Google’s Q1 2011 Review: Part 2 Of My Comments On The Gross Misvaluation of Google

This is part 2 or 3 of my illustration of the gross misvaluation of Google (see My Thoughts on Roger McNamee’s View of Google and Mobile Computing). As a reminder to our paying subscribers, on November 2010 we downgraded the stock to Neutral from our Overweight stance while maintaining our valuation. Given the market’s reaction to the stock and the fact that growth was ahead of our expectations, we upgrade the stock back to Overweight territory. The full, unabridged quarterly review is available to all paying subscribers here: Google Q1 2011 results. Below are many of the salient points contained in said download.

Google Q1 results

For the quarter ended March 31, 2011 Google reported gross revenues (before traffic acquisition costs) of $8.58bn, an YoY increase of 26.6% and QoQ increase of 1.6% while net revenues (after traffic acquisition costs) increased 29.1% YoY and by 2.6% sequentially to $6.54bn. The YoY growth in gross and net revenues was the highest at least since 2008 demonstrating a increasingly momentum in the growth of Google’s digital ecosystem. The increase in net revenues (after TAC) was actually stronger than the increase in gross revenues, indicating that Google has not only packed in growth but lowered aggregate top line expenses.

However, despite a strong set of results the stock took a severe beating and was down c8% as the results were short of analyst expectations. The market’s reaction to Google’s numbers clearly reflects the very myopic view of US public markets wherein a stock is dumped if it fails to beat consensus – even when this view clearly overlooks the broader picture.

Google’s adjusted earnings came in at $8.08 a share below the $8.17 expected by the markets. However, a closer look at the results reveals that the perceived shortcoming was not a result of a revenue miss or margin compression but on account of Google’s entrepreneurial (and quite applaudable – at least from this investor’s perspective) endeavor to invest heavily in future projects. The miss was principally due to higher research and development expenses as the company continues to invest in new emerging businesses like Display, Mobile and Enterprise. Research and development expenses (including stock based compensation expenses) grew 50% YoY to $1.2bn and was 14.3% of gross revenues in Q1 2011 vs. 12.5% in Q4 and 12.1% in Q1 2O10. Had research and development expenses at 12.5% of gross revenues, the earnings would have been $8.51 per share, a clear beat to consensus and stock would have seen a roller coaster ride – despite the fact that future prospects would have been a fraction of that they are now due to lower investment in the future. Google has proven that their investments yield superior returns to that of cash holdings, ex. Youtube, Android, Admob, Google Voice, Teracent, etc. Instead, the stock was pushed down 8% as the shorter term players in the market reacted. Players such as sell side analysts whose employers benefit from the shorter horizon churning of stocks vs. a longer horizon and outlook, and traders who act on price movement and not value, were(are) clearly tangled between web of OPEX (ongoing cost for running a product, business, or system) and CAPEX (expenditures creating future benefits).

The eventual decrease in margins in the mobile sector will probably accompany an increase in gross revenues for the leaders of the entire mobile sector, as was clearly forecast in BoomBustBlog, reference Apple Gears Up To Combat The Margin Compression That Apparently Only It, Google & Reggie Middleton Sees Coming. Thus far, Google has effectively avoided this and may avoid it for some time due to their minimal reliance on hardware manufacturing, but it is coming.

Google continues to be a reckoning force in the online search market commanding almost two-thirds of US search queries – and Google’s influence in its cash cow products is still expanding. This cash cow allows Google to fund some very innovative, yet risky ventures without materially risking or crimping excess cash flows. As of March 2011 Google’s share of core search queries was 65.7% compared with 65.1% a year ago, as per comScore data. Despite commanding over two thirds of market share the company continues to hold its ground in terms of online search queries.

Total cost of revenues increased at a slower pace compared with revenue growth positively impacting the margins. Total cost of revenues excluding stock based compensation expenses (which includes Traffic Acquisition Costs) grew 19.7% YoY to $2.9bn (33.7% of gross revenues in Q3 2010 vs. 36.1% in Q1 2010). Traffic Acquisition Costs grew 19% YoY during the quarter to $2.0bn (or 24.5% of revenues) compared with $1.7bn in Q1 2010 (or 26.4% of revenues). Cost per click increased 8% YoY and declined 1% QoQ. Overall, gross margin improved to 65.8% in Q1 2011 vs. 65.1% in Q4 2010 and 63.8% in Q1 2010.

Sales and marketing expenses excluding stock based compensation increased 71% YoY to $948m, or 11% of revenues in Q1 2010 vs. 9.8% in Q4 2010 and 8.2% in Q1 2010 – a strong sign of heavy promotional investment into new business lines! General & administrative expenses excluding stock based compensation increased 42% YoY to $526m, or 6.1% of revenues in Q1 2011 vs. 6.0% in Q4 2010 and 5.5% in Q1 2010. Research and development excluding stock based compensation grew 58% YoY to $989m and was at 11.5% of revenues in Q1 2011 vs. 9.8% in Q4 2010 and 9.3% in Q1 2010 – again, a sign of very strong business investment into new ventures. Stock based compensation increased to $429m (5.0% of revenues) from $291m (4.3% of revenues) in Q1 2010 and $396m (4.7% of revenues) in Q4 2010. This is a mixed blessing. The increase in compensation needed to ward off competitors poaching of employees is a structural expense increase – a decided negative. The hiring of new staff during these tough economic times to help develop and expand new multi-billion businesses is a decided positive.

Considering all above, this investor queries, “What would one have a tech company with a monopolistic cash cow franchise, strong competitors and several fledgling multi-billion dollar upstart business to do with its excess earnings? Invest them deeply into new businesses and ventures for future value creation, or retain them as excess cash to sit on a balance sheet which already has in excess of $30 billion of unencumbered cash in it?”

Our investment thesis

As highlighted in the Google forensic report (63 pg Google Forensic Valuation, to plug in your own assumptions see Google Valuation Model (pro and institutional)), our key investment thesis for our Overweight on Google were

• Secular mix shift from offline to online ad spend and Google with c67% share in search market is set to benefit enormously from the secular mix shift though growth in search ad spend (ad words)
  • We had meticulously demonstrated the case for the next multibillion dollar business(es) after search in the form of display, mobile and other emerging businesses.
  • Increase  in share of display revenue as Google, which currently lags Yahoo in display, is ramping up its efforts through YouTube monetization, the Doubleclick acquisition and its Teracent acquisition
  • Opportunities in wireless search as Google goes mobile with Android and AdMob. Success of Android coupled with Google’s traditional dominance in search advertising has laid a solid foundation for Google to monetize the opportunity in the mobile space.
  • Literally free call options on a plethora of new multi-billion dollar revenue opportunities in the form of Google TV / Google Voice / Google Cloud Computing (for details refer to Google Forensic report)
    • Bolt-on acquisition strategy

Valuation

The valuation and the balance of this review including the metrics not included above are available as a download to all paying subscribers – Google Q1 2011 results.

Next in this space, I will illustrate Google’s success rate in building value out of its acquisition and investment strategy. If one where to look at it from a historical perspective, one would be very bullish on Google’s ramp up of internal and external investment… Very bullish indeed, particularly considering the recent price drop.

Read more at The Boom Bust Blog