google independent research report

7/31/2019 Google Independent Research Report

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Jeffrey B. Mann, CFA

Independent Research Report Google Inc.

Ticker: GOOG Recommendation: BUYCurrent Price: $604 Price Target: $800.76

Highlights: Market Dominance at a Discount

Global Market Share Leader and Brand Name Are Key Competitive Advantages: With an87.6% Market Share in search this powerhouse is poised for consistent revenue growth throughincreases in search traffic and rate increases per click. In a market with low switching costs,Google has been gaining market share by focusing on targeted search and providing servicesthat users want. This gives Google a competitive advantage as users increasingly flock to themarket share leader with the most traffic and content.

Consistently High Employee Productivity and Technological Innovation: Revenue peremployee rose from approximately $1,000,000 to $1,200,000 over the last 4 years faroutpacing its peers. 1 Googles resource in superior human capital is expected to continue toyield financial results as talented individuals are attracted to the culture and standards atGoogle. Google invests over 13% in R&D - way above industry peers. They also continue toinvest in disruptive technologies and innovations that are expected to yield long term returns. 2

Rising Margins, Earnings, and Valuation Models Signal a BUY: GOOG is holding 22% of its valuein cash with increasing profit margins and earnings, amidst a global recession. Valuation modelsdemonstrate 33% upside potential. All signals point toward favorable future growth.

1 Source: Appendix I: Employee Productivity2 Source: Appendix II: Technological Innovation

(in $ millions) 2011A 2012E 2013E 2014E 2015E 2016ESales $37,905 $44,349 $51,888 $60,709 $71,030 $83,105EBITDA 13,937 16,135 18,878 22,087 25,842 30,235Net Income 9,737 11,498 13,743 16,374 19,466 23,077EPS 29.76 44.57 53.27 63.46 75.45 89.45

Forecast Summary

52-week Price Range $473.02 - $670.25Average Volume (3m) 2,419,360Beta 1.18Market Cap (thousands) 196.91BShares Outstanding 258 million

Insider HoldingsInstitutional Holdings 82.00%

FMR LLC 7.07%Vanguard Group 3.93%T. Rowe Price 3.75%

Debt/Total Cap 12.50%ROE 19.59%Free Cash Flow/EV 7.07%

EV/Sales 3.94EV/EBITDA 10.64P/E 18.31


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Independent Research Report May 15, 2012

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Company Overview:

History

Googles birth dates back to the mid-90s when Stanford University graduate students, Sergey Brin and

Larry Page, developed a technology for a search engine. The initial search engine was named BackRub,for its unique ability to analyze the back links pointing to a given website. In 1998, Brin and Page raised$1 million in funding from private investors and venture firms to start Google. By 1999, Google wasanswering 500,000 search queries per day. That same year, it received $25 million in equity fundingfrom Sequoia Capital and Kleiner Perkins Caufield & Byers and AOL/Netscape incorporated Googlessearch technology into its Netcenter portal. By late 2000, the company answered more than 60 millionsearches per day and its index compromised more than 1.3 billion web pages. In that same year, inorder to capitalize on its growing search business, Google launched AdWords, a self-service advertisingprogram that could be launched online with a credit card. By 2004, Googles presence could not bedenied. Ever opportunistic, Google launched the Gmail email service and went public with an IPO on the

NASDAQ.

Today, Googles business is focused around online search, advertising, operating systems and platforms,and enterprise.

Search

Google maintains an index of websites and other online content that it makes available through theGoogle search engine. The search technology sorts through information to deliver relevant searchresults to user queries. Google Search is currently the #1 search engine in the United States with an84.2% Market Share. 3

Advertising

AdWords generates revenues by charging businesses to create ads based on keywords (words orphrases related to the business). When people search on Google using one of the keywords, the ad willappear next to the search results. People may then click on the ad to make a purchase or learn aboutthe company. Businesses pay up to a maximum of ten cents for each ad and they are only charged if thecustomer actually clicks on the ad, referred to as click-through.

The AdSense program enables websites that are part of the Google Network to deliver ads from theAdWords advertisers that are relevant to the search results or content on their websites. Google shares

the majority of the revenues generated from these ads with the Google Network Members that displaythe ads. AdSense enables advertisers to extend the reach of their ad campaigns to other websites.

Google Display compromises videos, text, images, and other interactive ads that run across the web oncomputers and mobile devices, including smart phones and handheld computers such as netbooks and

3 IBISWorld Search Engines in the US February 2012


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tablets. The Google Display Network provides advertisers the ability to deliver display advertising acrosspublishers participating in the AdSense program, the DoubleClick Ad Exchange, and Google-owned sitessuch as YouTube and Google Finance. The Google owned DoubleClick Ad Exchange is an auctionmarketplace for the trading of display ad space. YouTubes video advertising solutions provideadvertisers a way to promote their content to the YouTube community, as well as to associate with

content being watched by their target audience.

Google Mobile extends all products and services offered by Google by providing mobile-specific featuresto mobile device users. These include, search by voice, search by sight, and search by location. Inaddition, Google offers advertisers the ability to run search ad campaigns on mobile devices withpopular mobile-specific ad formats, such as click-to-call ads in which advertisers can include a phonenumber within ad text.

Google Local provides users with relevant local information from over 50 million places globally. Userscan find addresses, phone numbers, hours of operation, and directions for local queries such as shops,restaurants, parks and landmarks on google.com, google maps, and google maps for mobile. Users rateplaces theyve been and get customized recommendations based on their tastes within google maps.Google Places allows local businesses the opportunity to manage their online presence by allowing themto post their business listing for free and to add additional details such as photos and products/servicesoffered. In addition, Google Offers brings people daily deals from local and national businesses.

Operating Systems and Platforms

Android is a free, fully open source mobile software platform that any developer can use to createapplications for mobile devices and any handset manufacturer can install on a device. Currently,Android has captured 61% Market Share in the US smartphone market. 4

Google Chrome OS is an open source operating system with the Google Chrome web browser as itsfoundation. They are both designed for people who spend most of their time on the web, and are builtaround speed, simplicity, and security. Google is currently working with OEMs to bring computersrunning Google Chrome OS to users and businesses. The Chrome browser runs on Windows, Mac, andLinux computers. The Google Chrome web browser currently has 18.85% of the web browser market.

Google+ was launched in June of 2011 as an online community to compete with Facebook. As of January 2012, over 90 million people have joined.

Google TV is a platform that gives customers access to television, with the ability to search and find the

content they want to watch. The Google TV platform is based on the Android operating system and runsthe Google Chrome browser.

4 Source: https://www.npd.com/wps/portal/npd/us/news/pressreleases/pr_120502
https://www.npd.com/wps/portal/npd/us/news/pressreleases/pr_120502https://www.npd.com/wps/portal/npd/us/news/pressreleases/pr_120502https://www.npd.com/wps/portal/npd/us/news/pressreleases/pr_120502


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Google Books is a platform designed to help people search and consume content from printed booksonline. Through the eBookstore, Google provides a large collection of free public domain books inaddition to selling popular books in electronic book format.

Enterprise

Enterprise products provide technology for business settings in direct competition with Microsoft Officeapplications. Google Apps include Gmail, Google Docs, Google Calendar, and Google Sites, in addition toweb-based applications. In addition, Google provides search technology for use within businessesthrough the Google Search Appliance (real-time search of business applications, intranet applications,and public websites), on their public-facing sites with Google Site Search (custom search engine), andGoogle Commerce Search (for online retail enterprises). They also provide versions of Google Maps forbusinesses (public and internal websites), and Google Earth Enterprise (for imagery and datavisualization). These products have been adopted by businesses, governments, schools, and non-profitorganizations. Of note, Google Apps is the first cloud computing suite of message and collaborationtools to receive U.S. government security certification.

Revenue Mix

Google currently generates the majority of revenues from advertising and a significant amount isgenerated by Google owned websites. Google has indicated that margins on revenues generated fromGoogle Network Members websites are significantly less than margins on revenues generated fromGoogle owned websites. As you can see from Figure 2 , Google owned websites are gaining a largerpercentage of advertising revenue which is evidence that Google is attracting users with their contentand offerings, and experiencing greater returns.

Figure 1: Segment Revenue Figure 2: Advertising Revenue

Source: Google 10-K Source: Google 10-K

Industry Analysis:

The internet search engine industry is characterized by firms that operate search engines, internetportals and other types of search-based websites that display advertisements. Websites earn incomewhen a user clicks on an advertising link. Websites attract users by offering a range of mostly freeservices, such as internet search, e-mail, news, social networking, entertainment and other information.


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The U.S. search engine industry is a $17.1 billion market with annual growth of 11.5% through2012. 5 Google currently dominates the industry with an 84.2% market share.

Figure 3: Market Share

Source: IBISWorld Reports

Figure 4: Global Market Share

Source: Karma Snack traffic analytics

Our analysis of Porters Five Forces reveals an industry with high bargaining power for customers as wellas advertisers. 6 Customers can choose any search engine available at no cost. In addition, advertisers

5 IBISWorld Reports Search Engines in the US Industry Report February 20126 See Appendix III: Porters Five Forces Industry Analysis

Google,

84.2%

Yahoo, 7.2%Microsoft, 6.6%

Market Share: US Search EngineIndustry

Google,87.6%

Microsoft, 4.2%Baidu, 4.7% Yahoo, 2.4%

Market Share: Global Search EngineIndustry


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run multiple advertising campaigns through various search engines at little cost. For instance, anadvertiser may rather place an ad with Microsoft Bing where they may be the number one search resultas opposed to placing an ad with Google where they may end up as number ten on page two of searchresults. It is for this reason that we do not see this industry converging to one dominant player. WithMicrosofts recent agreement with Yahoo, they will be powering the yahoo search engine through

Microsoft Bing in exchange for 12% of revenues. Competition for market share will remain fierce withadvertisers choosing as many venues as possible. Next, we performed a SWOT analysis on Google toassess how they are addressing the industry dynamics. 7 What we found was that Google is addressingthe customer side of the equation, driving clicks and thereby revenues. Even though advertisers willseek any search engine that is relevant, Google will continue to innovate and drive the customerexperience in order to generate clicks. In addition, by allocating resources to drive mobile growththrough Android Market, Google is setting itself up to become the Google of mobile search andadvertising.

Competition

Microsoft is a global software company with $70 billion in sales in 2011. They generate revenue bydeveloping, licensing, and supporting a wide range of software products and services, by designing andselling hardware, and by delivering online advertising. Through the Online Services Division Microsoftcompetes directly with Google. The Online Services Division offerings include Bing Search, MSN,adCenter, and advertising tools. Search and display advertising account for all of the divisions revenue.As of 2011, revenues amounted to $2,528 billion with operating losses of $2,557 billion. Microsoft hasbeen operating at a loss in this division with losses increasing relative to revenues. Even though we haveincluded Microsoft in our peer group analysis, attention should be paid to the overwhelming fact thatMicrosoft is operating at a loss in the division that competes directly with Google.

Yahoo is a digital media company with $5 billion in revenue in 2011. They generate revenue fromdisplay advertising, text-based search, and other sources. Display Revenue was $2.1 in 2011 and camemainly from banner ads on yahoo websites and affiliated websites. Text-based search advertising was$1.8 billion, a $1.4 billion decline from 2010 due to the ten year Microsoft agreement. Search pageviews have declined 1% year over year for the last two years. Yahoo will be increasingly relying onMicrosoft to drive advertiser acquisitions while being responsible for customer clicks for the text-basedsearch business. With poor operating results over the last few years we see less and less resourcesavailable at Yahoo to effectively compete with Google and drive customer growth.

Baidu is a Chinese language internet search provider which operates in China through Baidu Netcom

Science Technology, which holds the licenses and approvals to operate the companys websites andprovide online advertising services. The company operates in China, Hong Kong and Japan. Revenuesfor 2011 were $2.2 billion. Baidu currently has an 83.6% market share in China compared to Googles11.1% 8. It appears that Googles decision to redirect users in China to a Hong Kong site in response to

7 See Appendix IV: Google SWOT Analysis8 Source - http://www.resonancechina.com/2011/03/14/baidu-83-6-search-query-market-share/


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the Chinese Governments censorship of content has backfired. With China being the worlds largestmarket we see Baidu with considerable room to grow. Of note, Baidu recently formed a partnershipwith Microsofts Bing, which will enhance Baidus English-language searches.

Financial Statement Analysis:

Figure 5: Gross Margin

Firms in the search and advertising industry enjoy high gross margins relative to other more capitalintensive industries. We found that Microsoft was at the high-end, however the majority of its business

mix is in software business which benefits from economies of scale and thus higher gross margins. Thatbeing said, Google is at the bottom of its peer group and trending upward. We see opportunity forimprovement going forward which could give a boost to share price.

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Figure 6: Operating Margin

Operating Margins have been in line with peers but have experienced a decline within the last year. Thisreduction in operating margin is mainly attributable to a 0.80 basis point increase in R&D from 12.8 to13.6% of revenues. In addition, sales and marketing expenses rose 2.60 basis points to 12.1% of revenues and Google recognized a charge related to the resolution of the Department of Justiceinvestigation representing 1.3% of revenues. Google is currently spending the most on R&D as apercentage of sales across the peer group. In addition, sales and marketing expenses are at the bottomof the peer group. We feel this augurs well for future product development. This also demonstrates

Googles ability to create awareness of products without the need for high sales and marketingexpenses.

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Figure 7: Net Profit Margin

Net Profit Margins have been increasing across the peer group over the last five years. This has beendue to increasing sales with a bit of help from reduced effective tax rates.

Figure 8: Effective Tax Rate

In 2011, Google generated 53.7% of Revenues outside of the United States with the majority in the UKand Japan where corporate tax rates are 28% and 38%. In addition with US corporate tax rates at 35%,Google still enjoys a 21% effective tax rate. Through our research we were able to determine thatGoogle benefits from tax loopholes by using a technique that shifts most of its foreign profits throughIreland and the Netherlands to Bermuda, thereby decreasing taxes on foreign profits to 2.4% 9. We have

9 Bloomberg Inside Googles $1 Billion-a-Year Tax Cutting Strategy October 21, 2010

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seen Microsoft tax advantage of this as well and expect it to continue across the peer group. We arecautious as to the results of the coming US Presidential Election and the effect on corporate tax laws.

Figure 9: Current Ratio

The trend in Current Ratio for the peer group has been solid, consistently averaging a ratio over two.However, we found that Google has been accumulating cash at an accelerated rate. With over $44billion in cash and cash equivalents we see significant opportunity to return cash to shareholdersthrough, strategic acquisitions, share buy-backs, and or dividends. In addition, we see no threat of

Google having excess cash trapped overseas. Currently, Google has $35 billion in marketable securitieswhich are all U.S. based cash equivalent securities. That leaves $10 billion in cash, a $3.6 billiondecrease from a year earlier. Some of this cash may be sitting overseas, however we feel Googles useof tax loopholes will allow it to bring cash back to the U.S. at lower rates. In turn, this cash willeventually be used for strategic purposes overseas where growth is still in its infancy.

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Figure 10: Debt to Equity

Debt to Equity ratios have been trending upward for the peer group. With borrowing rates at rockbottom we believe that this will continue. Googles strong stable cash flows will allow it the ability toborrow at lower rates, something they were not able to do in the early stages of the companysdevelopment. We think this is a positive for the stock in rationalizing the capital structure.

Figure 11: Receivables Turnover

Receivables turnover has been strong for the industry as a whole yet declining. For Google, accountsreceivable are typically unsecured and are derived from revenues earned from Google NetworkMembers who are typically in the internet industry. Accounts Receivable has grown from 13% of sales

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in 2007 to 15% in 2011 and uncollectable accounts has increased from 1.5% to 2.4%. While significantincreases, we do not feel this to be a significant concern in light of current economic conditions.

Figure 12: Accounts Payable Turnover

Account Payable has been strong across the industry due to favorable position of key players withGoogle at the top. Accounts Payable has been an insignificant 2.2% of expenses. We feel that Googlemay have room to increase accounts payable in the future which should benefit the cash cycle.

Figure 13: Return on Equity

Return on Equity has been strong across the peer group with the exception of Yahoo. Baidu is currentlyin the early stages of growth exhibiting profit margins near 45% which are reflected in ROE. Microsoft is

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in the mature phase highlighted by strong cash flows and share buy-backs which result in their high ROE.We feel that Google is somewhere in the middle showing strong growth and stable cash flows but hasyet to utilize excess cash for shareholder friendly activities. Any action by Google on this front willprovide a huge boost to Google shares.

Figure 14: Price to Earnings

Price Multiples have been falling across the peer group over the last five years. We feel the industry as awhole is being undervalued relative to growth forecasted for the future. We next looked at the Price toEarnings Growth Multiple.

Figure 15: Price to Earnings Growth

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We removed Yahoo from our analysis due to negative and/or flat earnings growth over the last fiveyears. You will notice Google trading at a premium to Microsoft and Baidu, however we feel the marketdominating position of Google affords it the ability to command this price premium. We are seeing PEGratios at the low end for these growth companies and see this as a signal that the peer group isundervalued.

Valuation:

To arrive at our price target, we utilized a discounted cash flow model in conjunction with a price toearnings multiple and a comparable multiple analysis. We weighted each factor by 33.33%. To arrive atour earnings per share forecast we estimated revenue growth of 17% in line with analyst expectations.

Our P/E multiple price was calculated by multiplying next years forecasted earnings of $44.57 by thelowest P/E multiple over the last five years which is 18.3, to arrive at a price of $815.63. 10 We feel thatthis is conservative in light of current conditions and expect price multiple expansion with any positiveincrease in consumer sentiment.

Our comparable analysis utilized an EBITDA multiple given the wide applicability of this multiple acrossthe industry. This analysis yielded a price of $787.99 based on an industry multiple of 12.6x and a 2012EBITDA forecast of $16,135 billion. We used competitors that are in many respects similar to Google interms of profitability and business segments.

Figure 16: Comparisons Across Peer Group

Our discounted cash flow model forecasted a price of $798.90. Our assumptions include a WACC of 12.2% and a 3% terminal value growth rate. 11

10 See Appendix V: Income Statement Forecast11 See Appendix VI: Discounted Cash Flow Forecast

Company Name Market CapEV/

RevenuesEV/

EBITDAGross

MarginEBITDAMargin ROE %

Yahoo 19.0 3.3x 12.6x 70% 29% 9%Microsoft 258.3 3.0x 7.1x 78% 42% 38%Baidu 43.0 15.7x 27.0x 73% 58% 53%

Google 200.0 3.9x 10.6x 65% 35% 20%

Mean 7.3x 15.6x 74% 43% 33%Median 3.3x 12.6x 73% 42% 38%

Selected Comparables


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Figure 17: Price Target

Risks:

Ownership structure limits stockholders ability to influence corporate matters:

Google has Class A and Class B common stock. Class A common stock is what trades on the NasdaqStock Exchange and is referred to throughout this report. Class B stock has 10 votes per share whileClass A has one vote per share. As of December 31, 2011, CEO Larry Page, Co-Founder and DirectorSergey Brin, and Executive Chairman Eric Schmidt beneficially own 92% of outstanding Class B commonstock, representing approximately 66% of the voting power of the outstanding capital stock. This mayadversely affect shareholders in the future if management does not make decisions for the benefit of allshareholders. See Appendix II for excerpt from company 10-K.

Significant Reliance on advertising spending:

With over 96% of revenues coming from advertising, Google has a significant reliance on the advertisingmarket and industry. Advertisers can terminate contracts at any time if investment is not resulting insales leads or if advertisements are not delivered in an effective manner. In addition, advertisingspending tends to be cyclical, reflecting overall economic conditions and budgeting and buying patterns.

Adverse economic conditions can have a material negative impact on the demand for advertising andcause advertisers to reduce spending. If the economy goes into a double dip recession earnings will beaffected negatively.

May be subject to legal liability associated with providing online services:

Google recently accrued $500 million related to the Department of Justice investigation regarding theuse of Google advertising by certain advertisers. The law relating to the liability of providers of theseonline services and products for activities of their users is still somewhat unsettled both within the U.S.and internationally. Claims have been threatened and have been brought against them for defamation,negligence, breaches of contract, copyright or trademark infringement, unfair competition, unlawfulactivity, tort, or theories based on the nature and content of information which they publish or to whichthey provide links or that may be posted online or generated by Google or third parties, including users.In addition, they have been subject to domestic and international actions alleging that certain contentthey generated or third-party content they have made available within their services violates laws indomestic and international jurisdictions. We expect these allegations to continue and any adverseruling could have a material impact on the stock price.

P/E Multiple Value $815.63 33% $271.85Comparables Value $787.99 33% $262.64DCF Value $798.90 33% $266.27

Price Target $800.76

Price Target


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Appendix:

Appendix I: Employee Productivity

Appendix II: Technological Innovation

Our ongoing investment in new business strategies and new products, services, and technologies isinherently risky, and could disrupt our ongoing businesses.

We have invested and expect to continue to invest in new business strategies, products, services, andtechnologies. Such endeavors may involve significant risks and uncertainties, including distraction of management from current operations, insufficient revenues to offset liabilities assumed and expensesassociated with these new investments, inadequate return of capital on our investments, andunidentified issues not discovered in our due diligence of such strategies and offerings. Because thesenew ventures are inherently risky, no assurance can be given that such strategies and offerings will besuccessful and will not materially adversely affect our reputation, financial condition, and operatingresults.

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R e v e n u e P e r E m p

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Highest Employee Productivity

Google

YHOO

MSFT

BIDU


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Appendix III: Porters Five Forces Industry Analysis

Appendix IV: Google SWOT Analysis

SWOT AnalysisStrengths Weaknesses

Strong Brand Image provides distinctcompetitive advantage.

Wide portfolio of offerings attracts customerswhich drives revenues

Patent infringementslawsuits may affectfinancial results.

Opportunities Threats Strategic acquisitions. Rising Android market share. Robust outlook for mobile advertising. Entry into mobile payments market.

Intense competition. Exchange rate

fluctuations

Bargaining Power of Customers (High)

Bargaining Powerof Suppliers (High)

Rivalry AmongExisting Players

(High)

Threat of NewEntrants (Low)

Threat of Substitutes (Low)

Customers are able to useany search engineavailable at no cost otherthan the cost to connect tothe internet

Due to highindustryconcentration,advertisers areforced to place adsthrough the threetop players.However, due toinexpensive click

through rates,advertisers usemultiple adcampaigns.

Remainingplayers areincreasinglybattling formarket share.Microsoft nowpowers theyahoo searchengine and

shares revenueswith yahoo inorder tocompete wi thgoogle.

High Barriers toentry indicatedby high marketconcentration,brandrecognition of existing searchengines, andtechnological

expertiserequired tohandleindexing andalgorithms.

Search enginesare engrained inpopular cultureeven thoughtechnologyadvances rapidly.We do notanticipate anygame changing

advances withinthe forceablefuture.

Porter's Five Forces


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Appendix V: Income Statement Forecast


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Appendix VI: Discounted Cash Flow Forecast

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