- tries to find companies that will be cheap based on earnings in five years
- many cheap tech companies are cheap for a reason
- Google looked expensive in 2004 but was trading for 2x 2013 earnings
- tech stocks are historically cheap (March 4, 2013)
- in tech investing it is important to look for new trends
- there are many tech trends today and they are not dependent on the economy
- Apple is cheap by any measure
- the key is to think about what would get Apple to $800/sh.
- believes Apple to needs to go on offense; believes this will happen
- Apple’s use of cash will help determine value
- Apple could benefit by acquiring companies with new ideas and talent
- Apple is very open to listening to shareholders
- Contrarian bets in tech sector can become value traps
- Google is an infrastructure play on eCommerce
- Google’s margin of safety is that it is trading for 5x future earnings (5-7 years)
- Apple, Google and Samsung are the top tech companies
- they are looking for short candidates among companies that will be negatively impacted by the paperless office
- the desktop food chain will be hit be developments in tablets
- he likes the storage theme, for example, being able to retrieve files ubiquitously in the cloud
- took a pass on Yahoo because he can not value the U.S. business
- Samsung and Twitter are candidates to be great tech companies
- Twitter is hard to value: huge strategic value but little revenue
- The are investing in video content. Smart phones will lead greater consumption of video and more ways for content companies to monetize their libraries.
- Sometimes these new trends are uncovered from insights based on a few words from industry leaders. Jeffrey Katezenberg recently said that in the future we will pay for content by the “square inch”.
- This may mean that in the future users may pay $.50 for watching a movie on a smart phone, $1.00 on a tablet, $5 on the TV etc. which could lead to large new markets and ways to monetize content.
- It is very hard to make content. There are a handful of these companies in the U.S. and they excel at making content.
- He likes Time Warner, CBS and News Corp.
This is the second part of an article entitled “Does Google deserve a high multiple?”.
The article is based on a blog post by venture capitalist Bill Gurley entitled “All Revenue Is Not Created Equal: The Keys To The 10X Revenue Club”. The blog post discusses ten business characteristics that drive the multiple at which a company trades.
My argument is that Google stacks up pretty well based on Gurley’s characteristics.
5. “Gross Margin Levels”
According to Gurley, “Lower gross margin companies will trade at highly discounted price/revenue multiples.”
Google enjoys high gross margins. As Google states in its annual report, its cost of revenues consists primarily of traffic acquisition costs. Google pays members of its AdSense program for displaying targeted ads on the members’ web sites. Google’s cost of revenues also includes the expense of operating its data centers.
Cost of revenue: $8,622
Cost of revenue: $8,844
Cost of revenue: $10,417
6. “Marginal Profitability Calculation”
In his blog post, Gurley actually uses Google as his example in explaining the idea of marginal profitability.
If a business is scaling nicely, you will see a gradual increase in marginal profitability as its fixed costs are spread out over a growing revenue base. Investors love this because it portends higher future cash flows.
Gurley points out that, in Google’s case, the recent data is not positive. Google’s marginal profitability for Q1, 2011 was lower than both Q1, 2010 and Q4, 2010. On its conference call, Google attributed the uptick in spending to an expansion in hiring to drive future growth.
On a longer-term basis, the picture is positive. According to Value LIne, Google had a net profit margin of 29% in 2010. In 2005, it was 24.7% and in 2002, the earliest year for which Value Line has data, it was 22.7%.
Google marginal profitability is something to watch. Google is fighting on numerous fronts – search, mobile, browser, local, enterprise, etc. These efforts require large numbers of engineers. An investment in Google is, in part, a bet that some of these efforts, particularly those outside of its core search business, will generate a good return.
7. “Customer Concentration”
A company has a problem if a large percentage of its revenue is controlled by a small number of powerful customers.
In 2007, the New York Times reported that Google had 1 million advertisers based on a regulatory filing with the SEC. That number is likely materially higher today.
Google’s business has no risk from customer concentration.
8. “Major Partner Dependencies”
Just as a business is at a disadvantage if it is dependent on a small numbers of powerful customers, a business is at a disadvantage if it depends on a major partner.
For example, Nokia’s recent decision to use Microsoft’s Windows Phone 7 on most future Nokia smart phones has certain built in risks because it creates a dependency on Microsoft. Going forward, although it will surely have input, Nokia will be dependent on what Microsoft decides to do with its OS and how it evolves.
Also, Microsoft’s OS will be available on smart phones from other phone manufacturers which will tend to commoditize Nokia’s offering.
Google has no such dependencies. Google goes out of its way to be self-reliant. For example, its data centers run on Google’s own software which give it cost and performance advantages.
9. “Organic Demand vs. Heavy Marketing Spend”
Some companies requires heavy marketing spending to grow and compete and some businesses grow because there is strong organic demand for their products or services. All else being equal, the latter are the better businesses because 1) they don’t need to spend a lot on marketing which leaves more free cash for shareholders and 2) it tells you something important about a business if the demand for what its does is so strong that it can grow virally through word of mouth.
Google has enjoyed organic growth and it did not require marketing to achieve its dominant position. Only now are we beginning to see some limited marketing spend to accelerate the adoption of Chrome, which Google is using to protect its advertising castle. (For more on this see “The Freight Train That Is Android”; more on Google’s moat…)
According to Gurley:
“Nothing contributes to a higher valuation multiple like good ole’ growth. Obviously, the faster you are growing, the larger, and larger future revenues and cash flows will be, which has direct implications for a DCF. High growth also implies that a company has tapped into a powerful new market opportunity, where customer demand is seemingly insatiable. As a result, there is typically a very strong correlation between growth and valuation multiples, including the price/revenue multiple.”
Google’s revenues and earnings have grown at an annual rate of 50% over the past five years. This rate of growth will not continue given Google’s size. Going forward, it’s simply starting from a too large a base.
As Buffett stated, “The investor of today does not profit from yesterday’s growth.” In Google’s case there is reason to believe that strong growth lies ahead. Google is benefiting from four huge secular waves.
- This first is the continued increase in Internet usage around the globe.
- The second is the ongoing increase in online advertiser spending.
- The third is the rise of mobile Internet usage. Cisco projects that global mobile data traffic will increase 26-fold between 2010 and 2015.
- The forth is the massive amount of new data that will continue to be placed on the Web. This will only accelerate as more and more devices are connected to the Internet. This will benefit Google because it will make Google’s core search engine more valuable.
In conclusion, Google seems well positioned with regard to Gurley’s criteria. Investors will need to decide if these factors are already priced into the stock or if the current price undervalues Google’s future cash flows.
A few week’s ago, I wrote an article about venture capitalist Bill Gurley’s business traits which determine whether a company deserves a high-multiple valuation. As I wrote in the article, “The multiple at which a stock trades is nothing more than a shorthand proxy for its DCF.”
Here’s my take on how Internet juggernaut Google stacks up against Gurley’s criteria.
1. “Sustainable Competitive Advantage (Warren Buffett’s Moat)”
I just finished reading Steven Levey’s excellent book In The Plex: How Google Thinks, Works and Shapes Our Lives. The book is must reading if you are interested in Google. It was also recommended by Charlie Munger who thinks highly of Google’s moat. I’ve written before on the strength of Google’s moat.
Google is the leader in search, and they work hard at keeping it that way.
Googlers continually measure the effectiveness of their search algorithm by analyzing whether it achieves a good outcome. Basically, they judge a search to be successful if a person quickly selects a link and “goes away”. Multiple successive clicks indicate dissatisfaction.
Based on these observations, Google is constantly tweaking its algorithm and running hundreds of simultaneous tests on small but meaningful subsets of their users. If a tweak improves the outcome, it is rolled out and another baby alligator is added to the moat.
This Darwinian process makes it tough for someone to catch up and pass them. In The Plex sheds light on the large number of significant search problems that Google has already solved. Cumulatively these comprise a strong moat.
That being said, a technology centric company like Google will always be more susceptible to disruption than an entrenched consumer product company such as Coke or Wrigley’s.
Google’s data centers are another source of competitive advantage. Google is in a unique position to deliver globally-synchronized data in real time at a cost that is materially lower than it’s competitors.
According to In The Plex, “By perfecting its software, owning its own fiber, and innovating in conservation techniques, Google was able to run its computers spending only a third of what its competitors paid.” (Levy, Steven (2011). In The Plex, p. 198) [emphasis added]
Is also worth mentioning that the Internet seems to favor companies that establish an entrenched position. Amazon, eBay, Google, and Facebook have all proven difficult to disrupt by their rivals.
2. “The Presence of Network Effects”
When a product or service enjoys a network effect, the utility of the product or service increases as the number of people using it increases.
Google benefits from a network effect.
The more people who use Google, the more data it has to improve its search results and related products such as Google Translate. This leads to happier users who are more likely to continue to use Google because they are increasingly likely to find what they’re looking for.
Advertisers benefit from this because the more people who use Google, the more likely it is that users will click through and purchase something. The more advertisers there are on the system, the more likely it is that Google can deliver a relevant add to a user when he or she does a search.
A Darwinian ranking system of multiple variables continuously ranks ads and rewards better ads with better placement, further reinforcing this virtuous circle.
3. “Visibility/Predictability Are Highly Valued”
In business there is a continuum between highly predictive sources of revenue – such as a subscription based service – and one-off, non-recurring lumpy revenue – such as a business that sells major construction projects and which can only expect to sell a few per year.
Obviously the former types of business will sell at higher multiples – all else being equal – because their revenue is more predicable.
Google enjoys highly predictable revenue because it operates as a kind of toll-booth on Internet advertising, and its revenue is derived from millions of individual advertising clients – none of which controls more than a tiny fraction of Google’s overall revenue.
Moreover, just like there is a hard limit on prime real estate such as beachfront property in Los Angeles county, there is a large, but limited number of key words that drive Internet commerce. Google controls the lions share of this “real estate” for these invaluable search words.
It should be noted that advertising revenue is tied to the general economy and as such is cyclical. Google did experience softening revenues in the latest recession although this was mitigated by the strong secular growth in both Internet usage and advertising.
4. “Customer Lock-in / High Switching Costs”
There is nothing that locks users and advertisers into using Google in the classic sense of switching costs. This may slowly change as more users adopt Google applications such as Docs and Gmail. Google’s + initiative, if successful, may also make Google’s offerings more sticky.
The real issue is that, if an advertiser leaves Google, where do they go? Leaving Google means conceding visibility to your competitors for the 65% of Internet users who use Google in the U.S. and a much higher percentage in numerous other countries.
(to be continued in a second part)
A couple days ago, I posted a blog on Google’s moat. Today, I am posting a blog post written by venture capitalist Bill Gurley. Gurley explains how Android, Chrome and Chrome OS are being used by Google to strengthen its moat. According to Gurley, “They are not just building a moat; Google is also scorching the earth for 250 miles around the outside of the castle to ensure no one can approach it. And best I can tell, they are doing a damn good job of it.”
Google realizes that a major factor is which search engine you use is what’s available to you in the application you’re using. If you were to use Firefox and the default search engine was Bing (Firefox comes with Google as its default search engine), there is a reasonable chance you would stay with it. That is why Microsoft has worked hard to make Bing available in different channels.
With Andriod, Chrome and Chrome OS, the endgame is to aggressively frustrate any attempt to put a layer between Google and its users. This would be like Coke aggressively expanding into retail to insure that the its products were available. The conundrum for Google’s rivals is that Google does not expect to profit directly from this effort. It simply wants to keep the Huns at bay from its search castle.
Yesterday, after the market closed, Research in Motion, the makers of the Blackberry device, announced that they would be lowering their current quarter earnings due to lower average sales prices. In a separate announcement, the company proffered that their new tablet will support Android apps, yet the CEO also made it clear that he believes the world is overly focused on the criticality of having a large numbers of applications on your platform. They also suggested that the guidance issue is temporary, and relates mainly to a product cycle not a systematic change in the industry.
Despite all that has been written about Android, as well as its unquestionable early success, the world at large still doesn’t fully appreciate the raw power of this juggernaut. I have written about this in the past in Android or iPhone? Wrong Question, and Google Redefines Disruption: The “Less Than Free” Business Model. But even so, the more I see, the more I wonder if I too may have underestimated the unprecedented market disruption that is Android.
One of Warren Buffet’s most famous quotes is that “In business, I look for economic castles protected by unbreachable ‘moats’.” An “economic castle” is a great business, and the “unbreachable moat” is the strategy or market dynamic that heightens the barriers-to-entry and makes it difficult or ideally impossible to compete with, or gain access to, the economic castle. Here is a great post from the 37signals blog a few years back that walks through several different examples of potential moats.
For Google, the economic castle is clearly the search business, augmented by its amazing AdWords monetization framework. Because of its clear network effect, and amazing price optimization (though the customer bidding process), this machine is a monster. Also, because of its far-reaching usage both on and off of Google,AdWords has a volume advantage as well. Perhaps the most telling map with regards to the location of the castle can be found in Jonathan Rosenberg’s “Meaning of Open” blog post. In this open manifesto, Jonathan opines over and over again that open systems unquestionably result in the very best solutions for end customers. That is with one exception. “In many cases, most notably our search and ads products, opening up the code would not contribute to these goals and would actually hurt users.” As Rodney Dangerfield said in Caddyshack, “It looks good on you, though.”
Buffett has famously said that one useful way to think about a business’s moat – its durable competitive advantage – is to imagine that you had unlimited resources to attack it. If you still could not topple it, you would have found a business with a solid moat.
In Google’s case, this isn’t a hypothetical. Microsoft has spent billions of dollars in a determined effort to put a dent in Google’s moat. So far, all they have to show for it is heavy losses and only modest market share. It is believed that a large part of Bing’s market share has come at the expense of search engines other than Google. Microsoft was recently embarrassed when Google discovered that it was copying Google’s search results.
Charlie Munger had this to say about Google’s moat. “Google has a huge new moat. In fact I’ve probably never seen such a wide moat.”
It’s useful to think about Google’s moat the way you would think about the moat of a dominant city newspaper in the pre-Internet era.
NEWSPAPERS – THE READER’S PERSPECTIVE
For readers, the newspaper was the only game in town for keeping up with local news and an essential tool for buying a car, getting a job, learning about retail sales events, and an almost limitless number of niche activities. Reading the paper was also quintessentially habit forming: pleasurable, repeated daily and low cost.
If you use the Internet, Google is a basic essential tool. Its value lies in letting you navigate the Internet in a rational fashion, whether you’re looking to buy a new camera or need to know the capital of Uzbekistan. This value grows as more information is placed on line – something that is happening at a dizzying pace – and as Google’s search algorithm improves. Google is maniacally focused on improving its search engine and it benefits from having by far the largest number of searches to analyze and learn from.
It tells you something about a company when the company’s name becomes a verb that is synonymous with the underlying function it performs. Could you “xerox” that for me? Google has this kind of mind share.
If you’re Bing, you can’t attack by lowering the price to customers. Google is free. At one point, Bing even tried paying people to search. There is no easy lever to disrupt the habit of going to Google each day to navigate the web.
NEWSPAPERS – THE ADVERTISER’S PERSPECTIVE
If you were an advertiser – auto dealer, employer, department store, furniture store, pretty much any local business – you needed to advertise in the newspaper because you had to be in front of your customers and that was the only cost effective way to do it. The newspaper set the rate and you paid it. Period.
Google is a must-have outlet for advertisers given its 65% share of U.S. search. Its share is much higher in many international markets. Advertisers not only pay for advertising but also work hard to optimize their sites so they show up at the top of searches on important key words. A recent tweak in Google’s search algorithm showed the lengths that companies will go to rise in the search rankings. A company can see it’s sales materially reduced if it falls in the rankings.
Google’s advertising is superior to that of traditional media because it is targeted and the results can be quantified. More value means happier advertisers. That rates are set by auction helps mitigate accusations of monopolistic price gauging which were frequently heard in the “old days” from newspaper advertisers.
A dominant daily newspaper’s growth was constrained by the development of the local economy. Google is not constrained by local geography and is riding two huge secular waves: the transfer of advertising dollars to the Internet and the ever increasing adoption and usage of the Internet.
Regulatory risks swirl around Google but the threat to its core search business seems remote. Because Google’s business is based on technology, there is a some risk of disruption from creative destruction. However, Google is determined to stay ahead in search and it has plenty of cash to purchase start-ups with a better idea.
Recent price: 524.20
Cash per share: 113.00
Cash adjusted price: 411.20
2012 consensus EPS estimate: 39.91
2012 cash adjusted earnings yield: 9.7%
In the Spring 2010 issue of Graham and Doddsville, an investment newsletter from the students of Columbia Business School, value investor Glenn Greenberg argues that Google is cheap. His reasoning: “It is generating about $30/share of free cash flow this year and $34 next year. At the end of 2010 it will be sitting on $100/share of cash, as long as they don’t spend it all on high-priced acquisitions. Thus, at $540, you are paying $440 for $34 of free cash flow in 2011, an 8% yield. That seems really cheap.”
As of today, Google is trading below $500 a share.
Brave Warrior Capital, Greenberg’s investment firm, shows a new holding of 134,361 shares in its most recent 13F. Blue Ridge Capital, run by the highly regarded John Griffin, also initiated a material position in Q1, 2010.
Buffett has said that a durable competitive advantage is the most important thing to look for in an investment. The Curse of The Mogul, co-authored by Bruce Greenwald of the Columbia Business School, an expert on value investing and competitive strategy, states that, “Google is the rare company that seems to have strong elements of all three sources of competitive advantage identified – economies of scale, customer captivity, and cost.”
If you’re interested, here are a few places to start if you wish to research google further.
– Googled: The End of the World As We Know It by Ken Auletta
– Google Technology (a sample chapter from Stephen Arnold’s The Google Legacy)
Full Disclosure: The author owns shares of Google.