Media Talk

Steady as She Goes at Google

Google (GOOG/GOOGL) reported another solid quarter with 24% foreign exchange neutral revenue growth.  Revenue growth was driven by advertising, up 20% in constant currency terms.  Mobile is the driver with paid clicks rising 53%.  Mobile ads remain cheaper than desktop, so the shift to mobile leads to lower ad pricing (-19%) but the net growth indicates that GOOG continues to grow very rapidly despite its massive size and market share.

Perhaps equally importantly, operating margins rose for the 7th consecutive quarter.  This added financial discipline coincides with the addition of Ruth Porat as GOOG’s CFO in the summer of 2015.  Since Ms. Porat joined GOOG, the company restructured as Alphabet and isolated its Other Bets from the core search and YouTube businesses, has shown greater discipline at Other Bets, and initiated a share repurchase.

This added discipline and mostly good quarterly earnings over the past several quarters has led GOOG shares to trade at all-time highs, including an initial pop of about 4% on the 1Q17 earnings report.  However, GOOG has still severely lagged the stock performance of the other dominant megacap internet companies, Amazon (AMZN) and Facebook (FB).  Since 12/1/2015, GOOG shares are up 14%, while AMZN has risen 35% and FB is up 38%.

GOOG is not growing as fast as FB and does not have as large an addressable market as AMZN.  However, the search business arguably has the biggest competitive moat.  GOOG is more of a blue chip today than AMZN and FB and there are no other megacap blue chip companies trading near a market multiple while sustaining core organic growth around 20%.  GOOG is trading at around 22X 2018 estimated earnings, or a price-to-growth ratio of 1.0.  Most other blue chips trade at PEG ratios of at least 2.0.  GOOG is sitting on about $130 in cash.  Adjusting the P-E for cash brings the forward P-E multiple under 20X.  We expect tax reform to be signed into law by President Trump sometime in the next 18 months and it will likely allow GOOG to repatriate the overseas cash at a very low tax rate, providing another potential catalyst for the shares.

In the meantime, we expect the core organic growth at GOOG, driven by mobile, to maintain its recent pace.  This should be good enough for GOOG to gain more respect from investors, allowing the P-E multiple to expand.  We see GOOG moving up to 25X 2018 estimated earnings or $1,050.  This equates to 22X adjusting for cash on the balance sheet.

Beyond the usual analysis of business fundamentals, one risk to watch is the outcome of European regulators review of GOOG’s Android and Search businesses.  Recently, GOOG settled with Russia regarding Android, possibly setting a template for the European investigation.  The settlement may initially lead to a negative reaction in GOOG shares but we believe putting this issue behind the company will ultimately be viewed as a positive by investors.

GOOG/GOOGL is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts.  Steve is sole proprietor of Northlake, a registered investment advisor.  Northlake’s regulatory filings can be found at www.sec.gov.  GOOG/GOOGL is a net long position in the Entermedia Funds.  Steve is portfolio manager and managing partner of Entermedia, long/short equity hedge funds focused on media, entertainment, leisure, communications, and related technologies.

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