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Google Can't Sustain Premium Valuation

Stocks in this article: GOOG YHOO

Google's (GOOG) 10-K was similar to the last few quarters in that it contained a surprising number of nonconservative tendencies. Income smoothing and liberal use of expense accruals call earnings quality into question.

Normalizing benefits from valuation allowances, R&D expenses, tax rates and investment gains would cause profits for 2009 to come in 11% below reported levels. Return on equity would fall by a similar amount if measured in sustainable operating terms. A highly irregular cash-flow progression in the fourth quarter may be the most worrisome development.

Google's insistence on providing guidance in pro forma terms is a major point of contention. Excluding costs related to stock-based compensation and one-time charges inflates growth potential and understates valuation multiples. Consensus estimates for many companies, including rival Yahoo! (YHOO), are presented in fully expensed terms. We believe this deficiency should limit Google's ability to sustain a premium valuation. It hasn't happened yet -- P/E is still safely above 20 times. How this progresses in coming months will be interesting. Key takeaways from the annual filing are as follows:

Operating Trends

  • Revenue growth decelerated to 9% from 31% in 2008; pursuit of growth catalyst could lead to high multiple acquisitions (and more goodwill accumulation).
  • Pro forma EPS growth slowed to 19% from 25% in 2008, and is projected to approximate 17.7% in 2010 and 14.3% in 2011 (pressure on valuation multiples inevitable).
  • Cash flow was essentially unchanged in 4Q09 amid a 21% Q/Q profit upturn; deceleration in 4Q08 was caused by impairment and related profit decline (rules out seasonality as cause for irregular progression in 4Q09).
  • Elevated use of discretionary expense accruals (81.8% of current liabilities vs. 79.6% exiting 2008) aggravates cash flow abnormality.
  • Yahoo! maintains a far more conservative approach; discretionary accruals are only 68.1% of current liabilities exiting most recent quarter.
  • Another uncorrelated cash flow/net income comparison in 1Q10 would be cause for alarm.
  • Earnings Management

  • Allowance for bad debts lowered as a percentage of ending asset balance 2.48% vs. 3.03% exiting 2008); normalizing would shave about $0.042 from reported EPS.
  • Reducing R&D expenses (as a percentage of sales) added 45 cents per share to net income.
  • Lenient tax rate (22.2% vs. 27.8% in 2008) inflated earnings by nearly $1.47 per share.
  • Gains from investment sales increased $43 million vs. 2008 and added $0.105 to EPS.
  • Lowering valuation allowance on deferred tax assets lifted EPS by $0.093.
  • Contra account reduction on tax assets generally portends NOL utilization and tax rate variability (an area to monitor in 2010).
  • Removing income accelerating items would pull 2009 earnings down to $18.25 per share in sustainable operating terms (11% below reported GAAP EPS).
  • Return on equity for 2009 would fall to 16.0% from 18.1% as reported.

Valuation and Recommendation

Shares are up 55% over the past twelve months and valued at 26 times trailing GAAP earnings. Yahoo! trades at 37 times (premium vs. Google due primarily to depressed EPS base). Yahoo!'s financials may be nearing distressed levels, but the company deserves credit for providing guidance on a fully costed basis. Google's sustainable growth rate (ROE times retention rate) is respectable in isolation (18% for 2009), but potentially inadequate relative to a multiple in the vicinity of 30 times. Don't forget this disparity worsens if we remove favorable effects of income smoothing (i.e., ROE drops to 16% without nonoperational contributions).

With growth moderating and earnings quality concerns emerging, risk/reward looks far less attractive than it used to. We reiterate a sell rating on Google shares. Price objective is being lowered to $519 (from $536 previously) to account for downside toward previous expectations (target multiple moves to 19 times forward earnings from 23 times).

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