Friday, February 2, 2007

When 177% Growth Disappoints..

Another look at Google. I am focused on Google here not to trash the stock or the company. The company itself is phenomenal. I also am not trying to hurt existing shareholders by being negative about the stock and in the spirit of the full disclosure era we now live in I have no position in Google. I do hope to make people think twice about what I believe would be a poor investment at this point. I think even Google's management may agree with me. I read in their earnings conference call they are changing the employee stock program to allow employees to sell their employee options. Could this mean even they recognize the lofty price for the shares and are letting their employees cash out now? The buyers of these options will have it's expiration date shortened and will not be able to re-sell them. This will lead to an acceleration of these options being exercise and by default an accelerated dilution of shares. Again, very employee friendly of them and if you work for Google, it is nice to know they are looking out for you. As for the average investor at home? Not so much.

Google 4th quarters numbers came in and profits jumped 177% and shares sold off. Why?

The story here is NOT, a failure of management, a bad business decision or even an internet search slow down. What is the story then? The inevitable growth deceleration of a maturing company and and resulting effect on it's overpriced shares. Investors needed a surprise here to continue to justify these price levels, when they didn't get it, reality set in.

Some numbers:

Revenue (growth):
2004 - $3.1b (121%)
2005 - $6.1b (96%)
2006 - $10.6b (73%)
2007 - $15.8b Needed to attain est. earnings

EPS (growth)
2004 - $1.46 (256%)
2005 - $5.02 (243%)
2006 - $ 9.92 (97)
2007 - $13.92 (40%) Est.

The first thing that sticks out is the deceleration of both revenues and profits. This means that the premium (PE ratio) investors will pay for the stock must fall also. I arrived at Google's 2007 revenue requirement to achieve the $13.92 a share in earnings by taking the $13.92 a share times the shares outstanding of 329 million, that gives us total earnings. Currently there are only 309 million shares outstanding but there has been about a 20 million share a year dilution since they went public so I have added it in for 2007. (VERY important note here: Should employees increase their selling of options, this will cause an acceleration of this effect, further diluting earnings per share next year.) You then take their 29% profit as a percentage of revenue, do the division and you arrive at our $15.8 billion (49% growth over 2006) in revenue necessary to achieve our 2007 estimate eps. I also assume no deterioration of their ratios (this could very well happen, but I am assuming a consistent scenario so as not to be accused of "fudging" numbers to make a point).

Currently Google trades at 50 times 2006 earnings that grew 97% over 2005. What would you be willing to pay now that it is only going to grow earnings 40% next year? Let's run more numbers, if you pay:

40 times earnings we get a price of $556 or 11% higher than its current price
30 times earnings we get a price of $417 or 16% LESS than its current price

Which is more realistic? Investors rarely pay a premium over the current growth rate for a company with decelerating earnings. This means that 40 times earnings and under is the more likely scenario. As far as a "price prediction", I won't even guess. I do know that Google's earnings growth (while still stellar) must decelerate, its size now dictates it must. As that growth shrinks so will the multiple on its shares. This will lead to a stagnation or decline in its share price from its current inflated levels. I won't guess an exact number, there are way too many factors involved, I can only dictate a range based on the info and that range does appears to be flat to negative.

So what to do? If you are thinking of buying, don't. You already missed the boat on this one. Move on (and I would say stay away from tech). If you are thinking of selling, do what you want. The price should bounce around here for a while with the pressure being downward.

I repeat my prior statement. Google is a great company with great product, it's stock is just overpriced.


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