Google Earnings, Motorola and the Pay Per Click Challenge

Google $GOOG came out with earnings numbers that disappointed the market and received no end of negative commentary from journalists and commentators. The stock declined 10% in after hours trading and the next day closed 8.5% down.

  However, I suspect this is more to do with adjustments to the game of hitting analyst estimates rather than any weakness in the underlying performance of Google. Granted, there are some changes in terms of accelerating paid clicks (up 34%) but declining cost-per-click (down 8%) but I don’t consider them to be a major issue and will discuss this later.

Google Don’t Give Estimates or Guidance

Google don’t give guidance nor do they give estimates. Ever. This makes life that bit tougher for analysts. It also happens to cause significant variance with actual earnings and estimates, because analysts do not have a number from the company from which to ‘anchor’ their estimates. We can see the variance expressed in the stock chart below. Note the high volume big gaps that occur, up and down, every three months after earnings are given

 

Indeed, the standard deviation of the difference between earnings and estimates is nine per cent over the last five earnings! However, this mainly represents the inability of analysts to forecast correctly what the numbers will be, rather than the underlying progress at the company.

Google’s Underlying Performance

The underlying performance was strong, although there are some structural changes taking place at Google. Most notably Google is increasing operating expenses quicker than revenues so earnings are not growing as strongly as the top line.

The strategy is to grow Google advertising in the mobile space and the acquisition of Motorola Mobility is a key part of ensuring the primacy of Google’s Android operating system. According to NPD, Android based smart phones have 53% of the market vs. Apple iOS at 29% and RIM Blackberry at 10%

It is inevitable that screen time will increasingly be taken by smart phones and tablets so it is essential that Google grow in the mobile sector. In fact, some analysts are looking at the eight percent decline in cost-per-click as a sign that mobile will be less profitable than pc advertising. Moreover, the acquisition of Motorola Mobility is seen as a challenge to Google because it is a hardware rather than Software proposition.

 I’ll discuss this below, but firstly let’s look at the numbers…

• Net revenues rose 27.6% to $8.13bn
• Total Costs and Expenses Rose 29.6% to $5.46bn
• Free Cash Flow rose 300% to $2.97bn
• Full Year Free Cash Flow was $11.1bn
• Non-GAAP EPS rose 8.6% to $9.5
• Paid Clicks rose 34%
• Cost-per-click declined 8%

…clearly, there is a need to look closer at some aspects of these numbers.

Why Google Cost Per Click Declined

Frankly, I don’t think this is as much of an issue as much of the media made it out to be. Google explained that currency effects (stronger dollar) had an affect as well as a conscious shift to increasing paid clicks at the expense of cost-per-click.

An example of this is the increase in site links. These are the individual links to various parts of a website that appear after a search. Whilst they are great for encouraging interaction with a site and thus increase paid clicks, I suspect they do generate less cost-per-click. This is not a problem as long as the overall revenue increases in the mix.

As for the issue of increasing mobile ads, this too, should not be seen as a particular issue. Smart phone internet usage is definitely different but probably involves more focused search (via engines) and re-occurring visits to favourite websites (facebook, youtube)  then the meandering browsing experience of sitting in front of a pc.

 There is every reason to expect that Google will be able to continue to generate growth even though internet usage shifts to online.

Google can meet its Challenges

Whilst a lot of negative commentary is directed towards what management will do with Motorola Mobility, I think this is somewhat misguided. Motorola is a hardware company, but increasingly, the value in a handset is actually coming from the operating system, software and mobile applications!  Google knows what it is doing here.

 In addition, the shift to advertising on mobiles involves a change in activities that Google has performed endlessly and iteratively, with pc advertising. It is not a significant strategic shift, Google knows how to generate revenues from links and advertising and has

Google’s Evaluation

In summary, at the current price of $586 we are looking at a business that is growing net revenues at 27.6% and has just generated 11.1/154.5bn=7.2% of its Enterprise Value in free cash flow over the last year.Trading on a PE ratio of 16.3x I think this business is cheap despite the ‘disappointment’ in these results.

There are issues with the management’s attitude to shareholders and refusal to pay a dividend despite having a $35bn on the balance sheet. However, Google’s prospects look bright and fears look overdone. There is more to investing than meeting analysts estimates!

Alcoa's Outlook Not Really a Cause for Optimism

Alcoa $AA gave results recently and the markets liked the outlook given by the company. Indeed any sign of an optimistic outlook from a bellwether like Alcoa will have equity investors excited. But what was really behind the underlying assumptions in Alcoa’s bullish outlook statement?  Moreover why are some investors taking this macro economic outlook from Alcoa and concluding that it’s now time to pile into equities?

The Equity Risk Premium

One argument relies on the valuation of the equity risk premium. In other words, equities look cheap compared to bonds right now. Whilst I’m sympathetic to this argument, I think it is flawed. I think the traditional academic treatment of bonds vs. equities is predicated on bonds having a risk weighting of 1 and then building in a premium for what you would then pay for the 'riskier' equity. 

All of which is fine, if you are happy to believe that the risk weighting of bonds really is 1. Clearly, some parts of the market thinks that Germany is more than 1, otherwise why buy debt on negative yields...

http://ftalphaville.ft.com/blog/2012/01/10/825611/german-negative-yields-as-harbinger-of-deflation/


...whilst the reluctance to lend Italy money for 10 years goes on unabated...

Church & Dwight a Recession Proof Small Cap

Church & Dwight Co $CHD is a great stock to do some equity research analysis on because the co is largely recession resistant, trades on a good evaluation and offers the prospect of some upside from a fall in commodity input costs.

Church & Dwight are in the personal and homecare space and, are a small cap  company which is comparable to the like is Reckitt Benckiser, Colgate, Clorox, Unilever etc.  The company is little discussed but has an excellent track record of generating earnings through the cycle. This analysis seems them being able to generate at least double digit returns for a stock investor from here.

Church & Dwight Brands

The brands can be categorized as a diversified collection of personal and homecare goods. Much of their brands are value propositions which offer upside in a stagnant economy as consumers trade down to cheaper brands. In terms of profits and sales, 80% of them come from their eight leading ‘power’ brands…

• Arm & Hammer (toothpaste, baking soda, detergent, cat litter)
• Trojan Condoms and Vibrators
• OxiClean Laundry Additive
• Spinbrush Battery Powered Toothbrush
• First Response Pregnancy Kit
• Nair Hair Removal
• Orajel Pain Relief
• Xtra Extreme Value Laundry Detergent

…which reads like a roll call of US value brands found in the home. However, Church & Dwight is far smaller than its major competitors and its business model is tailored towards grabbing leadership in niche markets.  What makes this company special is its execution.

Church & Dwight Earnings

The management has demonstrated a tremendous ability to grow earnings and revenues over the years and this can easily be summarized below…

(m)	2006	2007	2008	2009	2010	2011E
Revenue	1,955	2,221	2,422	2,520	2,589	2,710
Gross Profit	761	877	972	1,101	1,157	1,205
EPS	1.04	1.23	1.43	1.74	1.98	2.18
EPS Growth		18.3%	16.3%	21.6%	13.8%	10.1%

Analyst estimates for 2012 are for a further 4% revenue growth and 10% EPS growth.  

All of which paints a picture of a recession proof company but 2011 has proved challenging as end demand was lower than initially expected and rising commodity costs put pressure on margin expansion. No matter, the outlook for 2012 presents upside potential as the US economy generates employment gains and commodity costs abate with slowing emerging market growth.

 It is also worth noting that gross margins jumped in 2009 with the fall in commodity prices and, Church & Dwight has managed to hold onto them despite rising costs in 10-11. Similarly, with such a well run business, working capital management is excellent and the co generated large amounts of free cash flow. 

Church & Dwight Evaluation

The stock trades at a price of $44.51 with a market cap of $6.37bn. There is $275m in cash on the balance sheet with $250m in outstanding debt. FCF has grown from $200m to $364m from 2007-2010 at a CAGR of 22% with trailing FCF currently running at $391m.

Obviously, a PE ratio of 20.4x for 2011  makes little sense and even in further ahead where analysts see EPS of $2.19, the PE ratio only drops to 18.5x in 2012. However, the true value in an investment lies in its ability to generate cash and on a current FCF/EV of 391/6350= 6.2% the stock is attractive.

For a relatively secure double digit growth over the next couple of years, this stock could trade on an evaluation closer to $50 with upside potential from reducing commodity costs.  A decent 12% upside.

Anite Half Year Trading Update

A super half year trading update from Anite today which can be read here and there is a more detailed write up on Anite in a previous blog post here. It looks highly likely that broker forecasts will have to be upgraded and this makes Anite an even more attractive stock to buy in order to play the growth in the smart phone market.

Investors would be advised to look at the previous post whilst interpreting the update, of which will summarise below.

Anite Half Year Trading Update

This is a first half update, which for Anite, runs to October. The year end is in April. The key point to note (re earlier post) is that Anite is typically a H2 weighted business. Handset revenues are the strongest growth driver at the moment, so the focus will be on this division.  Note that overall revenues declined from H2 to H1 (2010) last year and that handset revenues were flat.

 However, in this H1 Anite are telling us that revenues are up 60% from the same period last year. This implies a sequential movement in handset revenues from H2 to H1 (2011) of £28.9m to £32.9m, when last year this movement was flat. For H2, Anite are predicting that Handset testing revenues and operating profit will be similar to the first half. This may prove a outlook which is too cautionary.

Now, appreciating that Anite benefitted from in Q1 from a large order from one specific customer, there is still reason to expect that H2 will see its usual stronger performance. In this update, Anite confirmed that Q2 order intake was ‘very healthy’ and that since the last update in September the strong trends have continued. This is in line with what everyone else is saying in the smart phone industry.

Anite Analyst Upgrades

Indeed, knocking up some back of envelope assumptions demonstrates the potential for an upside re-rating here.

• Conservatively assuming (in line with Anite)  that H2 handset sales are the same as H1 would give full year handset sales at £20.6*1.6*2=£65.94m
• Last full year sales for Network Testing and Travel were a combined £44.15m

Combining the two, gives full year revenue of £110m when current analyst forecasts are for £103.3m. And, of course, this assumes no H2 bias for handset sales. It also assumes flat full year sales for Network Testing and Travel, even though it appears that Anite are bringing forward the period when ‘material’ sales in 4G testing are due to kick in, to ‘later in the year’ from previously in 2013.

Therefore, there is reasons to believe that Anite’s full year numbers will beat even the revised forecasts that the company is conservatively guiding analysts towards. Following this update,  95p is a reasonable price target.  

Nice Systems Offers Recession Resistant Growth?

Nice Systems $NICE is a stock that benefits from increasing security and regularity compliance within financial services. They make the kind of surveillance and monitoring systems that the likes of UBS would have needed to make sure that a rogue trader like Kewku Adoboli might have been picked up early on in his activities. As such, Nice Systems primary profit driver is increasing regulation and awareness of ever complex needs to gather information from multiple sources, both internally and externally.

Nice Systems Equity Research

There is a detailed write up on Nice Systems in a previous post on Earnings View. The post is intended to analyze Nice Systems as a possible stock to buy in the light of recent results and guidance.

Turning back to the original post-referred to above- it’s clear that Nice Systems has done quite well this year.

	Feb Guidance	Current Guidance	Mid-Point Change
Full Year Revenue	$775-800m	$792-806m	+1.5%
Full Year EPS	196-202c	205-209c	+4%

The numbers are nothing stellar but it is solid performance and the stock price has moved in a highly correlated manner to the S & P 500. In other words, the stock is flat. The recent earnings were quite good and the company raised guidance but analysts were left enquiring over the book to bill ratio for the third quarter and why it was below one. A number of reasons were given for this on the conference call, which are summarized below

• Slower customer bookings in the third quarter, some of which were closed in the ongoing fourth quarter
• Book to bill forecast to be much higher in the fourth quarter
• Weakness in Q3 not seen in any product line or geography
• Management explained that the book to bill was also had a pattern of being weaker in the third quarter in previous years, and that this was partly due to the increase in maintenance revenues and the way that business was conducted

All of which, is perfectly feasible but cannot allay particular fears about the macro economic uncertainty creeping into their order book. Moreover, as the share price is tracking the S & P 500, it is perhaps prudent to wait until they confirm a return to a string book to bill ratio in Q4.  That said, Nice Systems rival Verint $VRNT Inc raised full year revenue guidance growth to 9% from 8% in September.

Nice Systems and Verint Systems Recession Proof?

The odd thing about these two stocks, Nice Systems and Verint Systems is that they both increased net income and cash flow through the recession. This is to be understood, as their revenue drivers are relatively secular. However, with Nice Systems, there was a drop in revenues of 6.5% from 08-09 and gross profit fell by 10% However, Nice managed to only lose 7% in EBIT due to reduced SG & A expenses.

This suggests that Nice Systems is relatively recession proof but the problem is that a large amount of the company’s revenue comes from the financial services vertical. Unfortunately, if there is a Sovereign Debt Crisis induced slowdown then it is this sector and its suppliers that will get hit the hardest and, Nice Systems will not be immune from negative sentiment.

Nice Systems Stock Evaluation

No matter, even though the outlook does look uncertain and, investors will want to see the book to bill ratio improve in the next quarter, this stock is an intriguing one to follow for the potential to outperform when/if the Sovereign Debt fears subside. It is certainly not cheap on a PE basis but Nice Systems do generate consistently good free cash flow and as of September had nearly $600m in cash and equivalents on the balance sheet. Its an attractive stock to buy but, for now, its on monitor.

Anite Offers Exposure to Smart Phone Growth



A Smart Phone Stock to Buy



Anite is an interesting stock with which to play the growth in smart phones and next generation 4G LTE technologies. The stock is well placed for growth and is a very good candidate for investors looking to buy stocks for a GARP based portfolio.  Anite has two divisions, namely wireless testing and travel. The latter is an odd fit and will be discussed later, because the real excitement is with the wireless division.

A quick break down of historical six months revenue and adjusted segmental profits reveals the transformation in the business over the last couple of years. Firstly, starting with revenues…

Revenue	Oct 09	Apr 10	Oct 10	Apr 11
Handset	15,226	20,527	20,606	28,937
Network	8,634	11,392	11,965	12,183
Travel	11,335	11,656	9,728	10,275
Total	35,195	43,575	42,299	51,395

…and then a breakdown of segmental adjusted operating profits…

Adj Op Profits	Oct 09	Apr 10	Oct 10	Apr 11
Handset	375	3,085	3,537	6,466
Network	1,517	3,052	3,610	2,810
Travel	2,512	3,063	1,548	2,658
Total	4,404	9,200	8,695	11,934

…and the shift towards profit growth coming from higher margin handset sales is clear to see.

Unlike UK listed Spirent SPT or US listed Ixia $XXIA, Anite provides software whilst the previous companies primarily provide hardware. This means that Anite has more operational leverage and the expansion in margins has indeed been impressive.

A Smart Phone Growth Stock

The handset division is seeing increasing growth from testing in next generation LTE smart phones and in September’s update Anite confirmed that LTE handsets made up 46% of total handset testing revenues, as opposed to 17% for the same period last year.  Qualcomm $QCOM gave results recently and whilst most of the attention was focused on the strong growth of 3G in emerging markets, Qualcomm was very optimistic on LTE as well…

‘And what we're seeing in terms of forward-looking mix is, I would say, tremendous growth in the mass-market smart phones around the world. You're seeing a lot of designing activity in those mass-market areas. We're also starting to see, I think, more penetration of LTE and the leading AP processor coming together.’

…and this market looks set to grow. The early cycle semiconductor companies like Aixtron, Samsung and Intel all affirmed that the strongest growth area for their businesses is in smart phone chip demand.

Moreover, turning to Anite’s Network Testing division, there is a similar trend developing. There is reason to believe that Anite are guiding towards an acceleration in demand here and its not clear if this is baked into analyst forecasts yet. For example, back at the full year results in June, Anite said…

‘Business activity levels in the second half of the year were at more normal levels.  The second half of the year also saw the first minor sales of LTE products in network testing, although levels are not expected to become material until 2013. ‘

…but at the September trading update, Anite implied that ‘material’ sales would now be in the year to April 2012…

‘The Network Testing business performed in line with expectations in the quarter.  The first sales of the Invex 4G benchmarking product were made in the period, although material sales are not expected until later in the year following planned investment in the first half to support the product development.’

So, the handset division is trading ‘significantly in excess; of last year and ahead of expectations and network testing sales appear set for early acceleration. Meanwhile, the Travel division appears to have stabilized with revenues focused on servicing a large client in TUI.

Anite Evaluation

With a stock price of 66.5p Anite trades on a market cap of £198m and has net cash of £9.1m on the balance sheet. Analyst forecasts are for adjusted EPS of 4.5p and 5.4 for 2011-12 respectively.  This would put Anite on a forward PE ratio of 14.7x and 12.3x respectively. This is hardly expensive when you consider that Anite is primarily a software company so much of that profit will be translated into free cash flow.

Indeed, Anite are expected to generate £4.2m and £7.8m in FCF for the next two years and, with mid teen’s earnings growth looking set for the next few years, the stock is undervalued. An evaluation closer to 90p is possibly better value.

In addition, UK peer Spirent has $227m in cash on its balance sheet and is looking to make acquisitions. Anite would be a very good fit. Watch this space.

Is Genuine Parts Company A Genuine Value Stock?

Genuine Parts Company $GPC is a stock that provides a compelling combination of cyclical growth and defensive stability. The recent results were impressive and it is a stock which is a prospect worthy of equity research reports. What makes GPC attractive is that as, a distributor with diversified end markets, it has the ability to decrease working capital in a downturn.

Furthermore, its largest division (Automotive) has the potential to do well in a recession. Although passenger miles do go down in a slowdown, the average age of a car tends to go up as consumers hold off purchases. And older cars need more spare parts. It is an industry trend that has benefitted the likes of pure automotive stock plays Autozone $AZO and O’Reilly Automotive $ORLY.

Genuine Parts Company

However, Genuine Parts Co is a stock that is about a lot more than automotive parts distribution. They also have a cyclical industrial division and small electronics & electrical division (EIS). In addition there is an office products distribution business which has diminished in importance to the GPC over the years.  To demonstrate the evolving nature of turnover and profitability, here is a breakdown of the last five years for Q3…

Division Profits (k)	Q3 2007	Q3 2008	Q3 2009	Q3 2010	Q3 2011
Automotive	115,023	111,730	107,735	124,059	141,233
Industrial	69,669	77,220	36,495	72,856	97,191
Office	33,183	33,426	26,692	26,657	27,024
EIS	7,685	10,272	6,802	8,393	11,138
Total	225,560	232,648	177,724	231,965	276,766

Now clearly, the automotive division is a lot less cyclical than Industrial whilst the office products division is stuck in a rut due to the ongoing rationalization of employment and ultimately office fit outs. However, the key to understanding this business is how Genuine Parts Company is capable of reducing working capital requirements in the face of a recession. This results in favorable free cash flow generation potential over the course of the cycle…

	2007	2008	2009	2010	To Q3 2011
Net Income	506,339	475,417	399,575	475,511	430,159
Depreciation & Amortization	87,702	86,698	90,411	89,332	66,938
Change in op assets & liabilities	47,430	(33,806)	355,312	110,055	(311)
Op Cash Flow	641,471	530,309	845,298	678,663	497,408
Capital Expenditures	(115,648)	(105,026)	(142,259)	(85,379)	(63,932)
Free Cash Flow	525,823	425,283	703,039	593,284	433,476

…and at the Q3 results presentation, the management said this with regards cash flow generation for the full year 2011…

'While our several consecutive years of strong cash flow, we expect to generate strong cash flows for the full year and continue to estimate cash from operations of approximately $700 million for the year. At this level, free cash flow after deducting capital expenditures and dividends should be more than $300 million, which is in line with last year. We are pleased with the continued strength of our cash flows and remain committed to our ongoing priorities for the use of the cash.'

In other words with capex forecast at $105m this means 2011 free cash flow is likely to be at $595m.


Genuine Parts Company Evaluation

Now looking at the current stock price of $57.52 this equates to a market cap of $8,980m and an EV of $8950m. The last five years of free cash flow (across a difficult cycle)  average at around $568m which would GPC on a 5 year FCF/EV margin of 6.3% and this is pretty good value, especially as analysts are predicting 10% EPS growth for 2012. However, there are concerns. Most of the cash flow growth has come from cost savings, inventory reductions and greater working capital management. There is a limit to how far this can go.

Furthermore, net income has not really gone up in the last five years and industrial sales tend to fall off a cliff when the economy gets bad.  For example, in 2008 Industrial sales were growing at yearly rate of near 7% until Q3 then suddenly they fell to 0% in Q4 and then -16.4% in the first quarter of 2009.  It is worth noting how late in the year this drop off occurred. This suggests that the Industrial division tends to be a bit late cycle, so the strength we are seeing now could fall quite sharply if the economy worsens.

Frankly, I think it is better to hold a pure play like Autozone AZO or O’Reilly Automotive ORLY and then balance them with other more cyclical stocks than make an outright purchase of GPC right now.