Friday, October 14, 2011

Google's 3rd Quarter 2011 Earnings

From the Google (GOOG) 3rd quarter earnings press release:

GAAP net income in the third quarter of 2011 was $2.73 billion, compared to $2.17 billion in the third quarter of 2010. Non-GAAP net income in the third quarter of 2011 was $3.18 billion, compared to $2.46 billion in the third quarter of 2010.

GAAP EPS in the third quarter of 2011 was $8.33 on 327 million diluted shares outstanding, compared to $6.72 in the third quarter of 2010 on 322 million diluted shares outstanding. Non-GAAP EPS in the third quarter of 2011 was $9.72, compared to $7.64 in the third quarter of 2010.

 The stock is selling at $ 594/share (up 6.4% from yesterday's close) as I write this. With $ 37.4 billion ($ 114/share) of net cash on the balance sheet the enterprise value per share of Google is...

Enterprise Value: $ 594/share - $114/share = $ 480/share

Google should earn close to $ 32/share this year (using GAAP earnings) and likely quite a bit more than that in 2012.  So a 15x or so multiple. Even if not cheap, not exactly outrageously expensive either (though I wouldn't buy it near the current price) given what appear above average prospects.

Now, I am skeptical of the non-GAAP earnings estimates used by Google and widely accepted by analysts.

As good as Google's business is, I think it is fair to say that the non-GAAP numbers are optimistic.

Now, it's not that the GAAP earnings numbers are a perfect measure. They certainly are not.

I just think it just makes more sense to go with the more conservative number that GAAP provides in this case.

Here's why.

First of all keep in mind that, primarily due to stock option grants, shares outstanding will tend to grow over time (like many technology companies).

I realize the extra 5 million shares outstanding year over year (327 million minus 322 million from above) isn't the end of the world. On a percentage basis it's a small number.

Still, even though 5 million additional shares is not a huge number on a percentage basis, a company that continues to add that many shares each year for let's say a decade or so will guarantee the long-term owners  find their share of an expected to grow in value pie to be meaningfully less.

The pie will grow nicely but there'll be meaningfully more slices.

Now, there is no precise or useful way to measure the cost of stock options (stock-based compensation* expense is an attempt) but there's no need to measure it with precision. That the ultimate cost of options is difficult to estimate doesn't make the cost to owners less real.

The extensive use of options makes it almost certain that a material amount of extra shares will likely exist down the road. An investor can attempt to make a rough estimate of how much dilution will likely occur based upon current compensation practices.

That's, at least, a good place to start.

With Google, you have a business that will slowly grow its share count. In contrast to this, many very good businesses these days are lowering their share count each year via share repurchases.

In fact, some are currently at a buyback run rate that could cut their share count in half in 5 years or less (whether that actually happens, of course, depends on the stock price among other things).

Google has a fine business yet the extensive use of stock options needs to be weighed appropriately to judge longer term return potential. Any estimate of Google's future business value should be given a haircut on a per share basis to account for the additional shares outstanding. The investment may still provide a satisfactory return but the effects of dilution need to be estimated.

Stock-based compensation expense* is an attempt an GAAP to estimate the cost of stocks options. It's far from perfect but shouldn't be ignored. The non-GAAP earnings number reported by Google and used by many analysts back out this non-cash expense. Some argue that since stock-based compensation is not a cash expense that the non-GAAP earnings number better reflect reality. There are cases when it makes sense to back out non-cash expenses. I'd argue in this case it makes less sense.

Why?

Stock-based compensation serves as a useful if imperfect way to make sure there is some sunlight on the not so easy to estimate but real potential cost of stock options to owners over time.

The long run share dilution becomes a real cost to shareholders even if, as a non-cash expense, it doesn't impact free cash flow. It's still a real cost because those cash flows, the main driver of future value, will be divided among more shares outstanding.

So stock-based compensation expense is very much an imperfect way to estimate the cost of stock options to investors but I applaud the attempt to make those costs more visible.

Adam

Long position in Google at a substantially lower price

* Calculating stock-based compensation expense requires the input of highly subjective assumptions (things like stock price volatility and forfeiture rate). Best case it represents a good faith estimate of something that's nearly impossible to know.
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