19 July, 2007

Investors Punish Google for Expenditures

Google (GOOG) reported earnings after the close today and investors saw the numbers and headed for the exits not in single file but in a horde. Google earned $3.56/share excluding employee options expenses and other things. The street wanted $3.59/share, so Google missed expectations, however the highest analyst opinion had an estimate of $3.93/share. Keep that in mind. Shares were sent down from $550 to as low as around $510 in extended-hours trading.

The raw numbers. $3.8Billion in revenue which is a 58% year over year increase and a 6% quarter over quarter increase. International revenue inched closer to being on par with US revenue with the split now being 52% to 48%. Of note, Google said that strength came from Spain, France and Italy. Every other call and talk about international markets, especially in Europe centered around the UK and Germany as being Google's strongest points. It's good to see strength increasing across the board.

Another key metric Traffic Acquisition Costs actually fell in the quarter to under 30% of revenue, this is how much Google spends on other sites to make money through ads on affiliated sites. In essence more and more traffic is coming from core Google.com properties.

Here comes the troubling or not so troubling part of the equation, depending on your investment time frame. Costs and Expenditures. While costs of Revenue stayed flat this quarter at about 40%, there were cost increases across the board for Research & Development, Sales & Marketing and General Administration. These cost increases led to overall margin deterioration from 33% down to 28%. That's a full 5% fall in profit margins. This is huge and the main reason for the earnings miss, which caused the stock to plummet after-hours.

Let's take another look. A company growing like Google, as a long term investor would I want my company investing in the future of its core businesses and beyond, researching into new revenue streams. I say yes. Shorter-term investors would probably say No, as they were looking for a quick gains, riding the coat-tails of this Internet giant. Google was helped in the past by favourable tax rates and more information will be shed on the tax issue during the company conference call. However, with Google looking to expand into other businesses, it should be no surprise to investors that Google would heavily invest in R&D. It certainly takes a lot of capital to invest in the heavy computing infrastructure that Google develops so it can provide the ever-increasing bevy of services that it provides such as Adsense, Adwords, GMail, Google Calendar, Google Apps, YouTube, Blogger, Picasa and more. It is through this R&D that will allow Google to continue to innovate as it tries to expand past search ads into new revenue streams.

To a long-term investor in the stock, as I am, I see this as a blip on the radar screen and look forward to the buying opportunity provided by these dips in the stock. Had Google not decided to book large increases in R&D this quarter how would the numbers look?

$3.87Billion in revenue dispersed over 315Million shares and using an average margin of 33.3% gives a Earnings Per Share number of $4.09!

Without the R&D spending increases Google would have blown away numbers by posting $4.09 vs. the expected $3.59, that's a $0.50/share earnings beat. Would this make shorter-term investors happy? I bet it certainly would. Being a long term holder I wouldn't complain if Google reported a number like this. Google's strategy of being a longer-term looking company (chalk that up to the Warren Buffet style of investing) is certainly showing its colours this quarter and with this brings disappointment to the growing crowd of Google fans who are growth investors.

The choice on Google becomes very simple at this point. Are you a believer that Google can effectively diversify its revenue streams making all this R&D spending worthwhile? Or do you think they are throwing money at the wind and should stick to what they both best in the short term, Search ads?

For a long term investor the choice seems easy, however a company as highly valued in the marketplace and as young as Google, brings with it high volatility and much risk, and today's earnings backslash showed this in full force.

Disclosure: Author is long GOOG


Anonymous said...

I don't quite agree qith your contention that google is a strong company to hold in a long term portforlio. Sure it is investing in itself more causing its earningns to be lower than expected, but even at the forward P/E of 32, we can't say this is a good value. At some point in the rosiest of scenarios (long term, perhaps 15 years from now) google will control a large portion of the market. It will at some point then be another media stock with FP/E of maybe 15. So google now is twice as expensive as it should be. BUT, do we really see google making it 30 or 40 years from now? There are serious contenders, and we should at least gather thought that microsoft or apple or any other software/hardware/media company might take hold of google's supremacy. Today google is near the top of almost all online markets (except auction/moneymoving) that require little human involvement. Strength of other companies and the open source software networks(and even websites as facebook has shown) leaves me fearful of google's prospects.

Chris Krasowski said...

You bring up some good points, but I disagree and continue to hold my position that Google is a great long term investment. A company like Microsoft trades at a P/E in the mid 20s, and for how long has Yahoo or Ebay traded with P/E's in the 30s. Google in the near future shouldn't go down to a P/E or even forward P/E of 15. If this happened within 3-5 years it would be the bargain of the next decade.

And yes Google can certainly be around in 30 or 40 years because I believe they have the ability to adapt. However technology is a very volatile industry that changes very rapidly and really no one knows for sure where we will be at as a society with technology in say 40 years. I define longer-term hold, in terms of technology companies to be somewhere in the range of 3-6 years.

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