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July 16, 2010

Mixed Quarter from Google Obscures Value and Growth Profile

Google (GOOG) is trading down over 5% in a weak market (S&P down 2.2%) after reporting mixed 2Q10 results. The stock has given up most its gains in the past two weeks since the company received a new license to operate in China.

GOOG reported EPS of $6.45 on revenues of $5.1 billion net of traffic acquisition costs. EPS missed the consensus estimate by 7 cents although revenues were more than $100 million ahead of estimates. Revenues grew 23% and were up 1% from the first quarter. For many companies these results would have been good enough but GOOG is a high expectations stock with recently negative sentiment so a clean beat was necessary to sustain and build on recent gains.

The stock is suffering mostly because operating expenses rose more than expected resulting in a drag on profitability despite better than expected revenue growth. The Street has been concerned for some time that GOOG is facing a tougher competitive environment in which slowing top line growth was going to be met by investment in the business.

Second quarter results again showed heavy investment as GOOG defends its market share in search and invests in display advertising, mobile advertising and search, and YouTube. However, this quarter at least, GOOG's investments seem to paying off as revenue growth beat expectations and accelerated.

The other issue for Wall Street is that while GOOG grew EPS 21% in the second quarter, growth in the second half is expected to moderate into the mid to upper teens. Wall Street hates growth deceleration, especially from a growth company.

Looking ahead to 2011, the big question is whether growth can be sustained closer to 20% or continues to decelerate to 15% as implied by consensus estimates. The stock is undoubtedly good value at less than 15 times 2010 estimates adjusted for the huge cash balance. On 2011 estimates, the multiple is less than 13 times.

I think GOOG's long-term growth will be sustained at least in the teens as search is still growing and new areas are beginning to gain traction. As a result, I think the stock should be owned at current prices. However, the Street is going to need a positive surprise or at least a sign that investment spending is leveling off before the shares respond strongly. Given current valuation and initial signs that growth investments are beginning to pay off, I think it is worth waiting.

Disclosure: GOOG is widely held by clients of Northlake Capital Management, LLC inlcuding in Steve Birenberg's personal accounts. GOOG is a long position in the Entermedia Funds. Steve Birenberg is co-portfolio manager, partial owner the Funds' investment management company, and has perosnal monies invested in the Entermedia Funds.

Posted by Steve Birenberg at July 16, 2010 11:21 AM in GOOG