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January 20, 2012

Google in the Penalty Box. For Now.

Two minute minor, five minute major, ten minute misconduct, or game misconduct?

I'm thinking ten minute misconduct. The quarter is not nearly as bad as the stock would suggest. Revenues were light but operating income, EBITDA, and free cash flow were in line with expectations. Operating margins, a big issue over the past year, were actually better than expected. Adding back some forex hedging, a Clearwire write-off, and a higher than expected tax rate and EPS would have been in line with expectations.

But apologies don't work here. In line numbers are not good enough for Google (GOOG). A top line miss raises issues as despite the low P-E, GOOG is a growth stock. Growth and revenue misses are not compatible.

Lots of analysts ascribe much of the revenue miss to forex but I don't buy that as these same analysts assumed forex would hurt in their models.

The real issue is Cost Per Click (the price of a search ad) fell 8% in the quarter, more than offsetting much better than expected 34% volume growth of search ads (paid clicks). Paid clicks were expected to rise 24% and cost per click was expected to rise 4%.

The volume surge was led by a shift to mobile and emerging markets and new search algorithms that improved the relevancy of search results. The issue is that these newer searches are priced lower. The question is whether pricing in these areas will eventually rise, and if so, how soon. Furthermore, will volumes maintain their higher trend or will they settle back before pricing improves. In other words, is the core search business mature such that driving growth is possible but only at the cost of lower pricing?

I suspect eventually we will learn that pricing in mobile and emerging markets will improve with volumes continuing to run above current expectations. The world is going mobile. Think smartphones, tablets, and ultrabooks. Advertisers will follow and bid up pricing because that is where the eyeballs are going. However, this thesis is going to take time to prove. At least one quarter, maybe two. And in those same quarters, GOOG will close the Motorola acquisition, which creates another headwind. Thus, this official in putting GOOG in the penalty box with a ten minute misconduct.

But let's not get too negative. GOOG trades at 11 times earnings adjusting for $136 in balance sheet cash. The missed quarter saw 25% revenue growth and greater than 20% operating income growth. Microsoft and IBM are trading sharply higher today on mid to upper single digit revenue growth reported last night. IBM trades at the same multiple as Google. Microsoft trades lower but not hugely so. GOOG offers 20% growth for half the multiple. Sounds cheap to me.

If Google can print a better quarter or two, the shares can regain today's losses and then some. This is what I expect so I am holding Northlake's Google position. If the shares head to the mid $500s, I would add to current positions. Whether it goes there before going higher is a guess.

While we wait, expect intense focus on search trends, particularly search ad pricing. There are lots of datapoints here on a monthly basis. But that is all noise and the big move in the shares is unlikely to come before the next earnings report, 90 days from now.

Disclosure: GOOG is widely held by clients of Northlake Capital Management, including in Steve Birenberg's personal accounts. Steve is sole proprietor of Northlake, an SEC registered investment advisor. GOOG is a net long position in the Entermedia Funds. The Entermedia Funds are long/short equity hedge funds focused on media, communications, and related technologies. Steve is co-portfolio manager of Entermedia, owns a stake in Entermedia's investment management company, has personal monies invested in the Funds.

Posted by Steve Birenberg at January 20, 2012 11:23 AM in GOOG