I’ve been bullish on Google Inc. for quite some time, and it has performed very well in the last year as part of my Strategy Lab model portfolio. There have been plenty of times when Wall Street was unimpressed with the company’s quarterly results, including the most recent set of financials. I’ve often discussed the severe myopia that Wall Street suffers from, and I’ve instead been an advocate of taking a long-term perspective on stocks.
Google’s second-quarter results feel like déjà vu. The core business is performing well, growth is solid and Wall Street can’t get its head around the idea that the world’s best companies don’t live in the same myopic world.
Let’s take a quick look at the numbers to understand why Wall Street was so disappointed. Quarterly revenue was $14.1-billion (U.S.) compared with analyst estimates of $14.4-billion. That’s not much of a miss, and I won’t bore you with the details, but suffice to say Google made some changes in what it permits its advertising partners to do and it raised the bar on quality during the quarter. This created a small self-imposed revenue hit. They’ve done this many times before, so it’s nothing new. Regardless, Google’s revenue (excluding Motorola Mobility, which it acquired in 2011) grew 20 per cent year over year.
The revenue miss was not the real issue. Analysts were much more disappointed by the weaker-than-expected profitability. Google’s earnings per share came in at $9.56 instead of the expected $10.78. This earnings miss is what really drove the negative headlines and hurt the share price.
When I see an industry-leading company post solid revenue growth but so-called “poor” earnings, I’m always curious to dig into the underlying reasons. When earnings shrink in the face of growing revenue, obviously it means expenses grew faster than revenue. So an investor must ask the question: Is the rising expense ratio a result of a weakening business model, often driven by competition? Or is the rising expense level the result of more bets on future projects?
In Google’s case, the answer is obvious. Operating expenses are up because Google is investing in Google Fiber, its Chrome operating system, disruptive projects in video delivery and other projects that remind me exactly why I’m holding shares in this incredible company. Oh, and by the way, despite the earnings miss Google’s net cash flow from operations still grew 11 per cent year over year.
As a side note, Google’s investment in Motorola, which works out to about $10-billion, is still bleeding cash, and this also contributed to the earnings miss. Even if they end up shutting down the handset hardware business entirely, it amounts to 3 per cent of Google’s market capitalization and they’d still own a huge pile of Motorola patents. As a shareholder, I realize that some bets don’t work out. And if a company only ever makes bets that are a sure thing, it’s practically impossible to generate the growth I’m after. Google has a track record of going after big, exciting projects. I don’t want them to start taking easy street on their drive toward next quarter’s results.
The bottom line is that Google’s business is still growing quite quickly, and the earnings miss is absolutely not a result of their business suddenly becoming more expensive to run. Instead, Google has done what I want my portfolio companies to do: accelerate spending on important projects for future revenue growth.
Google powers more than 900 million Android smartphones with 1.5 million new activations every day. It runs the most successful and popular search engine in the world. It owns YouTube, which is by far the most relevant social video site on the planet. These are just three examples of Google not just leading in its market, but utterly dominating.
Analysts expect the company to earn $52.45 per share next year, putting the stock’s forward year P/E ratio at 17. The stock may be up a lot since I added it to my Strategy Lab portfolio in September of 2012. The recent set of financial results reinforce my view that it has plenty of growth ahead. And if Wall Street wants to sell on these numbers, I think the rest of us should be buying.