Google (GOOG) a Value Play

Friday, September 17, 2010

Google signFor the first time in its history as a public company, Google (GOOG) can be argued as a value play for investors. Yet, Google has so many growing pieces that the growth argument is almost just as compelling. Either way, the sub-$500 price on GOOG shares seems to discount a much greater slowdown in growth than looks likely.

What's holding shares back?

It's important to understand why a stock is without friends in order to diagnose how your opinion differs from that of the market. Shares of GOOG have been beat up this year, down 22% YTD versus a 2% gain in the Nasdaq. Clearly investors see much slower growth going forward.

In many ways shares of GOOG have just undergone what stocks of large, maturing companies eventually must go through when growth metrics slow sequentially and the momentum crowd becomes bored of the stock. Google redefined the way we discover information on the internet and the persistent doubts about the company's ability to monetize their products only added to the repeated enthusiasm every earnings report for years. Eventually though, growth slowed now in the 20% range and investors fled shares for the new momentum stocks of the day.

From a mechanical perspective, company insiders have been bulk sellers of the stock for months running. I am not sure how much of an impact this has on the shares but willing buyers are being absorbed on a daily basis by insiders diversifying out of the company. I only raise this fact given the pressure that selling puts on the shares, not as a reflection of insider opinion. Peter Lynch had it right when he said: "insiders might sell their shares for any number of reasons, but they buy them for only one: they think the price will rise". The insider selling leads me to no conclusion other than some explanation of the downward pressure on shares.

The China battle is somewhat perplexing to me. Google has been in a widely publicized confrontation with the Chinese government with regard to censorship of Google's search results. After blocking Google, the government changed its mind in July and re-allowed to redirect to, the uncensored search site in Hong Kong. Baidu (BIDU) was the clear winner in this fight as the government was helping to eliminate a major competitor in the search space. Yet, China has never been a money making operation for Google but I suppose investors punished shares for the fear of missing out on future possibilities.

The growth story

Google's second quarter earnings for 2010 showed 24% year-over-year revenue growth. A healthy 13% of revenues are devoted to research and development showing Google's desire to stay ahead of the curve. The investment in developing the Android platform should be a key driver of growth going forward.

Google's search monetization business is a powerhouse and the company continues to build and improve offerings that generate revenue through search. YouTube is a prime example where a very effective monetization plan has finally been developed and, most importantly, widely accepted by users. Previously, there was no model for monetizing the YouTube site and it was just viewed as a massive collection of everyone's random videos. Now, YouTube has a viable business model and is growing its partnerships with contributors.

The Android operating system and the potential growth in the mobile arena should not be underestimated. The latest reports show that month-over-month growth in smartphone ownership from April to July 2010 was a whopping 11% in just a month. Yet, only 23% of mobile phone owners have a smartphone leaving considerable room for industry growth. Research in Motion (RIMM) is the leader in the smartphone space with 39.3% share and Apple (AAPL) is a distant second at 23.8%. Google entered this market with a vengeance and growth is surging rapidly stealing market share from entrenched rivals. Google, as a percentage of market share in smartphone platforms, grew 5% during the same month from 12% to 17% of the market while RIM, Apple and Microsoft all declined: 1.8%, 1.3% and 2.2% respectively, in market share. (Source)

Growth in the mobile platform market allows Google to bundle in its search features and add to its advertising revenues, already at 97% of revenues. Google's search will also be a key component for developers in monetizing the hundreds of thousands of apps developed for smartphones.

The value story

Google's current market capitalization is just north of $150 billion and the company employs nearly 22,000 people around the world. The impeccable balance sheet boasts $30 billion in cash (20% of the market cap) and zero debt. The brand has become synonymous with online search as the oft-heard words "Google it" define the company as the go-to resource for finding any information on the web.

The valuation is very cheap trading just 21 times trailing earnings and 15 times forward estimates. With consensus analyst expectations for 5-year growth in earnings per share at 18%, this PE rounds out to a cheap PEG of 1.15. With a profit margin at 28%, Google is dominating the search space with 65.4% of the market and feeble attempts from Microsoft and Yahoo have hardly dented its overall market share. (Source)

My one year price target for shares is $700 as I think continued growth in the Android will help Google generate EPS growth of 20% and the Android excitement will lead to, at the very least, multiple expansion. If shares of GOOG begin to receive the premium I believe they deserve, I see it trading for 25 times trailing which would already put shares at $578 based on valuation. Add 20% growth in earnings per share from trailing four quarters of $23.12 leads to next four quarters amounting to $27.74. A 25 price-earnings ratio applied to this estimate yields a $700 price target.

Brandon R. Rowley
"Chance favors the prepared mind."

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