Google is a buy, but investors might want to wait until after earnings
Oct 12th 2009 5:00PM
Updated Dec 4th 2009 4:44PM
That's because Google is a momentum stock, where investors pay a fat premium for shares based on accelerating top-line growth, which is then supposed to flow to the bottom line. It's always risky for retail investors to fiddle around with stocks during reporting season, especially when the company in question doesn't provide any earnings guidance -- and historically needs to beat Wall Street estimates by a wide margin to get any love.
But stand back from all the near-term noise and Google has a lot going for it. Indeed, the valuation and fundamentals make shares very intriguing over the next 12 months or so.
That's not to say Google has no longer term challenges. One point bears like to make is that the company is a one-trick pony, where 90 percent of revenue comes from search. (Bulls concede that Google is a one-trick pony, then quickly add, "But what a trick!") And despite Google's best efforts, it's still unclear if it can derive meaningful contributions to operations with its myriad of other efforts, from YouTube to Google Docs to Google Apps to Google Wave to Google Voice...well, you get the picture.
Then there's the very real concern that even if Google does make headway outside of search, that will only hurt its growth profile, says Kim Caughey, senior equity analyst at Fort Pitt Capital Group and the Fort Pitt Capital Total Return Fund (FPCGX). Caughey thinks like an owner, not an investor, meaning she buys stocks with a three- to five-year horizon. On that basis, she doesn't own Google.
"Our big-picture issue with owning Google is that it is already dominating the highest-margin category out there on the Internet," Caughey says. "So every other business that it gets into by definition will be lower margin."
But shorter term, shares look compellingly valued on a relative basis. True, the stock has soared 80 percent from the March market low, and is beating the S&P 500 by 20 percentage points over that time. Yet by the stock's forward price-to-earnings (P/E) multiple, it trades at just a seven percent percent premium to the broader market, according to Thomson Reuters, despite having much stronger growth prospects.
Indeed, analysts' average long-term growth forecast for Google comes to nearly 19 percent, according to Thomson Reuters. The broad market, recall, returns roughly eight percent, adjusted for inflation, over long periods of time, and will be lucky to do four percent to six percent in the nearer term.
Google also trades at more than a 40 percent discount to the S&P on a price/earnings-to-growth (PEG) basis. PEG measures how fast a company's stock is rising relative to its growth prospects, so this figure suggests that Google is a huge bargain compared with the market. Furthemore, Google is trading at discounts of roughly 40 percent to its own five-year average on both a trailing and forward P/E basis.
In other words, shares look like a steal by a number of measures.
Google has a lot going for it on a fundamental basis, as well. Not only is it dominant in search with an opportunity to take market share on a global basis, but it has a rock solid balance sheet, boasting $19 billion in cash and zero debt.
Perhaps even more important, Google is an early cycle stock, meaning it will move well ahead of a larger recovery. In fact, by it's own reckoning, the recession appears to be over, says Christa Quarles, an analyst with Thomas Weisel Partners, who rates shares at Overweight (Buy, essentially).
"From Google's perspective, the recession troughed [in the second quarter], sometime between May and June," Quarles wrote in a Monday note to clients. "Google is an early cycle recovery play with significant positive operating leverage to tap into when revenue returns, creating an opportunity for [earnings per share] upside."
True, it would be easier to like Google at these levels had it not gone on such a tear. Analysts' average price target stands at $536, implying upside of just three percent over the next 12 months. (We expect those targets to come up after earnings.)
Joe Clark, managing partner of Financial Enhancement Group, wouldn't exactly start a new position at these levels -- but he's not betting against Big G, either. "At this point [we're still] bullish in price, but think there are other places in the market with better upside potential," Clark says. "[But] I clearly would not be short Google at this price."
Google looks good, if not great, at these levels. And any weakness after earnings could be a nice opportunity to get a piece of a best-in-class company with above-average growth prospects.