Equity Research Analysis Natalie M. Asher www.nataliemasher.com 30 Sep 2011
INVESTMENT OVERVIEWGoogle is trading at lower P/E multiples than seen in the past. The company’s free cash of $2.6 billionhelps prepare for adequate future growth to remain competitive in the Technology sector. Concerns existabout the effectiveness of Google’s ability to create return with its funds from shareholders, as ROE hashad a consistent decline or plateau for the past five years. This may be the result of a growing firm that isbeginning to stabilize its growth and it cannot sustain its historically high levels of return. However, moremature competitors like Apple and Microsoft offer higher levels of ROE and ROA than Google currentlyprovides.Google is poised for further growth via acquisition and in-house development. We have yet to see howthe acquisition of Motorola Mobility will affect Google as a competitor. The patents will help againstcompetition and litigation, but the strategic use of the hardware business that is MMI has yet to be fully flushed out. Google could use the acquisition to take a more Apple-esque approach to controlling end-to-end product quality, or it could try to spin the business off without its patents. The hardware business does not garner As of 29 September 2011: the same margins as online advertising, but could be a strong strategic more for Google by being involved in all GOOG: $524.22 aspects of a user’s online and mobile experience. Google is known for allowing a certain level of autonomy by its Mkt. Cap. $168.51B acquisitions. As it continues to build its portfolio of companies it will need to ensure this acquisition model is Shares: 322.89M still relevant and operationally efficient to garner expected returns.Short Term Rating: HoldLong Term Rating: BuyUsing a current P/E multiple of 18.91 and an estimated EPS of $35.17, Google’s stock price should betrading near $665.04; a 27% increase from its current trading price. While this is a positive indicator thestock is undervalued, current volatility in the market negatively impacting Google’s stock price is likely notover. For more information on the financial analysis please see the Financial Overview. $800 $700 $600 $500 $400 $300 $200 2006 2007 2008 2009 2010 2011 Figure 1: Google Stock Price
COMPANYGoogle is the world’s largest online content search engine provider working toward the effort to “organize 1the world’s information and make it universally accessible and useful .” The search giant has made leapsand bounds toward this mission over its 13 year history; improving its proprietary search algorithm andadding a diversified portfolio of products to aid in gathering and organizing data. The company’s mainareas of operations comprise: search (e.g. Google); advertising (e.g. AdWords, AdSense); operating systems and platforms (e.g. Google Chrome OS, Android); and enterprise solutions (e.g. Gmail, Google Maps, Google Docs, Google Sites, Picasa, Google Analytics, Google+)The company earns the overwhelming majority of its income (96% in 2010) from advertising sales viaproducts like AdWords and AdSense. Recent acquisitions help prime Google for other revenue avenueslike smartphones, but the margins on these avenues are not as profitable as ad sales.SECTOR AND INDUSTRYGoogle is part of the broader Technology sector and the Internet Information Providers industry.However, the company continues to battle fierce competition from companies across multiple industries. Internet Information Providers Industry by Market Cap. GOOG 23% YHOO 33% 2% WMH.L 8% BIDU LNKD 31% Others 3% Figure 2: Industry by Market Cap.The sector is characterized by rapid product development and short product lifecycles. Major competitorsinclude Microsoft, Apple, Amazon, Yahoo, Baidu, and Facebook. Promising start-ups are acquired byindustry leaders nearly as fast as they launch. According to Yahoo Finance the Technology sector isaveraging a P/E ratio of 15.95, while the Information Providers industry is above average, at a P/E ratio of28.80. The industry is expected to see growth, but concerns exist about whether earnings and valuationsare inflated again, as in 2000.
SWOT STRENGTHS W EAKNESSES - Strong brand image - Revenue diversification - Portfolio offering - Litigation OPPORTUNITIES THREATS - Acquisitions - Intense competition - Developing products - Web spam and content farming - Advertising growth - Foreign exchange rates - Government regulationsSTRENGTHSStrong Brand ImageGoogle is among the most highly valued brands in the world. In the most recent brand ranking by WPP’sMillward Brown BrandZ study Google was ranked second, just behind Apple. The brand had spent theprevious four years at the number one rank.Portfolio OfferingAiding in Google’s staying power as a highly valuable brand, the company offers a strong portfolio ofhigh-quality products. The company is known for releasing products in beta stages and releasing timelyupdates to improve user experience based on feedback. This product development model has provenvery successful for Google.The portfolio offering allows a user to organize their online content with one login across a plethora ofGoogle apps. Android phones are being activated at nearly 500,000 units a day; far above Apple orMicrosoft’s smartphone offerings. Creating efficiencies in the online and mobile user experience andproduct loyalty through an end-to-end product offering allow Google access to a wealth of information.WEAKNESSESRevenue DiversificationAlthough online advertising is expected to increase, a business model that relies overwhelmingly uponone source of revenue – advertising – is a risk. Should Google see downturns in advertising demand,especially given current economic conditions, this could adversely affect revenues and operating profit.LitigationLitigation is a reality of the technology industry. Patent infringements, acquisitions, intellectual property,and a host of other matters could require significant resources and funds to settle matters of conflict.Furthermore, should Google ever lose in litigation, the payments could bring additional downside impactto profits, technology, and image.OPPORTUNITIES
AcquisitionsAlthough Google takes pride in its innovative nature and in house product development, large growth hasbeen sustained with the help of a plethora of acquisitions over the years. Google states in their 2010 10kreport they invested $1.8 billion during 2010 into various acquisitions to lay the groundwork for futuregrowth. Among the company’s most notable acquisitions are YouTube (2005), GrandCentralCommunications aka Google Voice (2007), DoubleClick (2008), Zagat (2011), and Motorola Mobility(2011).Owning a hardware company (MMI) will likely have a negative impact on company margins – online adsare a more profitable business segment than smartphones. However, the acquisition gives Google highly-coveted access to patents. Other acquisitions like Zagat bring more reliability and quality to online contentin apps like Google Places. Google is known for allowing a certain level of autonomy by its acquisitions.As it continues to build its portfolio of companies it will need to ensure this acquisition model is stillrelevant and effective.Developing ProductsGoogle’s acquisitions and in-house development have created more opportunity for Google to own theentire online experience for a user. Provided that Google can assimilate acquired companies andtechnologies in a timely manner, the company has an opportunity to increase user loyalty. AmongGoogle’s most promising new products are new developments within Android, Google TV and GoogleWallet.Google has entered into deals with MasterCard, Citi, Sprint, First Data, and Visa for its Google Walletproduct. By allowing users to make purchases with their phone Google will have access to spending dataand can improve advertisement offerings. Product offerings like these, combined with the now Google-owned Motorola products allow Google to work toward end-to-end control of products for user experienceand product quality; a critical competitive advantage of competitor Apple.Advertising GrowthInternet advertising has increased significantly and the trend is expected to continue. The BIA/KelseyGroup expects online advertising to grow at an annual rate of nearly 25%. The group also predicts thatsmall and medium businesses will change to 30% offline advertising and 70% online advertising by 2015.Google can directly benefit from these changes in the way businesses communicate with customers.These benefits can be seen in ads on their traditional Google platform and their mobile ads, as theyincrease their presence in the smartphone arena.THREATSIntense CompetitionGoogle’s competition comes from many avenues such as: traditional search engines, like Yahoo and Microsoft’s Bing; niche search engines, like WebMD and Expedia; social networks, like Twitter and Facebook; software companies, like Apple and Microsoft; and other forms of advertising media, like newspaper, billboards, TV, and radio.
Google’s industry is defined by rapid product development and constant new technologies. The mergerbetween Yahoo and Microsoft gives Microsoft more competitive edge against Google in searching andgathering search metric data.As competition increases from existing competitors and new start-ups, who have the potential to developmore rapidly than larger companies like Google, Google will need to focus efforts on improving existingproducts and remaining an innovative powerhouse.Web Spam and Content FarmingWeb spam websites employ tactics to violate Google’s search engine quality policies, while content farmscompile significant amounts of low-content data. Both attempt to rank higher than they would normallyearn in search results. If schemes like these are successful they can negatively impact user experience.Google has decreased the amount of spam and content farm hits by half over the past five years withinEnglish-language results, but recent increases have raised concern. Google has recently madeimprovements to its algorithm to reduce the effectiveness of the evasive measures of web spam andcontent farms.Foreign Exchange RatesBecause Google generates revenues outside of the US it is exposed to exchange rate risk. In 2010Google recorded a net loss of $124 million in translating foreign currencies to US dollars; mainly due tothe dollar strengthening against the Euro. Google does employ some financial investments to offsetpotential losses, but those also carry their own inherent investment risk.Government RegulationsThe US market comprised 48% of Google’s revenue in 2010. As Google expands into new countries andUS regulations change the company will need to maintain compliance with each government’s respectiveregulations. The resources, possible litigation, and public relations efforts required to effectively managechanging regulations could impact margins.Government regulations can also affect the level of service Google can provide to new segments,possibly impacting its brand and user acceptance. Take China for example; the government requiresGoogle to turn over any data it stores in China and censorship of search results. Google had two choices– turn over personal user data or store information outside of China. Google chose the latter, whichmeant that services like Gmail and YouTube were not an option for local Chinese users in the beginning.Combined with search reliability results and competition from leading local search provider Baidu, Googlecontinues to struggle with its Chinese relationship. As Google expands into new political environments,challenges like these will not be uncommon.FINANCIAL OVERVIEWREVENUE AND EXPENSESGoogle’s revenue growth is decreasing, as would be expected as their revenues reach well into thebillions and the online advertising market matures. Although I expect Google’s revenue to continue to
grow with the increase of advertising media moving to online content, it is not expected to sustainhistorical levels.Google’s compound annual growth rate (CAGR) for revenue since 2001 averages 91%. This figure is tooaggressive for future growth predictions, but the CAGRs for the past five and three years provide a moremoderate 37% and 21%, respectively. Because even Google is not immune to the global economic crisis,I expect impacts from spending habits and the weighting of the US dollar versus other foreign currenciesto keep revenue growth in check. A moderate revenue growth rate of 29% for 2011 and 37% the next twoto three years is reasonable. Due to Google’s intentions to grow on strategic acquisitions and invest intheir corporate infrastructure, I also expect expenses to grow at a similar rate, around 27% for 2011 andthen at 36% for the next two to three years. The historical and predicted growth rates can be seen inFigure 3 below. Revenue vs. Expense Growth (in millions) 60,000 450.00% 400.00% 50,000 350.00% 40,000 300.00% Total Expenses 250.00% 30,000 Revenue 200.00% Y/Y Rev. Growth 20,000 150.00% Y/Y Exp. Growth 100.00% 10,000 50.00% 0 0.00% 2006 2001 2002 2003 2004 2005 2007 2008 2009 2010 2011 2012 Figure 3: Historical and Future Revenue vs. ExpensesCASH FLOWGoogle’s free cash flow for Q2 2011 was $2.6B. The company has generally increasing free cash flow,which aids in funding Google’s inorganic growth and other product development. As Google expects tocontinue its acquisitions and invest in new product development to remain competitive free cash flow willbe an important factor.
Free Cash Flow (in billions) $3.00 $2.50 $2.00 $1.50 $1.00 $0.50 $0.00 Q1 2006 Q2 2006 Q3 2006 Q4 2006 Q1 2007 Q2 2007 Q3 2007 Q4 2007 Q1 2008 Q2 2008 Q3 2008 Q4 2008 Q1 2009 Q2 2009 Q3 2009 Q4 2009 Q1 2010 Q2 2010 Q3 2010 Q4 2010 Q1 2011 Q2 2011 Figure 4: Free Cash FlowEARNINGS PER SHARE (EPS)Google does not pay out dividends and reinvests all profits back into the company. One of the results ofthis has been a steady increase in earnings per share. The annual growth rate for EPS since 2001 is94%. As with the revenue growth rate, this is not a sustainable level. More appropriate levels of growth forestimating are in line with the five and three year growth rates of 42% and 26%, respectively. Using anestimated 32% growth rate for 2011 Google’s EPS should be near $35.17 for the year.Using a current P/E multiple of 18.91 and the estimated EPS, Google’s stock price should be trading near$665.04; a 27% increase from its current trading price.RISKSThe Weaknesses and Threats listed in the SWOT analysis are an already formidable list of risks to keepin mind. An adverse change to any one of these factors could have an undesired impact to stock price.Additional operational concerns, such as losing key executive management, could impact stock priceunfavorably. Furthermore, Google is characterized as a large cap growth stock, and any investor lookingto add Google to their portfolio must be willing to tolerate the considerable swings associated with thestock. While the returns for shareholders have been rewarding, Google pays no dividends. Google will notprovide the stability that investors looking for dividend paying stocks often require.