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.


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The Math On Software Maintenance Revenues

I noted previously that maintenance software revenues are supporting software profits and valuations, a view shared by JPMorgan analyst John Difucci. In his last published report, he walked though the math on how software maintenance revenues supports that thesis.

Again, I thought his report was excellent and well thought out and his graph and write up brings home the point as to why I believe that software stocks are one of the best investment tech sectors next to Internet stocks.

Here is a snapshot of his view:

"The power of the typical perpetual software model can be demonstrated with an example. In Table 2, we look at a typical enterprise software company, with about $200 million in total revenue in 2008, of which 50% is license and 50% is maintenance. Ignore any professional services at this point for simplicity’s sake.

Note that professional services have lower margins than maintenance and are likely driven by previous license sales. Professional services may provide a lagging component of the software segment, but from an accounting perspective, they often have little impact on the change in the bottom lines (and sometimes even the top lines) of most software companies. In addition, we provide a spreadsheet for investors to examine this model on the Morgan Markets website.

That said, consider the following development of our example:

• Dramatic license decline of 25% in 2009, then less declines for a couple of years before some growth returns.

• Normalized maintenance renewal rates of 95%, which decline to 90% in 2009, slightly improving to 92% in 2010, before returning to normalized rates thereafter.

• Initial average pricing pressure of 3% on maintenance starting in 2009 and lasting for a couple of years, before declining to 2% pricing pressure, and then is eliminated.

• Maintenance Margins of 85%

• License Margins fluctuate based on License Sales



Even for the above scenario, after license declines in three consecutive years (the first of which it declines by 25%), coupled with pricing pressure and reduced renewal rates, maintenance still never declines. In addition, since the overwhelming majority of profit is derived from maintenance revenue (not license revenue), total profit only declines in 2009, and increases every other year.

Note that in this example, we assumed license came in evenly throughout the year (which is typically not the case, it’s usually back end loaded). Given the ratable recognition of maintenance, only half of the annual maintenance signed is recognized in the year it is signed, with the remainder recognized in the subsequent year."


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JPMorgan Lowers Their Advertising Projections for the Year

In a 100 page report published last week, JPMorgan analyst Alexia Quadrani, one of the most well respected Wall Street analysts, lowered her global advertising estimates for 2009 to a decline of 5.5%, which assumes a 9% decline for the domestic market.

Her "U.S." Advertising Forecast and her comments:


• Our annual Advertising 101 piece is out today with an in-depth look at the global ad market, current trends, and an analysis of the six advertising and marketing services stocks we cover. We have included an expanded section this year on macro trends, how the ad market (and the stocks correlated to it) trend in recessions and expansions, and a close look at the changes in the auto industry and how that may impact an eventual recovery.

• We are lowering our 2009 global ad forecasts to -5.5% which assume a 9% decline in the US this year. Specifically in the US, we are projecting a 20% decline in local advertising and a 6.5% decline in national. Our preliminary estimate for 2010 suggests more modest declines, down 2% in the US and down 1% global.

• Our outlook for the advertising and marketing services stocks is largely unchanged as we believe these businesses will weather the storm better than most given their diversified revenue streams by geography and discipline, as well as their somewhat variable cost structure. We believe the approximate historical 200 basis points of outperformance to the overall market will continue as our organic revenue growth assumptions for 2009 are around -4% versus global decline in the overall market of 5.5%.

• We have tweaked down our estimates for both OMC and IPG largely reflecting a hit to profits from further severance expense expected in Q1. We are looking for organic revenue to decline 6.5% at OMC and IPG, with margins down 100-200 basis points on average, largely reflecting severance expense in the quarter. Our estimates for our other stocks remain unchanged at this time.

• Our advertising and marketing services group has outperformed the S&P year to date and we would expect this superior relative performance to continue as these stocks remain good places to hide as long as the ad market deteriorates. Our favorite name remains IPG given its valuation (3.2x 09 EBITDA) and relatively less exposure to Europe, which we believe will continue to be a headwind long after the US begins to recover.

There were a few other charts in the report that I found interesting:






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Citigroup Survey Shows Online Retail Pricing Up 5% QoQ

Citigroup Internet analyst Mark Mahaney published an interesting report on the online retailers that showed overall pricing have improved from the fourth quarter of 2008 suggesting that the heavy discounting may have subsided in the first quarter. If true, this would have positive implications for the broader economy and not just e-Commerce companies.

• We Priced Out The Top 10 Items In 6 Categories - We revisited the items in our Holiday shopping cart, using Yahoo! Shopping's Top 10 Lists. We focused on 4 leading online retail sites: Amazon, Wal-Mart, eBay, and Buy.com. While not exhaustive, this snapshot survey compared prices & selection in: 1) electronics, 2) toys, 3) books, 4) CDs, 5) DVDs & 6) video games.

• eBay Tops List With Deepest Discounts - Search Experience Still Lacking -Both eBay and Amazon.com had 100% of the items on our shopping list, while Wal-Mart and Buy.com had 87% and 85%, respectively. In terms of pricing, eBay was on average 18% lower than MSRP followed by AMZN at 15% discount, Buy.com at 14%, and Wal-Mart at 13% off MSRP. While eBay had the best deals, we found that the search experience on AMZN, WMT and even Buy.com was more shopper friendly than on EBAY - still more work to do here.

• AMZN's Relative Advantages - In terms of AMZN's three key bedrocks - Price, Selection & Convenience - our snapshot survey suggests the company's greatest differentiation to be in Convenience (best overall shopping experience), then in Selection, and least so in Price. The last point would seem to support the "Price To Tie" strategy we detailed in our 3/31 AMZN report.

• Prices Up Vs. Q4 = Positive Margin Tailwind - We compared current prices for AMZN & WMT vs. our Q4 shopping carts -- prices are up approximately 5% Q/Q on average. While only a snapshot, implication is that heavy discounting may not have continued into Q1, a potential positive for gross margins.
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JPMorgan Bullish On Software Stocks

JPMorgan published a well thought out piece on the software industry arguing that maintenance revenues will support software company profit margins and valuations. I argued the same in a post a few months ago during the height of the stock market turmoil. The firm thinks that M&A in the sector should pick up later this year.

From JPMorgan Analyst John Difucci:
• Software license revenues will likely decline (already have in many cases), similar to the sales of other products against the current macro malaise.

• But maintenance revenue will remain stable, and even grow, providing consistent profitability not likely to be matched by other industries. We outline the math of the perpetual license model employed by many software companies in detail in this report.

• Stock outperformance just beginning. Though software has outperformed the S&P by almost 1,500bps YTD, we believe there’s more to come. Most software names continue to trade below the value of maintenance alone, and as bottom lines hold up, we expect software names to appreciate in value.

• M&A later this year would also help. We expect reluctant sellers today to become more willing to discuss potential combinations as the shares appreciate, even as the macro backdrop remains difficult, providing a potential floor above current valuation levels.

• Some software names better positioned than others, and some do not apply to this thesis. We prefer enterprise, infrastructure software companies with meaningful maintenance, that are trading at or below 5.1x EV/Mtn, and with management teams with a good track record. Within our coverage universe, the names that meet most or all of these criteria are: CA, CDNS, CTXS, MFE, NOVL, ORCL, QSFT, SYMC, TIBX.
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