Does Google deserve a high multiple? (part 2)

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.

2008
Revenue: $21,796
Cost of revenue: $8,622
Margin: 60%

2009
Revenue: $23,651
Cost of revenue: $8,844
Margin: 63%

2010
Revenue: $29,321
Cost of revenue: $10,417
Margin: 64%

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…)

10. “Growth”

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.

  1. This first is the continued increase in Internet usage around the globe.
  2. The second is the ongoing increase in online advertiser spending.
  3. The third is the rise of mobile Internet usage. Cisco projects that global mobile data traffic will increase 26-fold between 2010 and 2015.
  4. 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.

 

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