August 1, 2012
OSU SIM Equity
Research
Summary
Over the past decade, Google has become
synonymous with internet search. Google has been
able to capitalize on this by selling targeted
advertising space on its network of sites significantly
better than its peers. Advertising revenues currently
account for 96% of total revenues. The company has
attempted to expand into other income sources
through its development of Android and acquisition
of Motorola Mobility (MMI) but thus far have been
unsuccessful in significantly shifting away from its
reliance on advertising revenues.
Investment Thesis
With a target price of $740 and factoring in the recent
10% run up of Google’s stock price which occurred
after the company reported quarterly earnings that
exceeded analyst EPS estimates and left just a 17%
upside, my current recommendation is HOLD. The
company did miss analyst revenue estimates and this
may inflame fears that the years of 20-30% growth
are past.
The stock has fluctuated significantly over the past
year due to uncertainty over the MMI acquisition and
concerns about future growth, particularly abroad. I
feel that many of the acquisition fears are misplaced
since MMI was purchased in cash and the acquisition
should have no negative impact on future advertising
earnings growth. The long-term risks that Google
faces are obsolescence due to disruptive technologies
and diversifying its revenue stream.
In the near-term, the main risk Google faces is a
slowing worldwide economy fueled by credit and
macroeconomic fears in the Euro-zone. If companies
begin to spend less on advertising, Google’s revenues
will suffer. Also key-talent retention and acquisition,
in addition to the health of CEO Larry Page are risks
that need to be factored in. Lastly, domestic and
international governmental regulation and fines are a
potential risk factor, although in the past the effects of
such have been minimal.
HOLD
Recommendation
Ticker
Sector
Industry
Price Target (USD)
Price as of July 31, 2012
Potential Upside/Downside
Dividend Yield
Total Projected Return
GOOG
Information Technology
Internet Software &
Services
$740.00
$632.97
17.0%
N/A
17.0%
Market Data
Market Capitalization (USD)
Shares Outstanding
52 Week Price Range (USD)
Beta
206.78B
327.03M
480.60 - 670.25
1.13
Financial Data (FY2011)
Revenue (USD)
Revenue Growth (2010-2011)
Operating Income
37.905B
29%
9.737B
Analyst / Fund Info
Fund
Instructor
Analyst
Phone (614) 361-4015
OSU SIM
Adam Robertson
Gary Foust
foust.48@osu.edu
Trailing 1 year performance (+4.74%)
August 1, 2012
TABLE OF CONTENTS
Company Overview................................................................................................................................................................. 3
Brief History.......................................................................................................................................................................... 3
Current Position .................................................................................................................................................................. 4
Current Market Events ..................................................................................................................................................... 5
Competitive Landscape .................................................................................................................................................... 6
Investment Thesis ................................................................................................................................................................... 8
Stock Analysis ......................................................................................................................................................................... 10
Financial Analysis ............................................................................................................................................................. 10
Valuation .............................................................................................................................................................................. 12
Discounted Cash Flow ................................................................................................................................................ 12
Valuation using Multiples ......................................................................................................................................... 13
Final Price Target ......................................................................................................................................................... 14
Risks and Concerns .......................................................................................................................................................... 14
Conclusion ................................................................................................................................................................................ 16
Appendix I – DCF Valuation............................................................................................................................................... 17
Appendix II – Multiples tables .......................................................................................................................................... 18
GOOGLE
August 1, 2012
COMPANY OVERVIEW
BRIEF HISTORY
Google was started as an internet search and indexing engine
at Stanford by Larry Page and Sergey Brin in 1995. It started by
using a new concept to attempt to sort through the massive amounts
of data, ranking results based on the number of links to the page it
could find. The resultant product was a significant improvement over past search engines, and
Google began to strengthen its brand and acquire user traffic. Google incorporated quickly in
1998, introduced AdWords in 2000 to sell targeted advertising, and by 2004 held its IPO.1 To
this day, AdWords and similar products that it offers make up a significant amount of its revenue
stream.
Since it began, Google has grown at an extraordinary pace and much of its efforts have
been to obtain more internet traffic, with a few notable exceptions. YouTube was acquired in
2006 to add more traffic to Google’s network sites. Google incorporated its AdWords program to
display video and picture based advertisements through YouTube, resulting in significantly
higher revenues as more targeted advertisements are sold. Nearly 60 hours of new video content
is uploaded to YouTube every minute.1
SMARTPHONE OS MARKET SHARE
In 2007, Google entered the mobile
platform industry with Android. The
Android OS has been very popular, partly
because of it being given away for free, and
is currently the most used Smartphone OS.2
Google has yet to fully capitalize on its
dominant position within the sector but is
well positioned to grow its revenue stream if
it is able to deliver targeted advertisements
to users of its Smartphone OS similar to how PC based users interface with AdWords.
Http://investor.google.com, http://www.google.com/about/company/,
http://investor.google.com/financial/2011/filings-archives.html
2 Figure 1 and statistic http://finance.yahoo.com/news/strategy-analytics-android-smartphone-market134800972.html
1
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GOOGLE
August 1, 2012
CURRENT POSITION
REVENUES BY SOURCE
Google receives 96% of
total revenues from advertising,
similar to year’s past.1 In order to
grow revenues for the company, the
advertising revenues need to
continue to grow because of the
sheer scale of them. Year over year
growth in both revenues and net income have been very high since Google has gone public and
they appear to be on course to continue that high growth.
Users access Google because of their past uses and its innovative ways to deliver the
content they need in a clean and concise manner. This past heavy use has made Google’s brand
image very strong with users; it is to the point now that Google is becoming a verb meaning
internet search. Google will be able to sustain its competitive advantage through heavy
competition because of its stellar reputation and brand name. Google has taken steps to ensure
that it stays relevant against other content providers, attempting to keep the traffic through its
sites while maintaining its core competencies. It has done this through developing Google+,
Google Local, Google Maps, etc.
The potential main causes for slowdown in growth are increased competition, challenges
in scale due to the large amount of revenues already collected, and increased maturity of the
internet advertising industry.1 Microsoft has attempted to enter this space unsuccessfully through
Bing and its partnership with Yahoo! but is still pouring money and energy in trying to procure
traffic and advertising revenues. There will be other challengers ahead as the industry is still
relatively young and has high margins. Another challenge that could affect future growth related
to scale and the shifting trend in internet consumption to mobile devices is cannibalization of
traditional computer-based traffic revenues by mobile browsing. Since space on mobile devices
is limited, there will be a decrease in the advertising space Google will be able to sell.
Margins have been mildly slipping due to increased costs of procuring traffic, a trend that
Google is trying to avoid. The company has attempted to keep as much traffic flowing through
its sites as possible and develop strategies to avoid this. It seems to be working for now as their
2012 Q2 EPS beat analyst expectations in spite of missing revenue expectations.
Google has been very
effective expanding globally and
now has slightly more than half of its
revenues from sources outside the
United States. This trend will most
% REVENUES BY REGION
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GOOGLE
August 1, 2012
likely continue in the near term as they expand into countries still growing their internet
infrastructure.
Outside of search and advertising, Google’s other lines of business are its mobile
platform Android and Enterprise technologies. The remaining 4% of Google’s revenues
primarily come from Enterprise technologies such as Enterprise search through the Google
appliances and licensing fees for use of their mapping technologies. Google has invested very
heavily in producing best-in-industry maps and they are able to capitalize on them. Google has
also made headlines recently as it has started to roll out ultra-high speed internet service in
Kansas City and released a tablet, the Nexus 7. Neither of these is expected to make significant
early contributions to either revenues or earnings, but over the next few years could potentially
break Google’s reliance on advertising as its sole source of revenues and earnings.
CURRENT MARKET EVENTS
In the past year, Google’s major action was to acquire Motorola Mobility Holdings
(MMI) for $40/share in cash. This was initially viewed as a way to grab patents for further
development of their Android OS; later there was fear that Google was acquiring MMI to start
manufacturing phones similar to Apple.
TTM PERFORMANCE COMPARED TO S&P 500
Google has stated numerous times that at
this time there were no plans to start
producing all Android phones internally
to alleviate these fears. For the near
term, I expect Google to live up to these
statements and not attempt to shun other
mobile manufacturers and continue to
build their market share lead in the
mobile industry.
Google has also been in the news
due to the health issues of its CEO and
co-founder Larry Page as well as the departure of some executives, most recently Marissa
Mayer. The concern is that if too many of Google’s long term executives leave there will be
significant leadership issues and knowledge leaks. Google and Larry Page have released
statements that the health concerns are not founded but the market is skeptical due to the passing
of Steve Jobs. The more pressing concern is the departure of executives that have been with the
company since its incorporation and have made significant positive contributions in the past. If
the trend of executives and other key talent leaving continues there could be a period of slowed
technological advancement and potential time for competitors to catch up.
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GOOGLE
August 1, 2012
More recently, Google announced its second quarter earnings which indicated continued
strong revenue and earnings growth, even with a generally sluggish economy. Its earnings were
well above analyst expectations even though revenues missed. The result was a 10% jump in the
share price as these results, although mixed, showed that Google is able to maintain its margins
better than expected and should be able to continue this in the future.
Something that has also plagued Google in the news recently is governmental
intervention. Google was recently fined the largest amount ever by the FTC for its breach of
Apple’s web browser privacy policies. Although the amount of this fine was trivial to Google at
$22.5M when compared to net income of nearly $10B, there are other larger cases pending and
popping back up, mostly in Europe. The largest is the European commission looking into Google
for anticompetitive practices, to which Google is nearing a settlement. 3 Another case accuses
Google of spying as it collected street view data for its maps. In addition to governmental cases,
there is patent litigation against Samsung by Apple that could affect how many devices with
Android installed are shipped in the near term.
COMPETITIVE LANDSCAPE
The main competition Google faces within its search and advertising business is through
Yahoo!/Microsoft and Facebook. Google is constantly trying to keep users on its sites so it has
more advertising space to sell, and its competition stems from this.
Microsoft
is
the
largest
and
strongest
competitor within the realm
of search. Microsoft has
invested quite heavily trying
to compete with Google
through
technological
innovations
and
direct
advertising to compete with
the Google brand name.
They formed a partnership
with
Yahoo!
for
technological collaboration
toward this goal, but thus far
http://www.nytimes.com/2012/07/25/technology/eu-nears-settlement-of-google-antitrustinvestigation.html
3
Page 6
GOOGLE
August 1, 2012
have been unsuccessful in stealing any market share from Google. In fact, last quarter the
partnership lost ground despite their heavy investment.4 Microsoft recently wrote down $6.2B
that it incurred while trying to compete.5
Facebook is also a large competitor to Google, however not in the same manner as
Microsoft. More and more time is being spent on Facebook that could have otherwise been spent
on Google network sites. Google has tried to compete in bringing the social networking traffic
through its network with Google+ but they have yet to gain enough traction to be considered
competitive. With the general public backlash against Facebook after numerous changes to
privacy setting and its botched IPO, Google could try to make a dent in Facebook’s market share
but attempts to do so would be very costly.
In the mobile platform realm, Google’s main competition had been RIM and Apple;
although RIM has lost so much market share it would be a stretch to still consider them a
competitor. Apple and Google have been fiercely competitive over the last few years and have
filed numerous lawsuits against each other. The competition is so fierce that it warranted a
mention in Apple’s late CEO’s autobiography "Our lawsuit is saying, 'Google, you fucking
ripped off the iPhone, wholesale ripped us off,'" Jobs told Isaacson. "Grand theft." He added:
"I'm willing to go to thermonuclear war on this."6 I don’t see this severely effecting Google’s
revenues as they don’t currently generate any significant money from this activity, but very high
costs could be incurred if it were found to be infringing on Apple’s patents.
4http://www.comscore.com/Press_Events/Press_Releases/2012/6/comScore_Releases_June_2012_U.S._Sear
ch_Engine_Rankings
5 http://www.thedailybeast.com/articles/2012/07/04/microsoft-s-6-2-billion-writedown-shows-it-s-losingwar-with-google.html
6 http://www.reuters.com/article/2012/06/01/us-apple-stevejobs-trial-idUSBRE8501CQ20120601
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GOOGLE
August 1, 2012
INVESTMENT THESIS
Given the fierce competition and yet Google’s perseverance through it, I expect Google
to continue to grow its revenues and earnings although at a slower pace as time goes on. With a 1
year target price of $740 and 17% upside, the stock is a definite hold but now is not necessarily a
great time to buy more. At its current pace of growth and acquisitions in total Google would
surpass $100B in revenues within 4 years. It will quickly become significantly harder to grow
core advertising revenues over 20% per annum, particularly given the slow growth that
economists are predicting over the next decade.
In the near term, I expect Google’s revenue growth to continue to be better than the S&P
and sector averages as companies continue to switch to more digital based advertising. This trend
will likely continue for at least 4 to 5 more years as the benefits are more documented and
realized. Until this advertising-medium switching peaks, revenues and earnings should continue
to grow at or near their current pace.
In addition to gaining new customers, Google is very much reliant on the state of the
overall economy to entice existing customers to continue to spend. As one can infer from the
below chart, as real GDP grows, so does Google’s stock price, with a correlation coefficient of
.80. Given the current bleak outlook on growth in the overall economy for the next 10 years,
growth prospects for any company tied to the state of the overall economy will be weak, but
given Google’s position it should feel the pain no worse than anyone else.
Source: Baseline
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GOOGLE
August 1, 2012
As expected, consumer spending is also positively correlated to Google’s stock price,
although not as prominent of a correlation. As people are spending more, companies are
spending more to attract them and it drives Google’s revenues.
Source: Baseline
With the general worry that the elections and impending fiscal cliff bring, consumer
spending and therefore real GDP growth may fall and this poses significant risks to Google’s
near term stock performance. However, if Google is able to maintain its margins through the
effective management techniques similar to what they have done in the last quarter the stock
should lose no value.
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GOOGLE
August 1, 2012
STOCK ANALYSIS
FINANCIAL ANALYSIS
Trailing 5 years historical data:
(millions)
Revenues
United States
United Kingdom
Rest of the world
FY
2011
$37,905
$17,560
$4,057
$16,288
FY
2010
$29,321
$14,056
$3,329
$11,936
FY
2009
$23,651
$11,194
$2,986
$9,471
FY
2008
$21,796
$10,636
$3,038
$8,122
FY
2007
$16,594
$8,698
$2,531
$5,365
Costs and expenses:
Cost of revenues
Research and development
Sales and marketing
General and administrative
$13,188
$5,162
$4,589
$2,724
$10,417
$3,762
$2,799
$1,962
$8,844
$2,843
$1,984
$1,668
$8,622
$2,793
$1,946
$1,803
$6,649
$2,120
$1,461
$1,279
Charge related to the resolution of
Department of Justice investigation
Operating Costs and Expenses
$500
$26,163
$0
$18,940
$0
$15,339
$0
$15,164
$0
$11,509
Operating Earnings
Operating Margin
$11,742
30.98%
$10,381
35.40%
$8,312
35.14%
$6,632
30.43%
$5,085
30.64%
As noted before, Google has been able to have very high operating margins in the past
and has also more than doubled its earnings and revenues in 5 years. I expect core revenues to
grow and margins to stay near current levels for its core advertising business for the immediate
future until a serious competitor challenges them.
One challenge in projecting Google forward is its recent acquisition of MMI. Revenues
will significantly grow inorganically between 2011 and 2012 because of the acquisition, but the
operating margin will have a steep decline as MMI is not projected to post a profit within the
next few years. There will be efficiencies in combining the 2 companies, but I do not believe it
will be enough to bring MMI back into positive earnings. To account for this, I projected
expected expenses for Google and MMI separately as a percentage of the revenues each will
bring to the company. MMI’s expenses are projected near their historical average of about 105%
of revenues.
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GOOGLE
August 1, 2012
Given these historical numbers while accounting for the acquisition of MMI, I projected
the following for the future 3 years:
(millions)
Revenues
United States
United Kingdom
Rest of the world
MMI
Costs and expenses:
Cost of revenues
Research and development
Sales and marketing
General and administrative
Charge related to the resolution of Department of Justice
investigation
MMI Expenses
Operating Costs and Expenses
Operating Earnings
Operating Margin
FY
2014E
$77,995
$28,721
$6,578
$29,092
$13,604
FY
2013E
$68,327
$24,760
$5,720
$24,243
$13,604
FY
2012E
$59,416
$21,072
$4,868
$19,871
$13,604
$20,663
$8,035
$5,740
$6,240
$18,101
$7,039
$5,028
$5,125
$15,740
$6,121
$4,372
$4,159
$0
$14,284
$54,961
$0
$14,284
$49,577
$0
$14,284
$44,677
$23,034
29.53%
$18,750
27.44%
$14,738
24.81%
Note that as Google’s core revenues are continuing to grow, the operating margins will
increase following the drop off this year as MMI’s revenues account for less of the overall
stream without significant improvement in their industry. Longer term these margins may
dissipate, but for the next 3 years without competition they should stay solid.
Relative to their peers,
Google’s operating margin and
other key vitals are very solid.
Even through the significant
growth seen over the past
couple of years, Google has
been able to maintain a
significantly better operating
margin and EPS than the
industry and
its
direct
competitors.
Source: http://finance.yahoo.com 7/31/2012
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GOOGLE
August 1, 2012
VALUATION
DISCOUNTED CASH FLOW
Attached as Appendix I is a detailed Discounted Cash Flow model. The model yielded a
final price target of $750 assuming revenue growth tapers off towards 4.5% long term, using an
11.25% discount rate. A 4.5% FCF growth rate is warranted as it will be difficult to maintain a
30% growth rate indefinitely. International and domestic growth will slow gradually, but with no
strong competitors Google should be able to grow above the industry average for the foreseeable
future. The 11.25% discount rate was used because Google, as any other IT company, is a more
risky investment than the average but with $44.6 B1 in cash, cash equivalents, and marketable
securities with little long-term debt, an 11.25% discount rate is reasonable.
The operating margin is also a key to the model and long term I have it projected at 20%.
Google has recently outperformed 20% since the development and much of the infrastructure
costs have been undertaken already, but with the attempted competition and potential price
pressure from advertising merchants, along with any potential technology shifts that could
happen in the future resulting in high R&D costs, a long term 20% operating margin is in line.
Sensitivity Analysis
The above analysis shows prices for various discount and growth rates. Given the current
stock price of $632.97, all scenarios above a 3.5% terminal growth rate and below 12% show
upside, some with significant upside!
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GOOGLE
August 1, 2012
VALUATION USING MULTIPLES
The industry multiples are also at or near historical lows which I fully expect to come
back towards their median, although not fully, as there is still significant growth prospects in the
Internet Software and Services industry. The internet is still young, growing with plenty of
potential growth, and not going away any time soon.
Since Google only has 8 years of historical data available from the time of its IPO in
2004, its 10 year historical multiples are skewed but have generally declined over the past 8
years. They are at or near historical lows which are unjustified given their growth prospects and
solid balance sheet. They are also below industry averages with respect to P/E and are at a
discount to their historical relative median pricing. Many of these multiples should pull back up
towards historical medians that are more in line with industry and sector averages.
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GOOGLE
August 1, 2012
One of the key exceptions to the target multiple going towards the historical median is
the Price to Sales ratio. With the acquisition of MMI finalized, Google’s sales will increase
without adding any free cash flow. This will skew this ratio downwards even below Google’s
historical lows. If Motorola is again able to be competitive, the ratio will come back although the
chances of this in the near term are slim.
FINAL PRICE TARGET
Given the above targets multiples
and DCF and assigning weights to each,
the result 1 year target price is $740. The
DCF is the best predictor in this case so it
was assigned the highest weight. When
compared to today’s price, there is a
potential 17% upside.
Method
DCF
P/Forward E
P/Sales
P/Book
Price Target
$
750.53
$
722.95
$
750.60
$
710.10
P/EBITDA
$
$
Final Target Price
717.39
740.00
Weight
60%
10%
10%
10%
10%
100%
RISKS AND CONCERNS
ECONOMIC
One of the largest risks in the 1 year stock price is the state of the overall economy. If the
economy is stagnating and companies reduce their advertising spending, Google’s revenues,
earnings, and stock price will all drop. With the upcoming election and fiscal cliff, there is a
possibility of this stagnation. Google has positioned itself well to weather this but without
prospects for growth, the stock price will fall.
GOVERNMENTAL
Another large risk that could weigh on the 1 year stock price is governmental
intervention. If Google is not able to come to an agreement with the European Council regarding
the antitrust lawsuit it is facing, it faces a drawn out legal battle that could be very expensive. In
addition to overseas intervention, there is a possibility of legal issues surrounding its collecting
personal data during mapping operations and not promptly deleting it when asked. The effects of
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GOOGLE
August 1, 2012
lawsuits in the past have been small when compared to Google’s bottom line earning but
lawsuits and other regulation puts the company in a negative light and could risk future
cooperation. A prime example of this playing out is Google’s diminished presence in China
following its row with the Chinese government.
TALENT
Google’s share price could take a large hit if some of their key executives leave the
company under any circumstance. As with most technology companies, the majority of Google’s
competitive advantage is drawn from the talent hired by the company and the innovation happing
within the organization. If Google runs out of top talent, long term prospects may quickly
dissipate and the stock price will drop to reflect that.
OPERATING
A final risk that could weigh on the 1 year stock price is a decline in operating margins
for Google’s core business. Analysts expect an overall drop due to its acquisition of MMI, but
there is fear that Google cannot keep its operating margin of core advertising revenues at or
above 30% for long. If its core operating margin drops much below its current levels, there will
be significant downside risk as these fears will be inflamed.
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GOOGLE
August 1, 2012
CONCLUSION
Given the final price target of $740, potential upside of 17%, and risks involved I
recommend Google as a HOLD. The strong fundamentals of Google’s revenue generation and
brand name strength will continue to serve them well as they continue to grow, but the majority
of the growth has already been priced in at the current price of $632.97. Without paying a
dividend, the potential total return is still above the market average but in line with other
Information Technology companies.
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GOOGLE
August 1, 2012
APPENDIX I – DCF VALUATION
Current Price (7/31/2012)
$
632.97
Implied equity value/share
$
750.53
Upside/(Downside) to DCF
18.7%
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GOOGLE
August 1, 2012
APPENDIX II – MULTIPLES TABLES
Selected Google Multiples
High
Low
Median Current Target
Multiple
Target
/Share
Target Price
P/Forward E 61.2
12.7
22.6
12.7
19
38.05
$722.95
P/S
29.0
4.6
8.3
4.7
4
187.65
$750.60
P/B
56.3
3.0
6.2
3.0
3.75
189.36
$710.10
P/EBITDA
108.32 10.73 22.13
10.73
13.5
53.14
$717.39
P/CF
250.2
12.9
17
44.05
$748.85
12.7
24.4
Selected Internet Software and Services Industry Multiples
High
Low
Median
Current
P/Trailing E
173.9
14.1
40.1
16.2
P/Forward E
123.3
13.7
32.0
13.8
P/B
11.3
2.6
5.3
2.8
P/S
24.4
2.8
7.2
3.7
P/CF
92.0
10.8
24.9
13.0
Selected Information Technology Multiples
High
Low
Median
Current
P/Trailing E
48.5
11.1
21.9
12.8
P/Forward E
34.9
11.3
19.8
11.5
P/B
4.8
2.3
3.8
3.2
P/S
3.3
1.3
2.4
2.2
P/CF
18.2
8.2
14.0
10.1
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