Google and Gas

“When everyone dislikes something it should be examined. When everyone likes something it should be examined.” -- Confucius

One of the biggest surprises to me from the Google conference call was learning that Google employs a Chief Economist. Had I only been aware of this earlier, I would’ve shorted more shares. I’ve been on many hundreds of conference calls over the years, but I’m having trouble remembering any in which a Chief Economist was one of the presenters. This was often one of the few positive qualities of these calls. Whenever I'd find myself struggling to pay attention to the mindless reading of the press release by the CEO, I'd mutter to myself, "Well, at least I don't have to listen to an economist."

The fact that high-flying, vanquish-all-comers, paradigm-changing Google is the first that I can recall offering up an economist to the investment community seems a bit ironic. This is Google! Shouldn't we be hearing from the Chief Envisioneer of World Domination instead? Perhaps this will be one of those little things we’ll point to in a few years as evidence that the days of heady growth for Google were winding down.

I wrote a critical review of Google's first quarter earnings release back in April when the stock popped from $450 to $540 and all of the analysts were tripping over themselves to see who could capture the most headlines with the biggest price target increase. In my conclusion of that piece, I said that I'd be keeping an eye on the stock and possibly buying put options if the stock kept running.

I didn't buy the put, opting to short the stock instead as increased volatility made put buying a little too expensive. And, unfortunately, I didn't short the stock as it neared $600. The short was initiated last week in the mid-$540s. Even though the stock had already pulled back 10% from its recent high, It was just too tempting. GOOG had held up better than the market during this latest downturn, and it seemed that the entirety of the sell-side community and press were bullish and expecting yet another outstanding googlerific quarter. On top of this, the concerns I shared from last quarter hadn't diminished, and the economy had deteriorated further. It was an appetizing recipe for an earnings disappointment.

Of course, the sell-side was out after the call defending their buy recommendations on Google. I haven't seen one downgrade. AmTech Research is keeping its "Buy" rating but lowering its target from $750 to $725. Cantor keeps their "Buy" and lowers their target from $750 to $675. Kaufman Bros. maintains their "Buy" and lowers their target from $680 to a nice round $657. $657? 57? 7? I mean, c'mon. You feel that confident in your $657 target that you didn't want to round it down 0.304414% to a nice even $655? How can anyone take this supposed precision seriously given the multitude of highly variable factors that go into that target in the first place? Asinine.

The average target price of these three analysts/lemmings implies 40% upside in the stock. The last downgrade I see is a beaut. Jefferies downgraded GOOG from a "Buy" to a "Hold" on February 1, 2008, the very day the company issued disappointing earnings and the stock opened 36 points lower. The downgrade also came one month AFTER the stock fell from a high of over $700 to about $520. See the station? See the train? No? That's because it's already gone. Over the following 5-6 weeks the stock traded as low as $412. When did the analyst upgrade the stock? He waited until April 18th, the day Google reported their "strong" first quarter earnings and the stock opened at $535. It would be difficult to try and time this stock worse.

So what about this quarter's earnings release? As you know by now, EPS came in a bit light, even with the benefit of currency and a nice low tax rate. Unlike the denials in the last conference call, the company finally owned up to being impacted by the slowing economy. They also admitted that the U.K. business was now large enough that seasonality was becoming evident. Paid click growth actually declined sequentially, and revenue growth (one of the concerns I highlighted last quarter) continued to slow.


Growth is clearly the overriding issue here. Huge early market share gains that could mask seasonality and economic weakness are quickly evaporating, which shouldn't be a huge surprise given the scale of GOOG. The question then turns to what the company is worth and what is an attractive stock price. With the stock now trading at about 20x 2009 estimated EPS, I don't find the stock particularly compelling, but I also no longer view it as ridiculously overvalued. Because of this, I covered the short today (Friday). I'll be watching the stock with an open mind from here and would be inclined to fade any substantial move in either direction.

As for the "Gas" part of this piece, since exiting my natural gas position on June 20th I've been patiently sitting on my hands waiting for another crack at it. With this sector and the price of natural gas now down over 20% from their recent highs, my patience has worn thin. I dipped my toe back in on Thursday afternoon, buying one of my favored domestic natural gas E&P names. As usual, the plan is to pump up the position should investors continue to bail out of the sector.

Disclosure: The Rubbernecker is happy to once again have a little gas.

Google - A Contrarian View

We saw quite a love-fest for Google on Friday following their Q1 earnings release. Given how important this report was for the market and for psychology, it's worth spending a little time on it.

Earlier in the week, comScore released a report in which they estimated Google's paid clicks grew only 2% during the first quarter. Concerns about this slowing had led to a sharp decline in the stock price of Google since the beginning of the year, falling from just over $700 to about $412 last month. With Thursday's earnings release, Google disclosed that its paid click growth actually increased 20% in the quarter. With revenue and earnings coming in above the whisper numbers (GOOG doesn't provide earnings guidance), we saw a huge relief spike in the stock.

There is plenty of positive press out there, so there's really no point in just rehashing it. Let's have a little fun instead and play devil's advocate.

• Even though paid click growth came in well above expectations, the 20% increase is a marked deceleration from last year's 43% growth rate. The bulls and the company argue that this is due to an intentional move by the company to decrease the quantity and improve the quality of presented ads. They hope to charge more for the fewer higher quality ads to offset the volume decrease. When asked about this on the call, management essentially said that the improvements were made later in the quarter, and it was too early to judge their impact. Fair enough on pricing, but then why the decline in paid click growth to 20%?
  

• ComScore claims that they only monitor US consumer growth, but Google's paid click data includes international. It seems very likely that US growth has matured and slowed dramatically while international growth remains very strong. If so, the fact that the huge US market has slowed so dramatically and so soon should be very concerning.
  

• Year-over-year revenue growth has been steadily declining.

• The company was adamant that they have seen no impact from the slowing of the economy. I don't really get this. Overall growth at GOOG is clearly slowing, and it appears that U.S. growth is slowing dramatically. How the company can be sure that the economy isn't a factor isn't at all clear. It seems logical to think that the economy has played some role and that growth may have been even stronger had the economy not weakened. Investors are typically less likely to pay a premium multiple for an economically-sensitive growth stock.
  

• GOOG is trading at 26x this year's EPS estimate. That's not particularly cheap, especially given the slowing growth trends (EPS growth is much lumpier, but it too has been slowing).

• Let's not forget the law of large numbers. Growing $5 billion of revenue at a 40% rate is much harder than growing $100 million at the same pace. Let's make sure expectations are realistic. Were Google to increase revenue at a 40% annual clip, they would overtake the current GDP of the U.S. in just under 19 years. That's not going to happen. As can be seen from the price action of GOOG stock this year, the market doesn't take kindly to strong growth stocks that falter. It's just a matter of time given their revenue base.
  

• As for this quarter, the company did benefit from a tax rate that was 1% lower than last quarter due to international growth (and weaker US?). That boosted EPS by about 7 cents. Also, though it wasn't discussed, clearly the company was a big beneficiary of the weaker dollar in the quarter. That's fine, but it isn't growth driven by improving operations. So, the quality of the earnings beat wasn't quite as dramatic as the press would have you believe.
  

Bottom line: We saw a huge relief rally when the paid click number came in much better than feared and the company exceeded revenue and earnings expectations. This was a case of the bar being set pretty low and being relatively easy to hurdle. The market had priced in worse numbers than the company posted, so the stock rallied. However, the quality of the beat was not as solid as indicated in the press, and the longer-term trend of slowing growth continues.

I'll be keeping an eye on GOOG and possibly adding a long put position as we move through the quarter should the stock continue climbing and volatility moderate.