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April 15, 2011
Google lays a sour egg just in time for Easter
Google (GOOG) shares are trading down 8% the day after reporting 2011 First Quarter earnings. EPS of $8.08 fell about a nickel short of the consensus of $8.13. Revenues of $6.54 billion were about $220 million ahead of estimates, growing 28% on an organic basis. Despite a tough comparison, this was the best revenue growth quarter for GOOG since before the economic crisis.
A good friend and former hedge fund manager pointed out that if GOOG split 10:1 then EPS would have been 81 cents, exactly in line with consensus, so we aren’t really looking at an EPS miss here. Rather, investors don’t like the 45% operating expense growth that led EBITDA margins to drop over 500 basis points. The worry is that competitive and regulatory dynamics will inevitably lead to slowing top line growth and require expenses to remain elevated. In turn, the multiple paid for GOOG's earnings has to be lower.
Management commentary on the conference call was quite upbeat. Analyst questioning was quite skeptical. Management firmly believes that it is getting a good return on its investment spending. This pattern of accelerating top line growth with rising expenses has been evident for three quarters now. In the latest quarter, operating expenses spiked upward even more than recent trends, leaving open the question of what happens next. That is not a good question for any stock.
If GOOG is able to sustain or even improve its revenue growth rate while operating expense growth moderates, the stock is extremely cheap at $540, or 15.6 and 13.5 times 2011and 2012 earnings estimates, respectively. The company has over $100 per share in cash on its balance sheet earning virtually nothing so arguably the P-E multiples are 2-3 points lower. This is quite cheap given a top line growth rate in the upper 20% range that has been accelerating.
On the other hand, despite the recent acceleration in revenue growth, GOOG is facing increased competition from social media, is shut out of China, and faces regulatory scrutiny around the globe that could restrict future growth. Search is maturing and while display and video advertising are growing at very high rates, they remain small and less profitable compared to search. If expense growth remains high and revenue growth slows, margins will come under further pressure. This will lead to lower long-term earnings growth and stock valuation.
Complicating the choice between these views is the management transition with an untested Larry Page assuming control of the company. Page's debut on the conference call was limited. The street clearly wanted to hear more from Page, another issue driving today's price decline.
My view is that GOOG remains attractive. Take that for what's it is worth as I've been long GOOG for over a year. In other words, I've been wrong. Nevertheless, I think a case can be made that first quarter results represent the worst of the operating expense comparisons and revenue growth should be maintained or even accelerate slightly over the next few quarters.
Expectations at GOOG, and for Page, are now quite low. The depressed valuation is indicative of low confidence in the stock. I think valuation limits further downside. Upside is substantial if one of the next few quarters shows operating expense growth moderating and revenue growth sustaining. I think it is a good bet that will happen.
Disclosure: Google is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg's personal accounts. Steve is sole proprietor of Northlake Capital Management, an SEC registered investment advisor. Google is a new long position in the Entermedia Funds. Steve is co-portfolio manager of Entermedia, owns a stake in the Funds' investment management company, and has personal monies invested in the Funds.
Posted by Steve Birenberg at April 15, 2011 02:40 PM in GOOG
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