Buy Google As P/E Compression May Soon End; 2Q 2012 Earnings Good Enough For Investors
Google's 2Q revenues satisfied investors who had been cautious. But, the real story behind Google's stock price performance has been its P/E multiple compression. A we discuss below, this trend has more often than not played out and Google's stock price may benefit going forward as the headwind from multiple compression abates. Regarding 2Q revenues, the key metrics for Google are Paid Clicks, up 42% YoY, and Cost Per Click, down -16% YoY. We think that as long as Google continues to show solid growth in its core business it should receive a premium valuation because of the optionality in its emerging businesses, including YouTube, Android and enterprise. In this update we will review the 2Q results using our six question revenues checklist, Intel). As so then, we will look at the valuations of comparable companies and explain our basic thesis for owning Google's shares.
Premium to the overall market
Although Google's P/E ratio of 18x is after all at a premium to the overall market, we believe that the majority of the multiple compression has already occurred. It is possible that Google's multiple will compress furthermore, however we think that Google deserves a premium because of the growth prospects in its core business and the optionality, which is hard to value, in its emerging businesses just as YouTube, Android, enterprise and other projects. As a result, EPS growth should shortly replace P/E multiple compression as the key driver for the stock. When this happens we think that Google's stock price could head higher.
Apple is one of the rare companies that was able to grow significantly during experiencing multiple compression. It is interesting to note that much of Apple's climb occurred afterwards its multiple compressed to approximately the market average. Since 2008/2009 its share price increased without a large increase in its P/E multiple.
The discussion of Google's P/E multiple misses an important point about the optionality in Google's business. Recently, Kurt Eichenwald wrote an article in Vanity Fair about Microsoft. The article says that Steve Ballmer, CEO, would say that Microsoft should be "last to cool, first to profit," meaning that Microsoft did not need to be on the cutting edge and could use its vast resources to catch up. The results of the last decade prove that this approach did not work. Google, nevertheless, is not making the same mistake. It is continuing to innovate with some very promising businesses and a few oddball engineering projects.
Google has hidden value in its YouTube, Android/Chrome, and enterprise businesses as then as mobile. Even though these platforms are not significant contributors to Google's results today, they have much potential for the future.
The third theme
"Let's talk about the third theme, the innovation, where we are in our enterprise business. I think it's become clear for us that we have a serious small, nevertheless growing business, which is going to be a future growth engine for Google. I hope you read this week about a company, who said competition was 50% more expensive than Google, and not as cool. That company is now $200,000 a year Google apps customer.
Companies, schools, governments worldwide are moving to the could faster than ever. More than 5 million businesses have now gone Google worldwide. The traction amongst large organizations even just as the U.S. Department of Interior, Fairfax Media in Australia, et cetera. I think it's clear, you can't fake a commitment to cloud computing, and we've invested to build and scale a business that has gone to upstart to upper crust.
Thousands of businesses switch to Google apps from our competitors day in day out. Recently, we've launch products like Google Drive, Google Maps Coordinate, as then as the ability to edit documents off-line and in a whole range of mobile devices and tablets. That just shows you the pace of technology that Google is bringing to the business research."
We do not want to make projections about Google's emerging businesses and some of them may fail. But, Google has a deep bench of businesses that could have a positive impact on its future revenues potential.
This was the first quarter that Google's results included the performance of Motorola Mobility. The traditional Google business generated $10.96 billion of revenue, up 21% from 2Q 2011.
Ongoing debate among analysts
There is an ongoing debate among analysts, commentators and investors about the key metrics for Google's business. Two key metrics are Paid Clicks and Cost Per Click. Google is continuing to expand its Paid Clicks, nevertheless its CPC is declining. CPC declines are mainly attributed to the growth of mobile search, which is less profitable than the traditional format. Other factors, just as search in emerging markets, are as well bringing down the overall CPC figure. While the conference call Patrick Pichette, CFO, said that currency headwinds negatively as well impacted CPC in 2Q.
Investors that are bullish on Google would argue that the growth of Paid Clicks is more important than CPC declines since Paid Clicks growth means that Google is expanding its market and will in the long run figure out how to earn more on mobile. Some would add that mobile search is taking everything into consideration incremental to traditional search since it occurs when people are out and about and could not if not access Google. Google bulls would as well underscore that revenue is however growing in the 20% range, even with declining CPC.
"Turning to geographic performance of Google standalone business, U.S., UK and rest of world are growing at a good pace as reflected in our results... Revenue from the U.S. was up 20% year-over-year to $5 billion. Our non-U.S. revenue accounted for 54% of our total revenue or $6 billion, and was up 22% year-over-year, which includes $81 million benefit from our hedging program. The UK was up 20% year-over-year to $1.2 billion, and at that time fixed FX term; actually the UK grew 22%."
Google's results reflect global demand for internet advertising. While periods of weak economic activity, companies as a rule cut back on advertising as they seek to reduce expenses, especially if consumer demand is weak.
Although Google's revenue came in slightly below expectations, Google's growth does not indicate that there is a pullback in advertising. To tell the truth, it seems that in most regions it is business as usual for Google, which is a good sign in an environment dominated by concerns of a global slowdown.
The following analysis looks at the valuation of Google compared to Apple, Microsoft, Amazon, Facebook and Yahoo. Not only is Google's valuation reasonable compared to its past history, nevertheless Google's valuation looks reasonable compared to other internet companies.
Our bullish view on Google is based on Google's core business continuing to grow. Those revenues will have more of an impact on the stock price as the headwind of P/E multiple compression abates. Moreover, we think that Google has hidden potential in several emerging businesses that could have a big impact on its results hereafter. In fixed and final form, we have a positive view on Google and hold its shares.
The bullish thesis on Google
There are many risks to the bullish thesis on Google. Even though the global slowdown has not but had a big impact on Google's results, continued macro pressures and slowing global growth could negatively impact Google. Even more, Google faces fierce competition from many large and small companies. As the research world changes rapidly, another company could quickly take share from Google. The social revolution, led by Facebook, is one area where Google is relatively weak and could lead to more trouble for Google hereafter. Additionally, mobile may cannibalize much of Google's traditional business and Google's success in monetizing mobile is all in all unclear. Taking everything into account, Google made a large bet on Motorola Mobility and it is not clear how it will turn out.
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