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:
- 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.
- 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.