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April 22, 2014
Sloppy Quarter After Stock Slide Keeps Pressure on Google
Google (GOOG) reported earnings that slightly trailed Wall Street estimates. The stock has reacted poorly even though the company did a good job explaining the quarter and spoke very confidently about the business and long-term strategy on the quarterly conference call. It is worth noting that GOOG provides very little guidance to Wall Street analysts and its earnings reports have more variance with Wall Street estimate than most companies of similar size and investor interest. The immediately prior quarter was better than expected but more often than not over the last two years, GOOG has come in just short of analyst estimates.
I see little impact on the long-term story from the volatility in short-term results and still believe GOOG shares have substantial upside over the next couple of years. Earnings estimates changed little with 2014 looking like $26 and 2015 looking like $31. Without adjusting for GOOG’s substantial cash reserves of about $80 per share, the P-E is 20x and 17X 0n 2014 and 2015 estimates, respectively. With sustained top line growth around 20% I think this is excellent value, particularly among really large cap companies where it is hard to find even 10% top line growth.
Looking at the reported numbers, revenues rose 19%, falling less than 1% short of analyst estimates. Earnings per share of $6.27 compared to street estimates of $6.35, also about 1% short. GOOG did explain that the recent Nest acquisition and some other activities led to one-time expenses and excluding those items, expense growth remained on the same trajectory as recent quarters. The company provided no hard numbers but a couple of analysts believe EPS would have exceeded the consensus excluding these one-time items.
This expense discussion goes to one legitimate concern for GOOG: as the company expands beyond search to display advertising, Android mobile operating systems, Chrome browsers and hardware, Google Glass, and cloud storage, operating profit margins will be pressured. For example compared to one year ago, GOOG’s cost and expenses rose from 66% of revenue to 68% revenue putting pressure on profit margins. For this quarter, this led to just a 4% gain in EPS despite the 19% rise in revenues. This same pattern has been evident in recent quarters going back over the past year.
I take the view that GOOG is smart to invest in its business. The investments support maintaining the company’s competitive position and extending growth into different areas. YouTube is a drag on profit margins but it seems quite clear that the investment has created a potentially very large opportunity for a new profit center that keeps GOOG growing at a well above rate in the future. I think the same argument could be made about most of the investment mentioned above.
One other concern raised by the latest quarter was that the volume growth of paid search clicks slowed to 26% form recent quarters when it was in the upper 20% to mid 30% range. Wall Street fears this could be a sign of growth deceleration in the core search business and Wall street hates deceleration when it comes to growth stocks. This is especially true after the recent shellacking of most growth stocks, including GOOG and all the internet stocks.
The bottom line is that sentiment heading into the quarter was very nervous after GOOG shares had fallen more than 10% since mid-March. The quarter reported may not have impacted the long-term outlook for the shares but the issues with profit margins and paid click growth were unwelcome at a time of stress.
I think it will pay to remain patient and possibly even add to positions. In my opinion, GOOG remains a core position for investors looking for large cap growth over a multiyear time horizon. That is what Northlake’s strategy is all about, so expect patience for client holdings or even small additions where positions may be underweighted.
GOOG and GOOGL iare 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. Northlake’s regulatory filings can be found at www.sec.gov. GOOG and GOOGL are net long positions in the Entermedia Funds. Steve is portfolio manager and managing partner of Entermedia, long/short equity hedge funds focused on media, entertainment, leisure, communications, and related technologies.