Google: Innovation And Acquisitions Will Drive Valuations

  • Google core operations of online advertising are growing rapidly for a company of its size.
  • The company has seen shrinking margins of late, a result of discrete and one time expenses which have hit the company.
  • Given Google’s history of successful acquisitions, Google’s growth will be driven by acquisitions over the coming years.
  • In spite of the short term weaknesses, Google’s long term growth trajectory is on a solid path.
Google aquisitions to drive growth

Investors seem to be climbing back aboard Google (NASDAQ:GOOG) despite the short-term struggles it has had with European censorship.  While regulatory risks are an on-going concern, the company’s core business continues to generate consistently high growth rates, giving me the impression that the company is due for a longer-term rally.

Google’s Business Model

Google revenue can primarily be attributed to its business of selling ads on its search-engine, fees from transactions on the Android store, and banner advertisements.Google revenue by source
Source: Google

The company generated $10.469 billion from search-advertising and $3.397 billion from display advertising in the first quarter of 2014. The $1.554 billion in Q1 2014 sales comes from other business units, which primarily consists of royalty income from the Google Play Store.

Google has been able to mitigate the damage from smartphones by offering the Android OS. All Android OS phones come pre-loaded with the Android Play Store, which Google monetizes by charging application developers a royalty on every license they sell. Furthermore, Google earns revenue on all music sales, and other multimedia content through its store, giving Google a better business portfolio when compared to peers in its space.

Google Revenue Growth Trends

Google revenue grew by 19% YoY in Q1 2014, which is a fairly high growth rate for a company of its size. Furthermore, analysts on a consensus basis anticipate the company to grow annual sales from $59 billion to $65 billion in fiscal year 2014. Analysts are anticipating the company to grow sales by 10%, which is below the company’s historical growth rate.

Google revenue and operating expense growth
Source: Ycharts

Over the past five years Google has increased expenses at a faster rate than revenues. For the most part, Google justifies its added spending by mentioning that it’s investing into its future. Because Google’s operating expenses grew at a higher rate than revenues, the company’s net profitability declined. If this persists Google may end up generating zero bottom line growth.

Google profit margin
Source: Ycharts

Between 2010 and 2013 Google’s profitability declined by around 10 percentage points. The decline in profitability reduces the likelihood of earnings growth, and subsequent share buybacks. Therefore, investors may have penalized the company for over aggressive spending. However, if Google stabilizes its expenses, so expense growth is similar to revenue growth, the company may return to mid-teen earnings growth rates.

Google’s CFO, Patrick Pichette mentions that the increases in expenditures are likely to be temporary:

Just a quick word on a few items that may have created noise in our operating expenses this quarter. We had some discrete legal expenses that hit our G&A line as well as one-time M&A related costs that increased our operating expenses, particularly in R&D. So, absent these discrete items, our expenses continue to demonstrate the same disciplined agenda we've always had.

Near Term Catalysts For Google Stock

Since, Google doesn’t provide any real guidance on earnings, consensus estimates can be wrong. Google’s growth rate is likely to be aided by acquisitions. I explain this in more detail in a previous article:

I anticipate Google to accelerate earnings, reduce tax exposure, and increase book value over time with this strategy. If Google can generate success similar to Yahoo! Google's book value, and share buy-backs will increase significantly in future years. However, overnight results are unlikely, and it will take us five years to truly understand the impact from investing $30 to $60 billion in foreign cash flow.

Assuming the company is able to generate returns similar to a venture capital firm, the $30 billion, plus $10 billion in foreign investment per year, when compounded at a 20% growth rate could turn into $163 billion over a five-year period.

20% growth on invested capital is extremely aggressive, but assuming it happens, the company can return the cash to investors through share buybacks, or reinvest the capital into other acquisitions. By investing into foreign companies, Google has the potential of acquiring a smaller company that could grow into the size of Alibaba or Baidu. Google can also acquire and integrate smaller businesses, which will allow Google to generate efficiency in its advertising business, or grow new lines of business.

Furthermore, Google’s Play Store continues to contribute top line growth. In the most recent quarter Google’s CFO,Patrick Pichette states:

Finally, Google's other revenue grew 48% year-over-year to $1.6 billion and was down 6% quarter-over-quarter. Digital sales of apps and content in our Play Store drove year-over-year growth. Chromecast sales were also strong.

Interesting enough, the PlayStore came as a result of acquiring Android for $50 million in 2005. Google’s acquisitions have been integral to the company’s historical growth rate, and I anticipate this to be Google’s primary growth catalyst going forward.

Google Stock Price Trends

Google price movement
Source: FreeStockCharts

The stock price is starting to recover as indicated by the above chart. It has pierced the 20-day, 50-day moving average. It’s likely that the stock will continue to trend higher, as the negative sentiment has all but disappeared on the stock.

I’m thinking that with the volume trending slightly higher, the demand for the stock is starting to come back. Therefore investors should anticipate the stock to trade at new all-time highs by the end of the year.

Conclusion

Despite the short-term weaknesses in the core business as a result of declining profitability, the company is likely to re-ignite this growth through acquiring foreign companies. When looking at history, Google’s acquisitions contributed to the company’s historical growth rate significantly.

As indicated by the Google stock price chart, Google stock is starting to recover in price. Management communicated that the decline in profitability was largely temporary as a result of short-term expenditures. Therefore, it’s likely that Google will meet earnings estimates in future quarters.

Analysts on a consensus basis anticipate mid-teen earnings growth over the next five years. Google may in fact exceed mid-teen earnings growth assuming a combination of share buy-backs, cost cutting, and accretion from acquisitions were to occur. Furthermore, Google’s core ad-business has demonstrated resilience, while Android Play Store grew revenues by 48%. Google Cloud and Google Fiber may become bigger businesses contributing to both top line and bottom line results.

Therefore, Google’s growth trajectory looks solid.

View the complete Google stock analysis by Amigobulls to see why the Google stock is a buy.

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