Google “Searching” for Answers to Growing Competitive and Regulatory Threats

by Dan July 8, 2011 3:56 pm • Commentary
GOOG ($532) reports Q2 July 14.

-implied move is ~5.5% vs the 4 qtr avg move of ~7%

-stock is one of the worst performing large cap tech stocks down 11% ytd vs Nasdaq which is up 7% ytd.

-Technically there is a good bit of resistance at $550 and after the almost 11% run in the last 2 weeks there has to be a good bit of news priced in as we head into next week’s earnings.

[caption id="attachment_3143" align="aligncenter" width="300" caption="1 Yr GOOG chart Provided by Bloomberg LP"][/caption]



This morning, Morgan Stanley had a very detailed note where they downgraded their rating on the stock to a Hold and lowered their 12 month target from $645 to $600 and lowered their 2012 eps estimate to $34.00 well below the consensus estimate of $40.00.

-The Street is overwhelmingly positive on the name with 33 Buys 6 Holds and No Sells.

Here is a quick summary from Morgan’s downgrade note:

-Google is spending to innovate in social / local, retaintalent, and to drive user adoption of key products, but those investments have uncertain ROI / payback periods. We are reducing our PT to $600 (from $645)and C2012e EPS to $34, below consensus of $40.

-Debate #1: Will margins decline from here? Yes.Given Google’s aggressive hiring plans, rising compensation expense, and significant advertising spend on Chrome & other Google products, we expect EBITDA margin to decline in C2011 / C2012.

-Debate #2: Will “newer” businesses drive near-term revenue out-performance? No. We believe the consensus is too optimistic on the net revenue contribution of newer businesses, such as DoubleClick,YouTube, AdMob, Android Market, and mobile search.In 2011, we expect search & contextual ads to contribute~90% of Google’s net revenue.

-Debate #3: Will investments in local eCommerce and / or social pay-off? Too early to tell. We are encouraged by early progress of Google Plus and Google Offers, but Google faces stiff competition from incumbents who have first mover advantage. The pay-offs of such endeavors may be longer-term.

-Where we could be wrong: Google may decide to exercise financial discipline by: 1) slowing hiring, 2)reducing advertising spend, 3) initiating a share buyback,or 4) tempering compensation packages. In any of these cases, shares may respond positively.

-We are reducing our C2011 / C2012 EBITDA margin estimates to 53% / 51% (down from 55% / 54%)compared to consensus estimates of 55% / 55%.

-Bull Case$ 700 19x Bull Case C12EOp. EPS of$38 New businesses pay-off sooner than expected: C10-15E net revenue CAGR of +18%, paid clicks CAGR of +12%, cost-per-click CAGR of +5%. Bull case assumes YouTube / Mobile drive near-term upside and investments in new businesses payoff. Base Case$60017x

-Base Case C12EOp. EPS of$34 Investments drive near-term margin declines: C10-15E net revenue CAGR of +16%, paid clicks CAGR of +11%, cost-per-click CAGR of +4%. Base case assumes EBITDA margins contract to 53% in C2011, 51% in C2012.

-Bear Case $39515x Bear Case C12EOp. EPS of $27 Core business matures, Google loses share: C10-15E net revenue CAGR of +11%, paid clicks CAGR of +10%, cost-per-click CAGR of+4%. New investments fail to drive revenue growth. Newer Internet business models disrupt Google’s core search business

My View:

-As a consumer, I am generally indifferent to their products and other than search and chrome I don’t use them. All the other stuff seems like a real waste especially when you consider their blown opportunities in Social Media in a period where they were so focused on MSFT. The irony is this company was conceived to be the anti-MSFT but in reality that is exactly what they have become in the eyes of competitors, customers, counter-parties, hackers and REGULATORS.

-They are trying to get their mojo back with some high-level management changes and a bit of re-org (read some of my earlier thoughts here), all of which may be a fairly daunting task for a company this size.

-Near term I expect some of the issues that were highlighted in the Morgan Stanley report, couple with new CEO Larry Page’s desire to set things of up for a series of beats, could cause earnings results to remain strained and commentary to remain downbeat.

-As we look past the Q2 report (the company does not officially give out qtr guidance) investors may remain focused on how the company will put the $36 billion in cash that they have on their balance sheet to work and worry about the potential for a big dumb acquisition.

-Given the stocks recent rally and my belief that some of the issues causing the company’s Q1 earnings miss have not subsided, I want to make a short term tactical bearish trade into earnings while defining my risk.


TRADE: GOOG $532 Buy the July 520 / 490 Put Spread for 7.00

-Buy July 520 Put for 9.00 and

-Sell July 490 Put at 2.00


Break-Even on July Expiration:

Worst case: above 520 lose all 7.0o in premium or less than 1.5% of the underlying…..btwn 520 and 5.13 lose up to 7.00

Downside: btwn 513 and 490 make up to 23.00 and best case 490 or below make full 23.00.