Saturday, January 21, 2012

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

 click to view interactive chart with technical indicators

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!

Wednesday, January 11, 2012

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...

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