Google: Undervalued Growth Company

TK All-Star posted on 12/08/11 at 09:52 AM

Alan Brochstein suggests Google may be High Quality at a Low Price

Last December, I shared my ideas on what makes a company “good” (Ten Hallmarks of a Good Company).  I followed up with a suggestion that Intuitive Surgical (ISRG) may not only be a good company but may also be a good stock.  Since then, it has increased in value sharply, rising from $250 to about $438 as the valuation has increased and as earnings growth came in a bit higher than expected.

If you missed ISRG, you are in good company, as, unfortunately, I never jumped aboard either. With that train way out of the station, I want to take a look at another potential pick for 2012. Again, the idea is to find a company that meets the criteria I described last year that appears to be priced a bit conservatively and allowing a good entry for new investors.  My pick?  Google (GOOG), which has continued to grow strongly in 2011 but has seen its stock rally only modestly at about 5%.

Before diving in, here were the ten hallmarks I described last year:

1.    Strong Balance Sheet
2.    High Margins, but No Cheating
3.    Strong Cashflow (Watch Capital Spending)
4.    Good Management
5.    Shareholder-friendly Compensation Policies and High Alignment
6.    Other Shareholder-friendly Practices
7.    Growth Industry
8.    Value Proposition to Customer
9.    Good Market Share
10.  High Barriers to Entry

Again, refer back to the original article if any of these points aren’t clear.

I think that GOOG meets all of these criteria.  The balance sheet is almost debt-free, with just $4.2 billion in debt but a stunning $42.5 billion in cash (about $120 net cash per share).  The company hasn’t yet closed its Motorola acquisition, which will use $12.5 billion.

Gross Margins through the first three quarters improved from 64% to 65% (including options expense), with net income margins of 26%.  Net income margins have declined slightly as the company has increased R&D as well as Sales & Marketing (they boosted salaries by 10% and have hired aggressively).

Cashflow has always been strong at GOOG, and this year is no exception, with Cash Flow from Operations less Capital Spending ahead of Net Income.  When I look at trends, I like to compare Depreciation and Amortization to Capital Spending, and GOOG, on this basis, has been investing somewhat in the business for the past two years.  So far in 2011, the net difference has been about 15% of Net Income, as the company has invested in data centers.

Evaluating management at GOOG is somewhat complicated with the change this year of founder Larry Page assuming the CEO role. He had previously served as President, Products for the past ten years.  One thing is for sure:  Insider ownership is quite high.  The bulk of ownership is held in voting stock (10 votes per share), which is 92% held by the founders as well as the Executive Chairman. Total insider ownership is about 66mm shares (20%).  Page, co-founder Brin and Executive Chairman Schmidt receive no cash compensation or stock compensation.  Other officers are paid low salaries compared to other companies, with large potential bonuses and large stock and option grants.  I like this because they are incentivized to grow profits and revenues in their cash compensation and to grow the stock price given their substantial ownership.

As far as the other characteristics, internet advertising (96% of sales) and, increasingly, mobile advertising are growth industries with high barriers to entry. GOOG has tremendous market share in search and appears to be migrating well from the desktop to mobile devices.  Google users seem to love it and of course pay nothing for valuable information.  Advertisers seem to get good value.

So, I think GOOG has all of the hallmarks of a good company, with strong growth and profitability and an eye on the future.  Let’s take a look at a chart that depicts both a strong past but also a very reasonable valuation assuming that the company can continue to grow:

In the top panel, we can see that the stock has been trending sideways now since the end of 2007 while earnings (the light blue line in the top panel) continue to rise (and are expected to rise).  In fact, for 2012, analysts currently project 19% EPS growth and 17% growth for 2013, down somewhat from the 24% compounded growth over the past 5 years.  In the middle panel, we see how much the PE has come down.  At 15X, it is very close to its all-time low and below the projected growth rate.  Keep in mind that this excludes the fact that the company has so much cash net of debt, which, after considering the pending Motorola Mobility acquisition, will still exceed $80 per share.

When I think about where GOOG could trade over the next year, I anticipate that the PE multiple might rise to a range of 18-20.  Looking to year-end 2012 and based upon current projected EPS for 2013 of $51.18 (according to ThomsonReuters), the stock could trade to a level of 920-1024.  Even if the stock holds its current multiple of 15, the stock could increase to 768 if the 2013 estimate remains achievable.

Just as ISRG looked to be underappreciated last year, I believe that GOOG may also be offering a great entry into a high quality company with strong growth, leading market share with high barriers to entry, a fantastic balance sheet, healthy margins and friendly management.  As with all companies, there is always the risk that the future ends up very differently than the past, and GOOG is certainly competing with other Technology companies like Apple (AAPL), Amazon (AMZN) and not-yet-public Facebook.  For now, though, the company seems to be hitting on all cylinders.

Alan Brochstein
Founder, Invest By Model and AB Analytical Services
TradeKing All-Star Commentator

Disclosure:  No Position in any securities mentioned.

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Posted by TK All-Star on 12/08/11 at 09:52 AM


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