Google (GOOG), one of the premier growth stories of our generation, has been transformed into a value stock (at roughly 12x 2012 EPS ex-cash )- in fact, it's become so cheap, and underappreciated, that it's become the perfect stock for Warren Buffett and Berkshire Hathaway (BRK.A), and we believe it's increasingly likely that Berkshire will soon become a major shareholder.
Google meets the following key Buffett criteria:
In addition, Google is large and liquid enough for it to be worth Buffett's time and effort - a large position could actually be impactful to the Berkshire portfolio. Following Berkshire's recent purchase of IBM (IBM) shares, it appears that Buffett has gotten over his tech-phobia, at least when the situation is right.
Also, notably, Buffett and Google founders Sergey Brin and Larry Page have been part of a mutual admiration society for many years. Brin/Page quoted the Oracle of Omaha in their IPO-founders letter and have been long admirers, while Buffett gave a nod to Google in his 2007 letter. Clearly, the men of Google manage their business in a very Buffett-like manner.
Of course, given Buffett's historic appreciation for Google, it's worth a brief examination of what's changed - if he didn't buy in 2007, why would he buy now? In addition to getting over his aversion to tech, most simply the stock has gotten significantly cheaper, while the brand has gotten exponentially stronger. For example, 5 years ago today, shares traded at 47.4x trailing diluted EPS (and 44.2x ex-cash), while today shares change hands for 20.4x TTM EPS, and 16.9x TTM EPS ex-cash. All of this despite dramatic revenue and EPS growth. We believe some of the multiple compression is a result of lack of operating leverage (which we detail below), but we think the stronger brand, the deeper moats, and the lower multiple will all be attractive to Buffett.
Google Valuation Table: Dramatic Multiple Compression | |||
February 6, 2007 | February 6, 2012 | Percent Change | |
Price | 471.48 | 608.16 | 29.0% |
Trailing 12-month sales ($ in billions) | 10.605 | 37.905 | 257.4% |
Trailing Diluted EPS | $9.94 | $29.76 | 199.4% |
Trailing P/E | 47.4x | 20.4x | |
Trailing P/E ex-cash | 44.2x | 16.9x | |
Source: Company filings
As to our view regarding Google meeting Buffett's criteria, on our first 2 points, we think they largely speak for themselves. The dominance of Google in core search is unquestionable. When your brand name becomes a verb (ie "I'm going to Google it."), you've truly made it. This has been the case with Google for several years across much of the globe, while YouTube and Gmail have become de facto standards, with Android and Chrome not far behind. Google dominates its core category, and uses that strength to buttress new categories.
On point 3, one has to look no further than the risk factors listed on page 19 of Google's most recent 10-K in which it states as a risk: "Our focus on long-term goals over short-term results." This is illustrated most clearly in the company's financials that demonstrate negative operating leverage that borders on the absurd. It is hard to identify another company that has grown revenue as rapidly as Google has, that has grown op-ex even faster. We would argue that the increase in op-ex is primarily to create more robust long-term opportunities (Android, Chrome, Google+, etc.) and that 2011 revenues would have been similar on op-ex that was flat, in dollar terms, versus 2010.
Google has increased its research and development expenses as a percent of sales from 12.0% to 13.6% and sales and marketing expenses as a percent of sales from 8.4% to 12.1%, from 2009 to 2011.
Year Ended December 31, | ||||||||||||
2009 | 2010 | 2011 | ||||||||||
Research and development expenses | $ | 2,843 | $ | 3,762 | $ | 5,162 | ||||||
Research and development expenses as a percentage of revenues | 12.0 | % | 12.8 | % | 13.6 | % | ||||||
Year Ended December 31, | ||||||||||||
2009 | 2010 | 2011 | ||||||||||
Sales and marketing expenses | $ | 1,984 | $ | 2,799 | $ | 4,589 | ||||||
Sales and marketing expenses as a percentage of revenues | 8.4 | % | 9.5 | % | 12.1 | % | ||||||
Source: Google 10-K
Had Google's 2011 op-ex been flat as a percent versus 2009, EPS would have been almost $5.00 higher. If Google had actually lowered R&D and SG&A by 200bps from 20.8% to 18.8% over the past two years, 2011 EPS would have been almost $7.00 greater, or more than 20% higher than reported. Of course, Google could have also used more aggressive pricing to boost top-line, at least for the short term, albeit at the risk of alienating customers or slowing growth. The point is, Google management could boost near-term EPS dramatically if that were its goal, but it's not. Instead, it is focused on strengthening brand and growing its long term opportunities - something that Buffett, as much as anyone, would appreciate.
We think the market is missing the big picture, which is a fantastic growth story, while focusing on less important details. Google shares declined 8% following the disappointment of an 8% decline in price-per-click. Somewhat lost was the sequential growth of Android, which was up more than 50 million units, is the fastest growing mobile OS, and is only now becoming modestly profitable. With more than 700,000 activations a day, the growth of Android is astonishing.
Similarly, Google+ which only launched in June, saw its membership increase in excess of 100% sequentially to over 90 million users. If it maintained this growth rate for all of 2012, it would be the size of Facebook. In other words, Google+, a business that is currently a drain on earnings and likely a negative to share price, in a few years could be worth $100 billion if valued similarly to Facebook. In other words, the stock might be punished today for an asset that could eventually be worth more than half of Google's current market cap. While that might sound implausible, we'd ask you to consider: What was Android's user base 3 years ago? How many people do you know over the age of 25 whose first personal email account was Gmail?
Google is able to grow these brands because it has the potential for virality more than almost any brand on Earth - almost anyone who uses the Web will see Google in some manner almost every time they connect.
And if a Google venture fails, they are not afraid to drop it. As the 2011 10-K says on page 3, "we decided to shut down a number of products in 2011, including Google Buzz, Google Desktop, and Google Labs. We learned a lot from these discontinued products and are putting that learning to work every day in new products such as Google+."
We believe a more accurate of Google is painted by looking at op-ex adjusted earnings. Google's earnings could be much higher if management chose to run it's business that way. Instead, the company focuses on strengthening its brand, deepening its moats, and creating long-term shareholder value, even if it's missed by the market today - a perfect Buffett investment if we've ever seen one.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
No comments:
Post a Comment