Hey Eric Schmidt, Don’t Let the Door Hit Your Ass On Your Way Out

by Dan July 15, 2011 8:22 am • Commentary

Last night after the close, GOOG reported an impressive set of numbers which has the stock up 12.5% in the pre-market. The rally far exceeds the move that was implied in the options market, even as it crept up over the course of the week.

Goldman Sach’s which has a neutral rating on the stock noted “that the $370 million revenue upside was driven by better than expected paid clicks”, but on the EPS front the upside wasn’t quite as impressive as “Of the $1.03 EPS upside to our $7.71 forecast, $0.68 related to higher other income, a lower tax rate and share count, and $0.20 was due to a larger FX benefit”……..”the beat was much smaller than it appears given non-core item contribution”

As noted in the original post, sentiment among investors clearly ran contrary to that of the analyst community and that very sentiment among investors/traders is causing the massive rally. Traders are covering shorts and underweight investors are playing catch-up….

I think it is a joke if the media and some at the company are going to give Larry Page credit for the upside in the qtr as he only took over in April, but if Page can stick with this hands on approach and remain committed to playing catch up in a smart(er) way in areas like social media, than the company will be back on the right track, even as they get bigger.

As for the directional call, I blew this one, I am long the July Put Spread and it will be worthless this morning……But again as many of you know I am in the business of making tactical bets around events where I have conviction….I defined my risk and knew given the trade structure and expiry that if I chose that this was going to be somewhat binary.

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.