Monday, 18 April 2011 21:46

Google's Q1 2011 Review: Part 2 Of My Comments On The Gross Misvaluation of Google

This is part 2 or 3 of my illustration of the gross misvaluation of Google (see My Thoughts on Roger McNamee’s View of Google and Mobile Computing). As a reminder to our paying subscribers, on November 2010 we downgraded the stock to Neutral from our Overweight stance while maintaining our valuation. Given the market’s reaction to the stock and the fact that growth was ahead of our expectations, we upgrade the stock back to Overweight territory. The full, unabridged quarterly review is available to all paying subscribers here: File Icon Google Q1 2011 results. Below are many of the salient points contained in said download.

Google Q1 results

For the quarter ended March 31, 2011 Google reported gross revenues (before traffic acquisition costs) of $8.58bn, an YoY increase of 26.6% and QoQ increase of 1.6% while net revenues (after traffic acquisition costs) increased 29.1% YoY and by 2.6% sequentially to $6.54bn. The YoY growth in gross and net revenues was the highest at least since 2008 demonstrating a increasingly momentum in the growth of Google’s digital ecosystem. The increase in net revenues (after TAC) was actually stronger than the increase in gross revenues, indicating that Google has not only packed in growth but lowered aggregate top line expenses.

However, despite a strong set of results the stock took a severe beating and was down c8% as the results were short of analyst expectations. The market’s reaction to Google’s numbers clearly reflects the very myopic view of US public markets wherein a stock is dumped if it fails to beat consensus – even when this view clearly overlooks the broader picture.

Google’s adjusted earnings came in at $8.08 a share below the $8.17 expected by the markets. However, a closer look at the results reveals that the perceived shortcoming was not a result of a revenue miss or margin compression but on account of Google’s entrepreneurial (and quite applaudable – at least from this investor’s perspective) endeavor to invest heavily in future projects. The miss was principally due to higher research and development expenses as the company continues to invest in new emerging businesses like Display, Mobile and Enterprise. Research and development expenses (including stock based compensation expenses) grew 50% YoY to $1.2bn and was 14.3% of gross revenues in Q1 2011 vs. 12.5% in Q4 and 12.1% in Q1 2O10. Had research and development expenses at 12.5% of gross revenues, the earnings would have been $8.51 per share, a clear beat to consensus and stock would have seen a roller coaster ride – despite the fact that future prospects would have been a fraction of that they are now due to lower investment in the future. Google has proven that their investments yield superior returns to that of cash holdings, ex. Youtube, Android, Admob, Google Voice, Teracent, etc. Instead, the stock was pushed down 8% as the shorter term players in the market reacted. Players such as sell side analysts whose employers benefit from the shorter horizon churning of stocks vs. a longer horizon and outlook, and traders who act on price movement and not value, were(are) clearly tangled between web of OPEX (ongoing cost for running a product, business, or system) and CAPEX (expenditures creating future benefits).

The eventual decrease in margins in the mobile sector will probably accompany an increase in gross revenues for the leaders of the entire mobile sector, as was clearly forecast in BoomBustBlog, reference Apple Gears Up To Combat The Margin Compression That Apparently Only It, Google & Reggie Middleton Sees Coming. Thus far, Google has effectively avoided this and may avoid it for some time due to their minimal reliance on hardware manufacturing, but it is coming.

Google continues to be a reckoning force in the online search market commanding almost two-thirds of US search queries – and Google’s influence in its cash cow products is still expanding. This cash cow allows Google to fund some very innovative, yet risky ventures without materially risking or crimping excess cash flows. As of March 2011 Google’s share of core search queries was 65.7% compared with 65.1% a year ago, as per comScore data. Despite commanding over two thirds of market share the company continues to hold its ground in terms of online search queries.

Total cost of revenues increased at a slower pace compared with revenue growth positively impacting the margins. Total cost of revenues excluding stock based compensation expenses (which includes Traffic Acquisition Costs) grew 19.7% YoY to $2.9bn (33.7% of gross revenues in Q3 2010 vs. 36.1% in Q1 2010). Traffic Acquisition Costs grew 19% YoY during the quarter to $2.0bn (or 24.5% of revenues) compared with $1.7bn in Q1 2010 (or 26.4% of revenues). Cost per click increased 8% YoY and declined 1% QoQ. Overall, gross margin improved to 65.8% in Q1 2011 vs. 65.1% in Q4 2010 and 63.8% in Q1 2010.

Sales and marketing expenses excluding stock based compensation increased 71% YoY to $948m, or 11% of revenues in Q1 2010 vs. 9.8% in Q4 2010 and 8.2% in Q1 2010 - a strong sign of heavy promotional investment into new business lines! General & administrative expenses excluding stock based compensation increased 42% YoY to $526m, or 6.1% of revenues in Q1 2011 vs. 6.0% in Q4 2010 and 5.5% in Q1 2010. Research and development excluding stock based compensation grew 58% YoY to $989m and was at 11.5% of revenues in Q1 2011 vs. 9.8% in Q4 2010 and 9.3% in Q1 2010 - again, a sign of very strong business investment into new ventures. Stock based compensation increased to $429m (5.0% of revenues) from $291m (4.3% of revenues) in Q1 2010 and $396m (4.7% of revenues) in Q4 2010. This is a mixed blessing. The increase in compensation needed to ward off competitors poaching of employees is a structural expense increase - a decided negative. The hiring of new staff during these tough economic times to help develop and expand new multi-billion businesses is a decided positive.

Considering all above, this investor queries, "What would one have a tech company with a monopolistic cash cow franchise, strong competitors and several fledgling multi-billion dollar upstart business to do with its excess earnings? Invest them deeply into new businesses and ventures for future value creation, or retain them as excess cash to sit on a balance sheet which already has in excess of $30 billion of unencumbered cash in it?"

Our investment thesis

As highlighted in the Google forensic report (63 pg Google Forensic Valuation, to plug in your own assumptions see Google Valuation Model (pro and institutional)), our key investment thesis for our Overweight on Google were

  • Secular mix shift from offline to online ad spend and Google with c67% share in search market is set to benefit enormously from the secular mix shift though growth in search ad spend (ad words)
    • We had meticulously demonstrated the case for the next multibillion dollar business(es) after search in the form of display, mobile and other emerging businesses.
    • Increase  in share of display revenue as Google, which currently lags Yahoo in display, is ramping up its efforts through YouTube monetization, the Doubleclick acquisition and its Teracent acquisition
    • Opportunities in wireless search as Google goes mobile with Android and AdMob. Success of Android coupled with Google’s traditional dominance in search advertising has laid a solid foundation for Google to monetize the opportunity in the mobile space.
    • Literally free call options on a plethora of new multi-billion dollar revenue opportunities in the form of Google TV / Google Voice / Google Cloud Computing (for details refer to Google Forensic report)
      • Bolt-on acquisition strategy


The valuation and the balance of this review including the metrics not included above are available as a download to all paying subscribers - File Icon Google Q1 2011 results.

Next in this space, I will illustrate Google's success rate in building value out of its acquisition and investment strategy. If one where to look at it from a historical perspective, one would be very bullish on Google's ramp up of internal and external investment... Very bullish indeed, particularly considering the recent price drop.

Last modified on Monday, 18 April 2011 21:46


  • Comment Link Reggie Middleton Wednesday, 20 April 2011 08:56 posted by Reggie Middleton

    Apple's entire peripheral ecosystem is superior to its competition, primarily because it was basically the only player in town. Now that Android is the market leader, you should see that change some. For instance, Android can stream media to and from your music systems wirelessly, using standard protocols, eliminating the need for a docking station.

  • Comment Link richard in norway Wednesday, 20 April 2011 08:30 posted by richard in norway

    sorry forgot to spell check

  • Comment Link richard in norway Wednesday, 20 April 2011 08:29 posted by richard in norway


    one area i think apple have an avantage is docking stations, the shops are full of beutiful iphone docking stations. it was one reason that i was tempted to buy an iphone, it just makes it so easy to play music from the phone while chargeing(i don't like having two things)i went for the desire Z in the end because of the slide out keyboard and the price but i miss the plug and play i had with my old sony-erricson(i have a sony erricson docking station, basic but ok). i think that if apple come out with aslikde out keyboard then they could tempt me next time around, some of those docking stations are really cool

  • Comment Link Reggie Middleton Wednesday, 20 April 2011 01:03 posted by Reggie Middleton

    See the Kyocera Echo sold by Sprint for a view of the future and innovative form design:

    Don't judge the performance of the phone (whether you like it or not) but the form factor. This phone can produce a relatively large screen and has come nowhere near close to maximizing screen real estate. Imagine the HTC Evo, or better yet the new Samsung Galaxy 2 in a similar form factor. It will be about 13 mm thick, and feature a nearly 8 in screen that is not much bigger than an Evo. If one brings the screen real estate to the edge of phone (no bezel) and eliminates or virtually eliminates the middle bar, you will be pushing the screen to 9 inches, which is approaching iPad real estate, again all in the size of a smart phone.

  • Comment Link Reggie Middleton Wednesday, 20 April 2011 00:44 posted by Reggie Middleton

    Okay, let's try it again. All should be fine now, and again... My apologies.

  • Comment Link rkpagadala Wednesday, 20 April 2011 00:15 posted by rkpagadala

    Cant download the document. Error says
    "The document is being edited/updated by a User and is unavailable at this moment."

  • Comment Link Bruce Tuesday, 19 April 2011 21:07 posted by Bruce

    I'll grant you all this, as we're not really that far off. But, regarding "one smartphone like device" - the biggest problem I see with this is screen size: different tasks require different screen sizes - I can't read (for example, Homer) on a smartphone (nor even the kindle for that matter), yet I wouldn't want to carry around an iPad in my coat pocket either!! How do you see this resolved?

  • Comment Link Reggie Middleton Tuesday, 19 April 2011 18:20 posted by Reggie Middleton

    I never said I was optimistic about MSFT, I was just stating facts. Just because MSFT has the IP and physical (or is that digital?) goods doesn't mean they can pull off a win here. The problem they have now, just as the the problem they had 5 years ago, is that management has failed at executing properly in the mobile space. Google has created the most innovative business model and use of open source software this in this millenium while Apple is steady printing money. MSFT, who had the jump on both of them has lost ground.

    The Asus tablet and the iPad are not different markets, it's just that the Asus is not quite finished yet. Even using your own comparison, you actually bought two products when one would easily fit the bill. A properly executed Windows tablet can be read in bed and used for real work like the laptop, because it IS essentially your laptop.

    A lawyer fried of mine once told me about 11 years that smartphones would never catch on because most people prefer to keep their PDAs and their phones separate. That is because they weren't use to having a capable, all around device. My prediction is that in a relative short (as in a couple of years or so) tablets will be obsolete, and their will be one smartphone like device that will serve as primary telephony, videography/photography, computing, and media consumption. The key is to determine what platform that device will run on. We shall see.

  • Comment Link Bruce Tuesday, 19 April 2011 18:08 posted by Bruce

    What do you think of open office?

    I'm not as optimistic as you about msft - I've been waiting 10 years for them to get their mojo back. All of their franchises you mentioned are mature.

    I think the Asus tablet and the iPad are different markets, so comparing them side by side doesn't make sense to me. I bought the iPad to read in bed, maybe surf the internet, and for my son to play games on - etc. If I want to do anything really serious, I'll go to my laptop.

    I agree with you about Android and goog!

  • Comment Link Reggie Middleton Tuesday, 19 April 2011 17:32 posted by Reggie Middleton

    The Q1 download link has been fixed. My apologies. I haven't delved into Apple on a forensic basis, and probably wouldn't at least until they released their cloud products. As I have said before, they are printing money now, but are not well situated to compete with Google and Microsoft in a year or two. That very well may change when they introduce their data center products. Most people can't see this, for they can't look past the here and now. A good example is the analysts who ALL failed to predict Android taking the number one spot in smartphones in just over one year are now all saying that Apple will rule tablets until 2015, eventhough their tablet competition is stacking up to be more fierce on the Android side than their smartphone comp, and they will have much less of a headstart.

    The RIMM report should still be viable with the help of the pro valuation model (and as you can see RIMM has announced the very same problems that I said they will encounter), but I may revisit it after I finish the European debt research.

    MSFT has definitely not been a failure diverifying from its primary OS product. I simply disagree here. Its just that their primary OS product makes so much money that it is hard to match. Ask Apple, they have a similar problem, but they don't have the monopoly moat around their primary business that MSFT has, which is why Apple doesn't trade with a higher valuation than it already does. MSFT has the main Windows business, but it also has:
    - the Office franchise, which is number one its category, and is also number one on the Mac, if I'm not mistaken.
    - Exchange, which is numbfer one its category
    - Windows server, which is number one its category not withstanding the open source competition (linuz/LAMP) which Android is derived from
    - MS SQL and the associated development packages, nearly if not actually, number one in their respective categories
    - the Xbox franchise, which is number one its category if not a very close number two (to Sony Playstation), although I think the Kinect has cemented them in first.

    There is also a distinct possibility that they may go somewhere with the Windows Phone 7/Nokia hardware combo. Be aware that MSFT has always had the existing tech to blow its competitors out of the water (at least since the launch of the smartphone. Where they are severely lacking is management execution, and being hamstrung by the anti-trust consent decree.

    If they get their act together, its pretty much game over unless the government steps in again. They have just released a product for open beta called Office 365 which gives the full office suite (no real compromises), full file sharing and universal access through the cloud. They also run their Windows 7 OS quite well on tablets, see the Asus Windows 7 tablet on youtube, or better yet go to your retailer, bring your ipad 2 along, and give both a spin side by side. You will see why the current mobile OS based generation of tablets are literally toys compared to the full blown OS. The ONLY drawback is battery life, which MSFT will be addressing with Windows 8, which will run on ARM processors. Again, this is a management execution issue, for they should have been concurrently developing this along side the x86 architecture years ago.

    As for Google Docs, you should try it now. It is nowhere near the same product as it was years ago. Actually, no fledgling product stays static that long and still survives. That being said, it is still not the full blown Office suite.

    As for Android and the bottom line, you need to give it time. I think it is impossible not to look at Android's success and not see the potential profit to come of this franchise. Once Android takes over the mobile computing space, Google gets to call the shots in mobile computing - period! The mobile computing space is much larger than the PC and enterprise computign space, much larger. That is why it is so important to the competition that Android is stopped, and stopped now.

    That is why Nokia is focusing on Android and not Apple or RIM. As a matter of fact, in the mobile tech world, Google has become public enemy number one for anybody who hasn't already embraced Android, and even those who haven't embraced if full are being forced to compromise. See RIM's implementation of Android apps on its new tablet, the Playbook.

  • Comment Link Reggie Middleton Tuesday, 19 April 2011 17:08 posted by Reggie Middleton

    The Q1 download link has been fixed. My apologies.

  • Comment Link NDbadger Tuesday, 19 April 2011 12:15 posted by NDbadger

    I can't download the document either. I get the following error:

    The file is not available on the server

    I also get "script errors" a lot when trying to navigate your page.


  • Comment Link Rumi Tuesday, 19 April 2011 09:56 posted by Rumi

    A few things:

    1. I can't download the Q1 link. Are you sure it's linked correctly (there are zero downloads)

    2. Any plans to update AAPL/RIMM? How about a MSFT analysis? NOK? Samsung? etc.

    3. I'm not sure the market is myopic so much as applying the MSFT model to GOOG. MSFT has pretty well been a failure at diversifying away from its primary OS product. From talking to people, I get the impression that they believe that GOOG will inevitably follow that path as well--Google docs is not a terribly good product for example (at least, it wasn't when I last tried using it a couple of years ago). Android is great, but line:?

    I side more with your analysis (actually, I think your upside valuation is far too conservative), but I try to get the contrary view whenever possible. It'll be nice to read your next post on this topic...

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