts receivable, one will get the amount of $27 billion, which is remarkable, also Google has high margins. Their operating margin is 37% and their net margin is just under 29%. We are talking here about $85 dollars per share only in current assets, also I believe that they will keep increasing cash year over year. They have no long term debt, if you consider all the the investment they made in the last few years that is quite remarkable. Current P/E ration of 24 doesn’t mean anything. ROA and ROE are looking fine at 17.4% and 20.6% respectively. Even if you look at the current earnings yield you can see that Google is undervalued: Earnings yield: 4,2% vs. 10-year Treasuries: 3,47%. 

But sadly, all of this data doesn’t tell us anything about the future of the business. That is why we need to be in the business of predicting  the future outcomes, we need to think about possibilities, the power and eagerness of the management to achieve great things to advance and grow even further. We need to compute the impacts of future services or products on income statements and balance sheets. So many times we will fail in doing so, but we need to continue, that is the only way we could ever realize and come up with the nearest version of real value for some business we are analyzing at the present time. 

Google is going to continue the dominance of the search business in many years to come, that is probably unlikely to change. But you don’t need me to tell you that, a blind man can see it. What makes me specially excited are the new investments and potential revenue drivers for the future. I’m insanely excited about Android, Cloud Computing, tablets and mobile ads. In my opinion, Google still is a growth stock and a wonderful company at more than s reasonable price, considering the bright future that awaits them. 

“Google, I think this is the beginning of a beautiful friendship.”

Thank you for reading. 

And stay tuned. 

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.