GOOG: A Particular Set of Skills

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GOOG has levered its dominant prowess in data processing into market leadership in advertising, and plans to extend that leadership by orchestrating a mobile commerce ecosystem, with the potential to generate enormous value for itself and its partners. Investment in Search/Now, YouTube, Android, Maps, Shopping, and DoubleClick, along with initiatives like Express, Pay, FI, and Fiber, will directly support these plans, enabling advertisers to better deliver their messages and measure effectiveness through to an eventual sale, and merchants to better understand and engage their customers and potential customers. GOOG’s investments support other ambitions as well. Android leads to a range of personal and home devices – Nexus, Nest, Cardboard, etc. – that collectively have the potential to be a significant business. Similarly, Compute Engine and Docs are baby steps into an unfamiliar enterprise IT world that could one day be a massive market for GOOG’s world leading data processing technology and infrastructure. Still, there are threats to GOOG’s hegemony. EU antitrust charges could blunt advertising opportunities on that continent. AMZN and other shopping apps have taken a meaningful share of product discovery on mobile devices. FB and TWTR have done the same for media. We believe that these risks will prove far less damaging than most investors assume, and, in contrast, that GOOG’s data processing leadership will generate far more value in its current initiatives and in many initiatives to come.

The top data processing company by a wide margin. GOOG invented most of the major technologies underpinning modern data processing, and remains years ahead in its implementation of massively parallel, web-scale computing. Its infrastructure of networked data centers is the industry’s largest, most powerful, and cheapest. Its computer science talent is also best, with world leading capability in data center design, data management, data analytics, deep learning, and security. This prowess is GOOG’s core and greatest strength, and can be leveraged in many, many directions.

GOOG uniquely positioned to orchestrate m-commerce. The core Search and Android franchises position GOOG to control the ecosystem with privileged reach, engagement and user data. To one side, GOOG will reach to advertisers with new ad tech, more aggressive targeting, new formats, and improved tracking. To the other, it will reach to merchants with superior loyalty program support, payments innovation, platform reach/engagement, and merchant services like Shopping and Express Delivery. Even network investments, like Fiber and Fi, could work in support of GOOG’s m-commerce ambitions. In accelerating the progress of m-commerce GOOG expect to create value for advertisers, merchants and consumers, cementing a role for itself as an information broker and transaction facilitator – and re-establishing the primacy of its role in discovery – in the process.

Digital media synergistic with m-commerce. YouTube is the world’s dominant video streaming platform engaging 1B+ monthly users, but it has been curiously under-monetized to date. GOOG intends to accelerate ad revenue growth by integrating its user profiles with those generated by search, promoting popular and ad friendly exclusive programming, and extending to new platforms – subscription music, live streaming, 360 degree VR content, etc.

Early days in the IoT. GOOG sells a number of consumer devices – Nexus phones and tablets, Chromecast, Nest home products, Cardboard VR viewers, Glass, etc. – but collectively, these products have yet to make major contributions to the company’s top or bottom line. However, in the longer term we see substantial opportunity for GOOG to leverage its considerable technology strengths into leadership in several emerging markets. The newly announced Brillo OS, built on Android, could break the standards wars and interoperability logjam that has retarded the progress of the Internet of Things (IoT), giving GOOG, and its Nest products substantial advantage. Chromecast may portend a cloud-based side run around TV hardware. Cardboard and the just announced Jump platform for 360 degree video production is a leap to market with affordable, “good enough” virtual reality that could trump the more ambitious plans of FB and MSFT. Android Auto will start to show in vehicles this year, extending the smartphone sphere of influence, while investments in autonomous driving could pay off in different directions, from technology licensing to operating fleets of taxi/delivery vehicles.

Not yet serious about enterprise. As the world leader in distributed data processing technology and infrastructure, GOOG would seem to have a lot to offer in an enterprise market that is in the early phase of an exodus to the cloud. Thus far, it has offered a low priced SaaS office suite with perfunctory support for MSFT Office documents, a modestly successful corporate email product, and powerful and cheap IaaS hosting services that lack effective marketing or comprehensive customer support. GOOG can do better, and occasionally, shows signs of caring enough to follow through. We believe that GOOG would be a natural partner for a traditional IT vendor – e.g. CSCO, EMC, etc. – with strong relationships but without traction in the cloud.

Threats. Mobile Apps – GOOG is adapting search to deliver mobile focused results, overlaying apps with always available context aware search. Its share of ad sales is higher in mobile than on the desktop, and participates in 73% of all product research on mobile devices. Fragmentation – Stronger controls on licensees via the Google Services Mandatory program reining in platform drift and platform upgrades are rolling more smoothly. Still an issue in China, where government limits on Google services blunt their value. Government Intervention – The EU’s politically motivated investigation could weaken Google’s mobile platform and search hegemony, but remedies are expected to leave its long term strategy intact with modest financial impact. Bigger risk is on management distraction and chilling M&A, favoring a quick settlement rather than drawn out fight. Competition – GOOG’s ambitions pit it against AMZN, AAPL and FB. While these rivals are big, extraordinarily capable and aggressive, so is GOOG and the markets that they mutually address are gigantic with room for all four to grow and succeed.

Valuation. Trading at 16.3x forward earnings and 5.3x trailing sales, with a 1.24 PEG ratio and a 20% projected cash CAGR, GOOG is not expensive compared with its peers, with the possible exception of AAPL. In our proprietary valuation framework, GOOG’s 5th year terminal value is only 65% of its EV, with 80% of large cap TMT names carrying more robust implicit long term expectations. For a company with unchallenged leadership in cloud-based data processing positioned against multi-trillion dollar opportunities in mobile commerce, media, IoT, and enterprise, the market’s perspective is far, far too pessimistic. While it may take some time to counter the skeptical narrative that has grown around the stock, we see it is a near sure bet to maintain its strength long term.

Please see our published research page for the full note.

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