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The Google premium is gone
Sure, it was just a tax-rate miscue. And the company is still growing like gangbusters. But investors won't give the search giant a free pass anymore.
By Robert Walberg
Like Icarus, Google's share price flew too high. And, sure enough, it melted under the intense spotlight aimed at the company's fourth-quarter earnings report.
Despite posting an 82% jump in net income on an 86% surge in revenues, Google's (GOOG, news, msgs) missed the Street's consensus earnings-per-share estimate of $1.76 by a whopping twenty-two cents. The stock plunged more than $50, about 12%, in after-hours trading Tuesday.
The earnings miss wasn't all that it seemed. But until Google answers a few key questions about its future, some investors might think the same of the company itself.
One big reason earnings fell well short of estimates was a higher-than-expected tax rate. According to management, the effective tax rate in the fourth quarter was 41.8%, well above the 30% rate of the last two quarters. Google announced that it expects its fiscal 2006 tax rate to fall back to the 30% area.
After sifting through a number of research reports from Wall Street, I think its clear that analysts were expecting a tax rate much closer to 30%. Applying that figure to the current numbers suggests that the company would have beaten the consensus estimate by a few cents rather than missing by more than twenty.
Too much funny money
From a rational perspective, most, if not all, of Tuesday's sell-off wasnt justified. But do investors really want to expose themselves to a stock that can plunge over 70 points on a single headline? In just the past few weeks, Googles stock price has fluctuated by more than 120 points.
That kind of volatility means only one thing -- theres too much funny money in the stock. No question, Google is a well managed company in a fast growing business. But expectations and valuations divorced themselves from reality when the stock became a play toy for speculators. Price targets of $600 and then $2000 were based on pie-in-the-sky projections for a business that most analysts are struggling to understand.
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We all know that Google is the king of search and that it continues to take market share faster than its peers. Based on the fact that revenues and earnings nearly doubled in the last quarter alone, search is a sound and profitable market. It's also clear that Internet ad spending is growing fast as more and more Fortune 500 businesses change their ad-spending habits. Given its dominance of search, Google is well positioned to win a large share of those ad dollars.
But what we dont know yet is if Google can grow its other business ventures, such as Gmail, Froogle and Google Base, at anywhere near the same rate. And how much will these businesses divert attention away from its core business? Will they drive up its costs, pressure its profit margins and slow growth?
I dont know the answers to these questions. But questioning Google, its business plan and its growth assumptions has been something far too few investors have been willing to do. Of the 39 analysts that issue ratings on the company, only two had sell ratings on the stock prior to yesterdays earnings, according to Thomson/First Call.
Choosing caution
Fortunately, the recent setback in the stock price has returned Google to a more reasonable valuation. While the company doesnt make a practice of steering investors toward future earnings targets, the Street is looking for Google to earn about $8.75 a share in fiscal 2006. If the stock trades close to its after-hours close of $379, that means the stock trades at 43 times the next 12 months' earnings. Not cheap, especially considering the uncertainty of such estimates, but considering that Google is likely to grow revenues and earnings by at least that much next year, the stock is now at a much more compelling entry point.
Nevertheless, I prefer to err on the side of caution. Googles growth is exciting, but there are some disturbing trends, including the big jump in sales and marketing costs and a sizeable drop in operating income as a percentage of revenue. And some big questions: How Google will fare in China? How it will resolve its privacy issues with the federal government? What it will do to maximize its $1 billion investment in AOL? What are its plans for selling digital music?
Googles free-ride is over. Investors will want answers to these questions before they blindly toss money at the stock. Consequently, the stock is unlikely to trade at such extreme multiples again any time soon -- if ever.
Expect a slew of embarrassed analysts to rush out tomorrow and advise clients to use any earnings related pullback as a buying opportunity. They will point to the past and say that history shows that pullbacks are few and far between and when they occur, investors need to pounce. But dont bite -- not until the dust settles.
At the time of publication, Robert Walberg did not own or control shares of companies mentioned in this column.
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