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January 23, 2013

Google Concerns Ease

Google (GOOG) has consistently produced 20-25% growth for the last three years but the stock has gone nowhere. Investors have worried that the growth will slow due to competition from social media (Facebook) and the shift from desktop to mobile search. Over the past week, both of these issues have been addresses with a favorable outcome for GOOG investors.

First, Facebook announced its new search product. The product looks interesting and seems like it could be a success for the company but it does not go head-to-head with GOOG in web search. Rather, it provides search just for Facebook's extensive data on its users. Facebook's announcement was still pressuring GOOG shares but I think any material impact on GOOG's growth from Facebook is still many years in the future.

The bigger issue holding back GOOG shares for the past year has been whether the company could manage the shift to mobile computing. The issue is that ads in mobile (smartphones and tablets) are priced much below those on the desktop (PCs and laptops). For example, GOOG has been reporting 25-40% growth in paid clicks (searches for which GOOG is paid) but at an average cost per click (price GOOG receives for the ad) falling 5-20%.

Investors have been concerned that this mix shift would hurt margins as the cost to obtain mobile clicks is higher. In addition, the outsized growth in paid clicks is bound to slow as penetration of mobile devices matures. GOOG's latest earnings report showed progress on the mobile monetization challenge. Paid click growth remained robust at 24%, whiles cost per click fell 4% adjusted for foreign currency. The cost per click decline slowed from an 8% decline last quarter. Wall Street greeted these numbers favorably, pushing the stock up over 6% to anew high for 2013. Heading into the report, GOOG shares were down in 2013 despite the steady market rally.

I think that Wall Street is beginning to accept that GOOG is well-positioned for mobile monetization. The steady growth in paid clicks and stabilizing pricing for the ads sets GOOG up well to sustain 20% earnings growth for the next few years. If investors believe in the growth, the stock trades at a very reasonable valuation, particularly after adjust for about $150 in cash on the balance sheet that is contributing very little to earnings with interest rates near 0% on short-term investments.

GOOG could make around $45 this year and $54 in 2014. Put a 15 multiple on $50 in EPS and you get $750. Add in the cash balance an price target of $900 is quite achievable.

The bottom line is that GOOG had a quarter. Revenue, EPS , and margins met or slightly exceeded expectations. Key drivers of the search business showed that the outlook for the next couple of years is better than the bears having been touting. I think this quarter might be the one that allows GOOG to turn the corner with investors. That will surely be the case if next quarter shows further improvement on the paid click/cost per click front. I suspect it will and GOOG shares will finally live up to their potential.

Google 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. Regulatory filings can be found at www.sec.gov. Google is a net long position in the Entermedia Funds. Steve is portfolio manager of Entermedia, owns a controlling stake in the Funds' investment management company, and has personal monies invested in the Funds.

Posted by Steve Birenberg at January 23, 2013 01:43 PM in GOOG