by Rick Summer, CFA, CPA (Analyst at Morningstar)
Google's GOOG third-quarter earnings report brought hand-wringing from the market and new issues to light for us. While we believe our long-term thesis is intact, we are concerned that we may have been overly optimistic about operating leverage, given the changing revenue mix. Still, although we may modestly decrease our fair value estimate after completing our analysis, we consider the company slightly undervalued at these levels. Perhaps most importantly, we see no evidence of diminishing competitive advantages.Revenues for Google Sites grew 15% compared with 2011, while revenue from the Google Network (ads placed on partner sites) grew 21% versus 2011. The strong dollar created a headwind to results as well, with a negative impact on Google's stand-alone revenue growth rate (excluding Motorola) of 600 basis points versus 2011. As Google Network revenue outpaced Google Sites, we believe this may be the start of an important trend: Google will increasingly rely on placing ads and distributing content for content owners to subscribers, but fee sharing and content acquisition costs will constrain the company's ability to gain operating leverage from the business.With respect to operating costs, we note that other costs of revenue increased 57% sequentially (while Google's stand-alone revenue grew 5%). Even after accounting for effects of acquisitions and costs from the launch of the Nexus 7 tablet (Google's Android tablet), we estimate that other costs of revenue increased more than 30% versus the prior quarter. We believe this dramatic increase highlights Google's evolution toward a content distribution platform. Although the firm recognizes gross revenue by selling content on YouTube and Google Play, we suspect the bulk of the economics flow to the content owners, resulting in lower gross margins. If these efforts become even more significant relative to the total company, overall operating margins will suffer. Although we believe the company has other levers within is expense base to eventually expand margins, we may take a more cautious stance.
Thesis 03/05/12
After rising to prominence by attracting massive numbers of users and ad dollars for its Internet search product, Google is investing in its next act.As the pre-eminent leader in search, Google maintains more than 60% of worldwide market share; no other competitor has even 10%. We believe the company's early technical advantages attracted users who now use it habitually, creating a switching cost based on familiarity with the engine. While the firm may face near-term headwinds from efforts by Microsoft's MSFT Bing and social network Facebook, we expect the larger players to win share from weaker players, including AOL AOL and IAC's IACI Ask. Although we expect small movements in market share, we believe Google's dominance will persist and not lose more than 3-5 points of share.
A strong secular growth trend for online advertising is core to our thesis. The market for Internet search advertising is still growing in the double digits, while display advertising is growing thanks to newer innovations tying display ads to specific actions, including clicks, leads, and customers. Also, faster-growing geographies such as Asia are propping up overall growth rates as Western Europe has recently been slowing. We forecast global Internet ad spending to grow in the midteens annually during the next five years. We expect that Google will leverage its dominant position in Internet search and support strong growth in display and mobile advertising, allowing it to meet or exceed the overall industry growth rates.
Although competitors like AOL and Yahoo YHOO have routinely claimed competitive advantages in display advertising for content rather than search, Google is not on the sidelines. In fact, we estimate the company generated more than $4 billion in display advertising in 2011, exceeding Yahoo's display revenue for the year. While we would be more enthusiastic if it announced large deals with branded advertisers, we still expect Google will participate quite aggressively in this market. The company is continuing to innovate around its DoubleClick Ad Exchange in an attempt to offer advertisers ways to incorporate real-time bidding and directly target audiences with specific demographics as opposed to choosing websites. Ultimately, advertisers want specific targeting; providing technology that helps automate this targeting delivers tremendous value in maximizing budgets. Furthermore, Google recently announced a plan to invest an additional $100 million in its heavily trafficked YouTube website. As rich video content continues to move online, we are optimistic about YouTube's value and ability to monetize its content.The importance of Android cannot be overstated, particularly in light of the massive adoption of smartphone and tablets. Android is an open-source mobile operating system (the code is shared with the community using a free software license) to allow handset manufacturers and users to load applications that software makers build. During 2011, Android's installed base of smartphones vaulted to 38% market share according to Gartner, well ahead of market leaders Apple AAPL and Research in Motion RIMM. While many industry watchers are scratching their heads over the significance of a business that generates no direct revenue for Google, we are more enthusiastic: The move protects the firm's economic moat and provides new revenue streams. With Android living on smartphones, more users are likely to use Google's services. In fact, we have seen estimates of Google's market share in mobile search exceeding 90% last year.
Still, there are risks on several fronts. First, we cannot ignore the potential impact of social networks such as Facebook, Twitter, and LinkedIn LNKD. While we believe these will not be an immediate or direct threat to Google's search business, we do believe they are immediate and significant competitors for display ads. Additionally, these firms undoubtedly will invest in search capabilities, and we could be wrong about their ultimate success. We also believe the returns on capital for the new businesses will be lower than the returns in its core search business. As many companies are investing heavily in content strategies, Google will have to continue investing in an attempt to keep pace in attracting more branded advertisers.
Valuation
Our fair value estimate is $780 per share, representing a 2012 price/earnings multiple of 23 and an enterprise value/EBITDA multiple of 14. We forecast revenue to grow more than 12% annually during the next five years, slightly ahead of the growth rate for the overall online ad industry. Google reports its business in three market segments: Google websites, Google Network websites, and other.
Revenue driven by Google websites include its search engine and Web properties such as YouTube and Google Finance. Although we expect minor short-term loss of market share in search, we believe that improvements in monetization (the conversion of a search to a paid click on an advertisement) and overall market growth will help drive revenue. Additionally, with additional investment in display revenue technology and content on YouTube, we have modeled Google websites to grow more than 18% per year. We also expect uplift from mobile search to support strong revenue growth in this core business. Excluding YouTube, search is the most significant cash generator and highest-margin business for Google. We are more conservative in our view of revenue coming from Google Network. Google Network represents revenue earned by the placement of ads on partner websites. We anticipate this growth will lag the market, growing at 8% per year through 2015.
While we believe Google could easily drive operating margins substantially above 40%, it would have to ratchet down its investment in R&D and its data centers to achieve these targets in the short term. We expect operating margins to stay below 30%, reflecting increased investment and higher personnel costs caused by the pay raise instituted in January. After this year, we forecast operating margins to begin expanding again and reaching 32% in 2015. Because Google is heavily investing in new markets, we still expect free cash flow to be depressed over the next few years. However, we expect growth in free cash flows to exceed 25% annually through our explicit forecast period.
Risk
Although we believe Internet search is habitual, explicit switching costs are relatively low. Fickle consumers may move to a competitor that is able to establish a stronger brand or a more useful experience. Google is investing in new businesses where it is less competitive, which may lead to a deterioration in its operating margin and return on capital. Advertisers may find new ways to reach their target audience in a cost-effective manner, like Facebook. Finally, competition in technology is fierce, and employee retention may become more difficult and cause an increase in operating costs.
Management & Stewardship
Cofounder Larry Page was named CEO in April, taking over from Eric Schmidt. Schmidt was CEO from 2001 to 2011, a period that saw Google define its business model, become a public company, and stay at the forefront of the Internet advertising industry as the largest company by revenue and enterprise value. Schmidt is retaining his position as chairman of the board and serving a more active role in lobbying Washington. With Schmidt as a key executive, the company essentially has been managed by a three-person team of him, Page, and cofounder Sergey Brin. The company's equity has a dual-class structure that concentrates the voting power in the hands of these three executives, who hold two thirds of the voting rights. They also have a significant economic interest in the firm at more than 15%, which helps to align the interests of management with the shareholders.
We are comfortable with management at the firm, but employee retention will be a continual challenge for Google. Page's style and efforts will not mirror Schmidt's and may cause some short-term disruption. In fact, the senior vice president of product management resigned the week that Page's new title became official. Although we don't view the move as emblematic of any looming management issues, we would not be surprised to see other similar moves as competition for personnel is ruthless in the technology sector. To address these concerns, the company is rumored to have given a 10% pay raise to every employee effective in January.Generally, we are encouraged management's by the long-term focus on capital allocation, although the lack of transparency around milestones for new projects presents an analytic challenge. We are encouraged that past acquisitions including DoubleClick, Android, and YouTube are bearing fruit and deepening the company's moat. Additionally, the management has recently begun pruning products that have not been hitting internal success metrics, a positive development, in our view.
Overview
Financial Health:
Google's balance sheet is flush with more than $44 billion in cash equivalents and about $4.2 billion in short-term debt and long-term debt.
Profile:
Google manages an Internet search engine that generates revenue when users click or view advertising related to their searches. This activity generates more than 80% of the company's revenue. The remaining revenue comes from advertising that Google places on other companies' websites and relatively smaller initiatives, such as hosted enterprise products including email and office productivity applications.
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