Google in the Penalty Box. For Now.

Two minute minor, five minute major, ten minute misconduct, or game misconduct?

I'm thinking ten minute misconduct. The quarter is not nearly as bad as the stock would suggest. Revenues were light but operating income, EBITDA, and free cash flow were in line with expectations. Operating margins, a big issue over the past year, were actually better than expected. Adding back some forex hedging, a Clearwire write-off, and a higher than expected tax rate and EPS would have been in line with expectations.

But apologies don't work here. In line numbers are not good enough for Google (GOOG). A top line miss raises issues as despite the low P-E, GOOG is a growth stock. Growth and revenue misses are not compatible.

Lots of analysts ascribe much of the revenue miss to forex but I don't buy that as these same analysts assumed forex would hurt in their models.

The real issue is Cost Per Click (the price of a search ad) fell 8% in the quarter, more than offsetting much better than expected 34% volume growth of search ads (paid clicks). Paid clicks were expected to rise 24% and cost per click was expected to rise 4%.

The volume surge was led by a shift to mobile and emerging markets and new search algorithms that improved the relevancy of search results. The issue is that these newer searches are priced lower. The question is whether pricing in these areas will eventually rise, and if so, how soon. Furthermore, will volumes maintain their higher trend or will they settle back before pricing improves. In other words, is the core search business mature such that driving growth is possible but only at the cost of lower pricing?

I suspect eventually we will learn that pricing in mobile and emerging markets will improve with volumes continuing to run above current expectations. The world is going mobile. Think smartphones, tablets, and ultrabooks. Advertisers will follow and bid up pricing because that is where the eyeballs are going. However, this thesis is going to take time to prove. At least one quarter, maybe two. And in those same quarters, GOOG will close the Motorola acquisition, which creates another headwind. Thus, this official in putting GOOG in the penalty box with a ten minute misconduct.

But let's not get too negative. GOOG trades at 11 times earnings adjusting for $136 in balance sheet cash. The missed quarter saw 25% revenue growth and greater than 20% operating income growth. Microsoft and IBM are trading sharply higher today on mid to upper single digit revenue growth reported last night. IBM trades at the same multiple as Google. Microsoft trades lower but not hugely so. GOOG offers 20% growth for half the multiple. Sounds cheap to me.

If Google can print a better quarter or two, the shares can regain today's losses and then some. This is what I expect so I am holding Northlake's Google position. If the shares head to the mid $500s, I would add to current positions. Whether it goes there before going higher is a guess.

While we wait, expect intense focus on search trends, particularly search ad pricing. There are lots of datapoints here on a monthly basis. But that is all noise and the big move in the shares is unlikely to come before the next earnings report, 90 days from now.

Disclosure: GOOG is widely held by clients of Northlake Capital Management, including in Steve Birenberg's personal accounts. Steve is sole proprietor of Northlake, an SEC registered investment advisor. GOOG is a net long position in the Entermedia Funds. The Entermedia Funds are long/short equity hedge funds focused on media, communications, and related technologies. Steve is co-portfolio manager of Entermedia, owns a stake in Entermedia's investment management company, has personal monies invested in the Funds.

Google Still Looking Good

Google (GOOG) reported better than expected third quarter earnings of $9.72. Consensus was $8.74. Revenue growth of 33% slightly exceeded consensus estimates. The EPS beat was helped by other income, foreign exchange, and a lower than expected tax rate but this quarter revealed again that GOOG's core organic growth is not slowing down. Given the low P-E of 1 times 2012 earnings excluding over $130 in cash, the growth rate is what matters. This marks the fourth consecutive quarter of accelerating growth for GOOG. The stock is too cheap, even after the big run into earnings and 7% rise after the report. A target over $700 is easily achievable if the economy and market hold together and GOOG tracks to current 2012 estimates.

Also encouraging was stable sequential margins. GOOG is tightening its expense growth and it appears that margins may have bottomed in the second quarter. Margin expansion is the big missing piece for GOOG shares. The company continues to invest heavily in mobile, display, Chrome OS, and the Chrome browser. Management commentary indicates that these investments are paying off on the top line. At the same time, products are being dropped so the focus of the heavy investment is on areas that can make a difference.

Closing of the Motorola Mobility (MMI) will dramatically impact financial results in 2012 due the large revenue it brings. GOOG needs to further improve its financial reporting and transparency so core growth in search, mobile, and display is apparent. GOOG also faces tougher comparisons beginning next quarter which could limit reported growth.

Despite these issues, investors should stay focused on top line growth ex MMI and margins. The last few quarters these issues have been in the right direction. I think it is time to believe that GOOG can sustain 20% growth at stable margins. If so, the shares have a lot of upside. I am a believer.

Disclosure: GOOG is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg's personal accounts. Steve is sole proprietor of Northlake, an SEC registered investment advisor. GOOG is a net long position in the Entermedia Funds, long/short equity hedge funds focused on media, entertainment, communications, and related technologies. Steve is co-portfolio manager of Entermedia, owns a stake in Entermedia's investment management company, and has personal monies invested in the Funds.

Google is a Growth Stock Again

The most important takeaway from Google's (GOOG) second quarter 2011 results is that GOOG is still a growth company. This means that earnings in the future will be higher than Wall Street expects for a longer period of time. In turn, investors will now pay a higher P-E multiple for GOOG. These basic facts explain the immediate 12% positive revaluation of the shares after the company reported.

It may seem odd to many but Wall Street has been very concerned that GOOG is a mature company facing a steadily declining growth rate. Parallels could be drawn to Microsoft or more recently Cisco Systems. The bearish thesis is that desktop search is mature and other revenue streams like mobile search, display, and YouTube were too small and unlikely to ever be profitable enough to reaccelerate overall corporate growth. Much of this concern emanated from competitive inroads made by social media, in particular, Facebook.

Going into the quarter, the street had been lowering estimates and writing cautiously about 2Q search trends as several large search consulting firms indicated the quarter was showing less than expected growth. The stock declined sharply as this exacerbated concerns that growth was slowing and the P-E multiple continued to compress.

The stock did stage a big rebound beginning two weeks ago when the company introduced Google +, its latest entry into social media, to good reviews. The stock gains accelerated as user growth at Google + was much faster than anyone anticipated. This was a hint of what was to come if the earnings changed the story arc from "mature" to "growth." Google + gave people hope again and while it will not have any earnings impact for years, it improved the psychology and the P-E multiple.

The earnings clinched the growth meme by showing that despite very heavy investment in operating expenses, GOOG is still able to grow the bottom line rapidly. Revenues rose over 30% and even with margin pressure from expenses, operating income grew over 20%. Key operating metrics such as number of searches and revenue per search came in at the high end of expectations, reducing fears about GOOG's most important business. Although no specific numbers were provided, the conference call strongly suggested that mobile search, display ads, and YouTube are witnessing accelerating growth. In other words, the investments are paying off.

Finally, the conference call went quite well, especially Larry Page's comments. He was in charge, handled much of the call, and took lots of questions. One analyst said it sounded like he had just graduated from an MBA program. That was meant as a compliment. Page focused on the company's growth initiatives but made clear he understood and the company took seriously the expense management. This was very reassuring as the ease with which GOOG has been criticized over the past several months is directly related to lack of confidence in senior management stemming from the abrupt senior management shakeup.

Street estimates for 2011 and 2012 are now rising. Next year is looking like $45. I think the stock can trade at 15 times that number now that GOOG is back in favor as a large cap growth stock. By the end of 2012, GOOG could have over $150 a share in cash which this simple target calculation ignores, making it conservative.

Heading into the quarter I was nervous being long GOOG for the first time ever. Exiting the quarter, even after the stock popped 12%, I am very comfortable being long and expect the stock to be significantly higher over the next six to twelve months if the market provides just a little bit of help.

Disclosure: Google is a net long position in the Entermedia Funds. Steve Birenberg is co-portfolio manager of Entermedia, owns a stake in the Funds' investment management company, and has personal monies invested in the Funds. Google is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg's personal accounts. Microsoft is held by select clients of Northlake. Cisco Systems is held by select clients of Northlake and in Steve's personal accounts. Steve is sole proprietor of Northlake, an SEC registered investment advisor.

Google lays a sour egg just in time for Easter

Google (GOOG) shares are trading down 8% the day after reporting 2011 First Quarter earnings. EPS of $8.08 fell about a nickel short of the consensus of $8.13. Revenues of $6.54 billion were about $220 million ahead of estimates, growing 28% on an organic basis. Despite a tough comparison, this was the best revenue growth quarter for GOOG since before the economic crisis.

A good friend and former hedge fund manager pointed out that if GOOG split 10:1 then EPS would have been 81 cents, exactly in line with consensus, so we aren’t really looking at an EPS miss here. Rather, investors don’t like the 45% operating expense growth that led EBITDA margins to drop over 500 basis points. The worry is that competitive and regulatory dynamics will inevitably lead to slowing top line growth and require expenses to remain elevated. In turn, the multiple paid for GOOG's earnings has to be lower.

Management commentary on the conference call was quite upbeat. Analyst questioning was quite skeptical. Management firmly believes that it is getting a good return on its investment spending. This pattern of accelerating top line growth with rising expenses has been evident for three quarters now. In the latest quarter, operating expenses spiked upward even more than recent trends, leaving open the question of what happens next. That is not a good question for any stock.

If GOOG is able to sustain or even improve its revenue growth rate while operating expense growth moderates, the stock is extremely cheap at $540, or 15.6 and 13.5 times 2011and 2012 earnings estimates, respectively. The company has over $100 per share in cash on its balance sheet earning virtually nothing so arguably the P-E multiples are 2-3 points lower. This is quite cheap given a top line growth rate in the upper 20% range that has been accelerating.

On the other hand, despite the recent acceleration in revenue growth, GOOG is facing increased competition from social media, is shut out of China, and faces regulatory scrutiny around the globe that could restrict future growth. Search is maturing and while display and video advertising are growing at very high rates, they remain small and less profitable compared to search. If expense growth remains high and revenue growth slows, margins will come under further pressure. This will lead to lower long-term earnings growth and stock valuation.

Complicating the choice between these views is the management transition with an untested Larry Page assuming control of the company. Page's debut on the conference call was limited. The street clearly wanted to hear more from Page, another issue driving today's price decline.

My view is that GOOG remains attractive. Take that for what's it is worth as I've been long GOOG for over a year. In other words, I've been wrong. Nevertheless, I think a case can be made that first quarter results represent the worst of the operating expense comparisons and revenue growth should be maintained or even accelerate slightly over the next few quarters.

Expectations at GOOG, and for Page, are now quite low. The depressed valuation is indicative of low confidence in the stock. I think valuation limits further downside. Upside is substantial if one of the next few quarters shows operating expense growth moderating and revenue growth sustaining. I think it is a good bet that will happen.

Disclosure: Google is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg's personal accounts. Steve is sole proprietor of Northlake Capital Management, an SEC registered investment advisor. Google is a new long position in the Entermedia Funds. Steve is co-portfolio manager of Entermedia, owns a stake in the Funds' investment management company, and has personal monies invested in the Funds.

Google Brings Good Earnings But Uncertainty Prevails. For Now.

Despite another strong earnings report, Wall Street is worried about the implications of Google's management change. Is it a sign that things are not as good as earnings make them appear?

It has been an interesting several trading days in Google (GGOG) shares. After the close on Thursday, January 20th, GOOG reported very good 4Q10 earnings. EPS easily exceeded expectations on much better than expected revenue growth. The top line benefited from rising searches, rising revenue per search, and continued growth in new growth initiatives in display advertising, mobile advertising, and YouTube. While coming in way ahead of street expectations, EPS growth would have been even higher if not for another quarter of heavy investment as GOOG seeks to sustain its lead in search and build display, mobile, and YouTube into material, new growth drivers.

When the results were first reported, GOOG shares soared about 4%. Investors have finally become comfortable rewarding GOOG for top line growth even if it comes with a price of higher operating expenses. The gains did not last long, however, as GOOG simultaneously announced a major shuffle of its top management. Eric Schmidt, long time CEO, was moved out of his operating responsibilities and replaced by Google co-founder, Larry Page. Schmidt, Page, and Sergey Brin, Google's other co-founder, came on the quarterly earnings conference call to reassure investors, but GOOG shares quickly reversed, giving up most of their gains.

Several things seemed to worry the street about the management change. First, Schmidt is well thought of and despite being at Google for 15 years is still viewed as a bit of an outsider, offering mentoring and positive influence to a company still dominated by its founders. Wall Street has liked Schmidt being a check on the founders. Second, Larry Paige, while acknowledged as a visionary, is not thought of us an operating manager. Furthermore, his strengths do not align with a CEO's typical role as the face of the company, particularly to Wall Street investors. Finally, the need to shuffle top management was interpreted as a sign that Google's competitive positioning and growth outlook might not be as strong a recent string of positive earnings reports suggest. Facebook and social media and Google's lack of success in its own social media initiatives are a worry that had been put on the back burner as search growth reaccelerated and new initiatives kicked in. Now Wall Street is asking whether the management change is sign of weakness?

Friday morning saw most Wall Street analysts defend GOOG and reiterate their buys while raising their target prices. This did little good as the shares were being sold and down from prices immediately before the earnings report. The stock really plunged in final half hour of Friday trading when it was announced that Schmidt would be selling 6% of his GOOG shares over the course of 2011. Selling continued into Monday morning with a low of about $600, a full 4% or $25 below the pre-earnings/management change announcements. The stock had sold off about 8% from its high immediately after the earnings were reported. Over the past 24 hours, the stock has begun to find its footing and regained about 3% but it still sits below its pre-earnings level.

I provide this recap mainly to educate Media Talk readers about the crazy ways of Wall Street, particularly in regard to short-term trading. Perception often drives trading and earnings are often discounted ahead of the actual report. In this case, we have a company that based on its most recent quarterly results is stronger than expected but uncertainty has been introduced via the management change.

I continue to have great confidence in Google's earnings and growth outlook and feel the stock offers a lot of bang for the buck. A P-E of 15 adjusted for massive and growing cash balance seems like a good deal for a leading growth stock that has the potential to sustain EPS growth of 15-20% for the foreseeable future. I concur with analyst targets of $700 plus and will continue to hold Google shares in Northlake client accounts, the Entermedia hedge funds, and my personal accounts.

Disclosure: Google is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg's personal accounts. Steve is sole proprietor of Northlake, an SEC registered investment advisor. Google is a net long position in the Entermedia Funds. Steve is co-portfolio manager of Entermedia, owns a stake in Entermedia's investment management company, and has personal monies invested in the Funds.

Google 3Q Earnings Revive Growth Thesis

I was expecting good 3Q10 earnings from Google but I thought it would be built on better cost controls. 2Q10 results that led to a big slide in the shares saw higher investment spending overwhelm a small top line beat. Ahead of the 3Q numbers, I expected another quarter of revenue strength but figured management had gotten the message and would keep a lid on expense growth.

Google did produce a strong quarter and significant positive surprise but it was built mostly on better than expected revenue. Search came in a little higher than expected, providing relief against the onslaught from Bing and competitive worries in mobile and from apps. Display and mobile both exceeded expectations, growing 30% and 60%, respectively. More importantly to investors, management provided specific revenue run rates and optimistic commentary for these emerging businesses. Display and mobile now make up about 15% of Google's revenue and their fast growth should represent more than 25% of future growth. With these businesses now sized and contributing, higher expenses to support their growth are deemed acceptable by Wall Street.

The bottom line is that Google's numbers revived the growth story. In addition, Google reminded investors it can still produce upside surprises. The stock is not expensive for a company still growing more than 20% annually. Earnings in 2011 could approach $35 and 2012 should be over $40. Back out the massive cash reserves on the balance sheet and the stock trades around 15 times forward earnings. This is a reasonable, arguably compelling, valuation for a fast growing leader in one of a few global growth industries, especially with Google shares still down 5% in 2010 after the 9% pop off today.

Disclosure: Google is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg's personal accounts. Steve is sole proprietor of Northlake, an SEC registered, long only investment advisor. Google is a new long position in the Entermedia Funds. Steve Birenberg is co-portfolio manager of the Funds, owns a stake in Entermedia's investment management company, and has personal monies invested in the Funds.

Mixed Quarter from Google Obscures Value and Growth Profile

Google (GOOG) is trading down over 5% in a weak market (S&P down 2.2%) after reporting mixed 2Q10 results. The stock has given up most its gains in the past two weeks since the company received a new license to operate in China.

GOOG reported EPS of $6.45 on revenues of $5.1 billion net of traffic acquisition costs. EPS missed the consensus estimate by 7 cents although revenues were more than $100 million ahead of estimates. Revenues grew 23% and were up 1% from the first quarter. For many companies these results would have been good enough but GOOG is a high expectations stock with recently negative sentiment so a clean beat was necessary to sustain and build on recent gains.

The stock is suffering mostly because operating expenses rose more than expected resulting in a drag on profitability despite better than expected revenue growth. The Street has been concerned for some time that GOOG is facing a tougher competitive environment in which slowing top line growth was going to be met by investment in the business.

Second quarter results again showed heavy investment as GOOG defends its market share in search and invests in display advertising, mobile advertising and search, and YouTube. However, this quarter at least, GOOG's investments seem to paying off as revenue growth beat expectations and accelerated.

The other issue for Wall Street is that while GOOG grew EPS 21% in the second quarter, growth in the second half is expected to moderate into the mid to upper teens. Wall Street hates growth deceleration, especially from a growth company.

Looking ahead to 2011, the big question is whether growth can be sustained closer to 20% or continues to decelerate to 15% as implied by consensus estimates. The stock is undoubtedly good value at less than 15 times 2010 estimates adjusted for the huge cash balance. On 2011 estimates, the multiple is less than 13 times.

I think GOOG's long-term growth will be sustained at least in the teens as search is still growing and new areas are beginning to gain traction. As a result, I think the stock should be owned at current prices. However, the Street is going to need a positive surprise or at least a sign that investment spending is leveling off before the shares respond strongly. Given current valuation and initial signs that growth investments are beginning to pay off, I think it is worth waiting.

Disclosure: GOOG is widely held by clients of Northlake Capital Management, LLC inlcuding in Steve Birenberg's personal accounts. GOOG is a long position in the Entermedia Funds. Steve Birenberg is co-portfolio manager, partial owner the Funds' investment management company, and has perosnal monies invested in the Entermedia Funds.

Google Misses. Sort of.

Even before the Goldman Sachs related market meltdown, Google shares were down 5% following the company's 1Q10 earnings report after the close on Thursday. Most all of the many headline numbers regularly provided by Google met or slightly exceeded expectations. However, the upside was minor and there were a few blemishes. The upside was mainly a return to growth in paid searches. The downside was the price Google earned per search was a bit less than expected. Another blemish was that international growth ex the UK lagged. But since revenues came in slightly better than expected that means the US search business was above expectations.

I think Goldman Sachs' analyst nails it when he notes given a trade-off between more searches or revenue per search, he would take more searches. The implication is that the search business is still quite healthy despite the economy and challenges from mobile computing and the rise of Apps. The analyst also notes to be drawn from this mix is that US search growth accelerated big time. Given a choice between US and international search, he would take US as this market is supposed to be closer to maturity. Thus, a takeaway could be there is more upside abroad ahead than previously thought if the mature market is still growing at this rate.

I buy those arguments, which strongly suggest Google is fine for the intermediate to the long-term. The short-term is trickier as expectations were high and sentiment toward Google is mixed to the challenges on the business and regulatory fronts. Since Northlake's approach is to invest for months and years ahead, I will be holding the shares as I expect the long-term story will re-emerge later this year providing upside to $700. Based on 20 times 2011 estimates earnings plus projected cash on hand (currently over $85 and growing each quarter).

Disclosure: Google is widely held by clients of Northlake Capital Management, LLC including in Steve Birenberg's personal accounts. Google is a long position in the Entermedia Funds. Steve Birenberg co-manages the Funds, owns a portion of the Funds' management company, and has personal monies invested in the funds.

Searching for Profits in Google

Earlier this week, I purchased a position in Google (GOOG) for all Northlake clients who use individual stocks as part of their portfolio strategy. GOOG pulled back from $630 in early January to $545 with the bulk of the drop occuring following the company's 4Q09 earnings report. A general correction in tech stocks and the possible loss of GOOG's growth opportunity in China also contributed. I see the pullback as an excellent buying opportunity. In 2010, upside exists from a cyclical upturn in advertising and the possibility of a return to China. Beyond 2010, I find the shares quite reasonably valued as GOOG continues its global growth in search, begins to gain material upside from its expansion in display advertising, and participates as an industry leader in mobile advertising. I see upside in 2010 consensus EPS estimates of $31. A 20 multiple on $33 in EPS equates to $660 offers 20% upside. Downside in the near-term, independent of a major market correction, should be modest given the stock has already dropped sharply.

Disclosure: GOOG is widely held by clients of Northlake Capital Management, LLC including in Steve Birenberg's personal accounts. GOOG is held in the Entermedia Funds. Steve Birenberg is co-owner and co-manager of the Entermedia Funds and has a personal investment in the Funds.