Google Should Again Outperform Street Estimates

Google is scheduled to report 1Q09 earnings after the market close on April 16, 2009 and the Street is expecting revenues of $4.117bn (+11% YoY, -2.5% QoQ), EBITDA of $2.409bn (58.5% margin), and Adj. EPS of $4.89.

Given the spate of negative headlines in the quarter, both from Google (product closings, layoffs) and commentary from SEMs that their search business has deteriorated in the quarter, sentiment for the 1Q09 report is subdued, with many expecting a negative sequential decline of 5%-plus for net revenues and a decline in margins.

Despite the negative headlines, the stock has rallied over the past month (March 9th), but that was in lock-step with the resurgence in the overall stock market – the shares are up 28% over the past month compared to a 26% uptick in the S&P500. Thus, the shares haven’t meaningfully outperformed the market.

So what do the key metrics imply for the quarter?

Search share. According to Hitwise, “Google’s market share rose from 72.11% in February to 72.39% in March, while both Yahoo and Live Search saw declines. Year-over-year numbers are also in Google’s favor: It’s up 8% over March 2008, while Yahoo and Live Search are down 19% and 17%, respectively.”

These numbers are domestic but it shows that Google continues to gain share at the expense of rivals. So that’s a positive.

Ad Coverage. This metric ticked down a bit both YoY and sequentially to 45% for both January and February, according to comScore, but still shows a high level of ad monetization existed in the quarter. Another positive.

Paid Clicks. comScore reported that paid clicks increased 22% YoY in January and February of this year, but down 4% QoQ. While that number is domestic and excludes searches on the network, my calculations for international and network suggests that global paid clicks should come in at around 18% YoY, which should represent flat growth from YoY growth trends in 4Q08; QoQ growth should come in at negative 2%. The negative sequential growth suggests that seasonal trends are becoming more visible in the model, rather than just cyclical pressures.

Pricing. Cost-per-click, the second most important metric in the model, should continue to show some level of weakness as commentary from advertisers suggests that they have traded down to less pricey terms. In addition, advertisers are exploring terms in the long-tail, which cost pennies, but at the same time, are more targeted and deliver higher ROIs. While this may appear to be a negative secular trend that may hurt Google’s monetization and revenue growth, the nature of the search model is such that as more advertisers explore long-tail terms, the cost of those terms will increase. This will go on until the term “long-tail” no longer has meaning and will represent the current level of terms, given that a finite level of commercial search terms exists. Thus, Google and the other search engines should not have concerns about the longer-term secular direction of pricing.

In 4Q08, CPCs on an FX neutral basis, decreased 2% YoY and 7% QoQ. Admittedly, this metric is harder to read than the others but data from advertisers have suggested continued negative trends. Further, there has to be less finance companies bidding on terms, and there is chatter that travel companies have pulled back spend on top-level travel terms – both should put pressure on the metric. Nonetheless, I do not anticipate a huge negative number in 1Q and I am modeling in a 4% YoY decline in CPCs for the quarter.

Revenue, Margins, EPS. Taken together, the 18% YoY growth rate in paid clicks and the 4% YoY decline in pricing should lead to search revenue growth of 14% YoY. Contribution from the other buckets (DoubleClick, YouTube, licensing, Postini, etc.), will not be meaningful enough to have an impact on the overall growth rate, so I am estimating 1Q09 YoY revenue growth of 13-14%, which is ahead of consensus growth of 11%. QoQ, my YoY estimate suggests a revenue decline of 1%.

On EBITDA, I am expecting a margin of 59% for the quarter, down 100bps from 4Q08 but up 50bps from 1Q08. My Adjusted EPS estimate is $5.00.

Valuation. The shares are trading at 17x ’09 Adj. EPS and 15x ’10 Adj. EPS, multiples that are below Google’s historical forward EPS multiples and below the long-term EPS growth rate. So despite the 28% run-up in the share price, the shares are still cheap on an absolute basis. On a relative basis, the shares are significantly cheaper compared to Google’s Internet brethren such as Yahoo!, Blue Nile, Amazon, Netflix, etc., all of which are trading at multiples north of 30x ’09.

My DCF produces a fair value of between $450-$500, depending on assumptions. Wall Street is forecasting a $24-$25 earnings per share figure in 2010. Lets say a $25.00 EPS. If we apply the current multiple to that figure (the most conservative method), we get a $425 fair value, which is still a 15% upside potential. Bump that target multiple up to 20x, which is reasonable and implies a PEG of only 1.25x, we get to a fair value of $500, which is a 35% potential upside. Hence, I am looking at a 15-35% potential upside in Google’s share price over the next 12 months. I’ll take that and will hold onto my shares.