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July 18, 2011

Google is a Growth Stock Again

The most important takeaway from Google's (GOOG) second quarter 2011 results is that GOOG is still a growth company. This means that earnings in the future will be higher than Wall Street expects for a longer period of time. In turn, investors will now pay a higher P-E multiple for GOOG. These basic facts explain the immediate 12% positive revaluation of the shares after the company reported.

It may seem odd to many but Wall Street has been very concerned that GOOG is a mature company facing a steadily declining growth rate. Parallels could be drawn to Microsoft or more recently Cisco Systems. The bearish thesis is that desktop search is mature and other revenue streams like mobile search, display, and YouTube were too small and unlikely to ever be profitable enough to reaccelerate overall corporate growth. Much of this concern emanated from competitive inroads made by social media, in particular, Facebook.

Going into the quarter, the street had been lowering estimates and writing cautiously about 2Q search trends as several large search consulting firms indicated the quarter was showing less than expected growth. The stock declined sharply as this exacerbated concerns that growth was slowing and the P-E multiple continued to compress.

The stock did stage a big rebound beginning two weeks ago when the company introduced Google +, its latest entry into social media, to good reviews. The stock gains accelerated as user growth at Google + was much faster than anyone anticipated. This was a hint of what was to come if the earnings changed the story arc from "mature" to "growth." Google + gave people hope again and while it will not have any earnings impact for years, it improved the psychology and the P-E multiple.

The earnings clinched the growth meme by showing that despite very heavy investment in operating expenses, GOOG is still able to grow the bottom line rapidly. Revenues rose over 30% and even with margin pressure from expenses, operating income grew over 20%. Key operating metrics such as number of searches and revenue per search came in at the high end of expectations, reducing fears about GOOG's most important business. Although no specific numbers were provided, the conference call strongly suggested that mobile search, display ads, and YouTube are witnessing accelerating growth. In other words, the investments are paying off.

Finally, the conference call went quite well, especially Larry Page's comments. He was in charge, handled much of the call, and took lots of questions. One analyst said it sounded like he had just graduated from an MBA program. That was meant as a compliment. Page focused on the company's growth initiatives but made clear he understood and the company took seriously the expense management. This was very reassuring as the ease with which GOOG has been criticized over the past several months is directly related to lack of confidence in senior management stemming from the abrupt senior management shakeup.

Street estimates for 2011 and 2012 are now rising. Next year is looking like $45. I think the stock can trade at 15 times that number now that GOOG is back in favor as a large cap growth stock. By the end of 2012, GOOG could have over $150 a share in cash which this simple target calculation ignores, making it conservative.

Heading into the quarter I was nervous being long GOOG for the first time ever. Exiting the quarter, even after the stock popped 12%, I am very comfortable being long and expect the stock to be significantly higher over the next six to twelve months if the market provides just a little bit of help.

Disclosure: Google is a net long position in the Entermedia Funds. Steve Birenberg is co-portfolio manager of Entermedia, owns a stake in the Funds' investment management company, and has personal monies invested in the Funds. Google is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg's personal accounts. Microsoft is held by select clients of Northlake. Cisco Systems is held by select clients of Northlake and in Steve's personal accounts. Steve is sole proprietor of Northlake, an SEC registered investment advisor.

Posted by Steve Birenberg at July 18, 2011 10:54 AM in GOOG