Friday, December 31, 2010

Rule #1 Analysis Blitz #8: Google (GOOG)



For this post, I'm going back to a stock I own.  It's probably a stock you know too, especially since you're reading this on the internet.  From a brief look at the statistics of this blog, about 90% of traffic is directed here from this search engine.  Yep, you guessed it, it's Google (as if you didn't know from the title of this post)!

Relatively speaking, Google is a really young company.  It was founded only in 1998 and became a public company a little more than 6 years ago.  If you are over 30 years old, you probably remember there was a time before Google was around.  When you wanted to search for something on the web, you would open your Netscape browser and click on the "Search" button.  It then brings you to some search page, of which, frankly, I can't recall the contents.  Later on, I realized that there were actually websites that did these searches.  My early favourite was Alta Vista.  Then, some time during my university days, I switched to Google.  I can't remember exactly when that happened, but it did so very naturally and I never looked back.

The same thing happened with Mapquest.  From Mapquest, I went to Yahoo maps just because I had a Yahoo account.  But when Google maps came on the scene, it was a no-brainer.  I didn't have to click on the arrows on the map to move north/south/east/west.  Just click the mouse and drag the map around...it was so intuitive and convenient.

Moving my main email account to Gmail took a little longer.  As you may know, I have my own domain and have been using POP3 email through Outlook to access my email.  Then, the frequency at which I checked email became less and less, because it was a hassle to download email (along with all the spam) onto my computer.  As well, I couldn't access my email while on the go. I had (still have) a Yahoo email account, but it was just never quick enough.  Then, I took the leap and let Google host my email account.  I get to keep the felixwong.ca address and have the convenience of having my email in the cloud.  Gmail is also amazing fast and keeps your emails in its appropriate threads.  Spam hardly ever gets into my inbox either.

I'm not going to go through all of my transitional stories to Google, but I think you get the point.  Its products and services are really top notch and I believe Google's management are real visionaries.  Let's see if the stock is "investable"!

Moat
You can download the completed Rule #1 spreadsheet here.

Before we begin, note that Google has only gone public for 6 years.  So, any data before that was from its private days.  I wouldn't pay attention to much to it's 9-year numbers, not that they're bad or even mediocre!  Everything looks astounding!  With the exception of sales growth, the lowest growth number in the summary table was last year's BVPS and it was at 26.4%!  Sales growth last year was relatively slower at 8.5%.  It raises a yellow flag, but with a 8.5%, it's close enough to our 10% threshold to give it a pass, especially since 2009 was just the beginning of the economic recovery.  We also see zero debt; in fact, Google has amassed $33 billion in cash.  There are only about 250 companies worldwide that have market caps as large as this amount!  Without a doubt, Google has one of the best balance sheets amongst the mega-cap companies.

Google makes a significant amount of its revenue from advertising.  They are the ads that appear at the top and right of the search results page that are under the "Ads" title.  The average advertiser pays about $0.50 - $2.00 every time a link is clicked.  When I was still in school, I never really understood why anyone would click on those ads and how Google could make any money.  However, when I started working and wanted to search for vendors, I found those ads to be very useful, sometimes more helpful than the search results themselves.  The reason is that I was trying to find somebody selling something, but the search results gave me everything from news on the topic, to a blog post, to a definition on wikipedia, etc.  The ads gave results only of people trying to sell stuff.  That's exactly what I was looking for, and because the ads are contextual (based on the keywords that I typed), they are usually pretty good.  The second major part of Google's revenue comes from their Adsense ads, which you can find on this blog after a post and on the right column.  Google scans the page for its content and matches advertisements that fit within that context.  As you can see on the ads on this blog, the advertisers are usually stock brokers or financial companies.

So, the moat of Google has to do largely with its search engine.  Why would you want to stay with Google?  Actually, let me ask myself why I would stay with Google and not go with Microsoft's (Ticker: MSFT) Bing? I did switch from Alta Vista to Google fairly painlessly.  If you have used Bing, there's definitely some appeal to the product.  It looks nice and the search results aren't bad either.  But why haven't I switched yet?  It's because Google offers a host of other products that have increasingly built up my loyalty for the company.  Many people criticize Google for offering products that don't generate cash, but I say those services are the essential ingredients to building an awesome brand moat.  When I switched from Alta Vista to Google, it was just a matter of changing my bookmark on my browser.  If I wanted to switch from Google to Bing, there would be this invisible mental blockade that prevents me from doing so.  I would unconsciously say to myself, "Ok, you use Gmail, Google Maps, Google Reader, Blogger, Android, why not just stick with the search engine?"  And that's exactly what has happened.  Although Google may not even give the most relevant results (I wouldn't know since I don't even use Bing or Yahoo), there's a preconception (perhaps even misconception) that Google is just better.  That is brand moat!  It's just like people choosing Coca Cola over Pepsi even though time after time, Pepsi does better in blind taste tests.

And Google was kind enough to give me a personalized "Happy Birthday" doodle for my 32nd birthday yesterday!  Why wouldn't I stick with Google?


As Google continues to branch out even more (just do a search on Chrome OS, Google TV, Google eBooks), it will get more and more intertwined with various aspects of your life.  If any company is going to produce a Skynet (from Terminator 2) or the Matrix, it's going to be Google!

Having said all this, it is not unimaginable that another company, Microsoft (although I doubt this would happen) or another startup, may displace Google in what it does.  The cost of switching over is not terribly great either.  You may need to fiddle with things for a couple of days, but after that, your internet presence can be switched over to any other provider.  So, Google does not get a perfect 10 for moat...it gets a 9!

Moat Score: 9 / 10


Figure 1: Rule #1 Analysis of Google (GOOG)

Margin of Safety
The sticker price on Google is $844.53 and entry price is correspondingly $422.26.  The stock is trading at $601.  So, the stock is still underpriced, but not enough to justify starting a new position right now.  This is using the assumption that future growth is at 20.4% and P/E ratio will be 21.6.  If we use a slightly higher growth rate of 23.5% and the current P/E ratio of 24, then the entry price would be $605.  I'm not going to use these assumptions, though, because I want to be more on the conservative side.  

Do keep in mind that it has about $104/share in cash.  If we could just "eliminate" that from the share price, it'd be at $601 - 104 = $497 and we can pretend that Google has no cash right now.  That's actually a pretty attractive price.  But there is some risk to this type of discounting method.  So, tread carefully.

Payback time is 8.8 years, which is pretty good, but this does hinge on a 20.4% EPS growth rate.

Google gets a 7 for Margin of Safety.  I would have given it a 6, but due to its strong cash holdings, I gave it a bonus point!

Margin of Safety Score: 7 / 10

Management
Google management gets a fair bit of spotlight, partly because it's the biggest internet company, but also partly because it sometimes come up with the wildest ideas, and any one of them could be game changers (or busts).  Sergei Brin and Larry Page were the Stanford graduates who created Google.  Due to their inexperience in actually running a business, they hired Eric Schmidt, then CEO of Novell to be Google's CEO.  Schmidt had been the CTO at Sun Microsystems before that.  Some call them the Google Triumvirate.  While Schmidt generally runs the business, it's Brin and Page who mainly drive the company's innovations.

Without a doubt, Schmidt is a seasoned veteran in the tech space.  Brin and Page, together, essentially eliminated all other search engines at the time with their mispelled website, Google (was intended to be Googol or the numbe10100).  These 3 dudes added together bring the brightest minds of Silicon Valley into one place, and that's definitely nothing to scoff at.

Similary to Apple's (Ticker: AAPL) CEO Steve Jobs, the Triumvirate each get paid a total of $1 each year.  Wow, I feel like a millionaire when I compare my pay to theirs!  Of course you know that's not what their total compensation is!  We would be able to see in Google's annual report what kind of compensation they are getting, but I'm not going to dive into that detail.  They probably have stock options, etc.  However, I do like that their pay is a symbolic $1. It means that their interest is in line with shareholder interest.  Since their compensation is stock based, whatever happens to their stock happens to their fortune.  As of January 2010, Brin and Page together owned about 57.7 million Class B shares of the company, which would be worth about $34.7 billion dollars right now!  That's not even counting what Schmidt owns (I believe he owns about $4 billion worth of shares).  The duo planned to sell 10 million shares over 5 years to diversify their holdings, but I'm not really worried about that.  With more than $30 billion at stake, the Triumvirate has more interest in growing shareholder value over the long term than any other shareholder!

I don't know if any other company has a more talented management team.  Schmidt is the seasoned veteran (distinguished in his own right), flanked by two brilliant, young, enthusiastic founder.  If Google doesn't get a 10 for management, I don't know what company does!

Management Score: 10 / 10

Meaning
From my introductory paragraphs, you can likely tell I'm a huge Google fan.  I use its search engine, Blogger, Reader, Maps, Gmail, Android, Analytics, Youtube, Apps, etc.  I know more about this company than most other.  The only disadvantage is that I may be biased towards it in my analysis.  I hope this is not the case here.

Anyway, as I mentioned long ago, I had some concern over Google's political leanings, especially of its support for legalization of same-sex marriage and rights of same-sex couples.  However, I did find some consolation when I looked at the USCCB investing policies that support of same sex marriage was not listed explicitly as something that would turn away the USCCB's investment funds.  Having said that, the USCCB still advises against investing in companies that "protect human life" and "protect human dignity".  I believe the support of homosexuality falls somewhere in these 2 categories.  I won't go into it too much, but I'm sure somewhere somehow, supporting same-sex marriages runs counter to the Catholic faith, but luckily not to the extent that one cannot invest in such company in USCCB's opinion.

On the brighter side, because of its left leanings, Google is also a very good corporate citizen.  Google has a philanthropic arm, Google.org, which has a number of initiatives to improve the well being of humanity.  Google has also invested a large amount of money in renewable energy.  It probably has its hands in the following USCCB categories: Pursuing Economic Justice, Protecting the Environment, and Encouraging Corporate Responsibility.  As many know, Google has an unofficial motto, "Don't be evil", and I believe many of its initiatives do offset, if that could even be done, its support for same-sex unions.

Just this year, Google decided that it wasn't going to continue censoring its results on its Google.cn website.  This is a bold endorsement for a freer China, but the Chinese government was quick in its response and began to block Google's site.  Google now puts up a link on its Google.cn website to its Hong Kong website, Google.com.hk, where the Chinese government plays by different rules.  This is somewhat of a workaround, but it shows that Google is not afraid to stand up for what it thinks is the right cause.

Another piece of news that surfaced this year was that Google collected wifi information as it was collecting Streetview images for its maps.  I actually don't think that was unethical, because it was only collecting information that was freely accessible and not encrypted.  So, Google was able to see information that people were sending back and forth on unsecured networks.  In my opinion, if you're on an unsecured network, you have to assume that your data is going to be visible by others.  In any case, Google apologized for this action and promised not to use those data collected.  Be your own judge on this issue.

With a company having the size and success of Google, there's always fear of it monopolizing its markets.  As Google continues to grow, its competitors will allege that Google is violating anti-trust laws.  Whether they be true or not, you should keep your eyes open to discern whether Google is doing anything unethical.

I will give Google a 7 out of 10 for Meaning.

Meaning Score: 7 / 10

Summary
Moat Score: 9 / 10
Margin of Safety Score: 7 / 10
Management Score: 10 / 10
Meaning Score: 7 / 10
OVERALL (not an average): 8 / 10

Although a mega-cap in its own right, Google is still a growth stock.  The internet is still in its infancy stage.  50 years from now, we will look back at what we have today and think how far we have come.  It would be like looking at a Ferrari Enzo today and then comparing it to the original Ford Model T.  Google is in the best position to capitalize on this (r)evolution.  Cloud computing will be the next stage of the game and we will see how it eventually pans out, but I would put my money on Google.  The company is like an octopus with its tentacles reaching into different spaces.

You may want to wait for a pullback before buying your first shares, but as the stock is still undervalued (just not 50% off), it may not see too much of one, especially since the macroeconomic conditions have improved. Lucky for me, I got in early.  I'm going to enjoy this ride!