Shares of Google's GOOG class are leaping by 14.6% in early trading after Google's second-quarter earnings report, and they're up for an obvious reason: the company is promising to finally begin to contain the growth in spending that has made its profits as unpredictable as its sales growth is metronomic.
RBC Capital's Mark Mahaney provides the key numbers. Operating margins that had fallen to 38% last Christmas from 44% in 2013 jumped to 41.5%, the second big jump in a row. And more of that is in the hopper, as the company begins to rein in capital spending and emphasize cost discipline in general for the first time in years.
"Apparently, cost focus has become Googly,'' Mahaney wrote in a note to clients Friday. "One of the most notable items from the quarter [was -- and the all-caps are Mahaney's] LEVERAGE! ... This was the first quarter with positive operating leverage seen since 2010. Yes, five years ago.... We are pleased to see margin stabilization, and believe the deterioration has been a large part of the Bear case on the shares -- we are hopeful this represents some level of stabilization."
But discipline can be contagious. And it can make Google a different company -- and a different stock -- if management is serious about balancing shareholder objectives with growth.
On Thursday's quarterly analyst call, Google's new Chief Financial Officer Ruth Porat didn't give a clear outline of what's next. At times, she downplayed the idea that something like a dividend or a massive stock buyback is coming soon. But analysts said she was at least more receptive than past Google executives have been, and applauded her emphasis on cost control at newly acquired companies like home-automation pioneer Nest Labs.
"The market has wanted four things from GOOG -- consistent revenue growth, margin stabilization, greater disclosure & cash back," Mahaney said. "In the second quarter, the Market got the first three, and CFO commentary seemed rational [and] receptive on the fourth."
From its 2004 IPO, Google has always been determined to march to its own drummer, eschewing Wall Street pressure to make money in a predictable, linear way. The company made a point of highlighting that engineers had time set aside to think about projects that were nowhere near ready to generate revenue, and made acquisitions like YouTube before anyone had figured out how to turn them into cash.
Investors as rich as Mark Cuban and pundits as savvy as Henry Blodget surely wish they could take back the predictions they once made about how YouTube would never make money or how cost issues would tank Google shares, respectively. (In fact, Blodget long since has taken his back.)
Now Google's focus appears to be changing. New CFO Ruth Porat, recruited from Morgan Stanley (MS), is emerging as the catalyst for a Google that, if not run conservatively, is at least edging toward giving shareholder-friendliness a try. She stopped well short of promising major returns to shareholders, but with a $70 billion cash pile and $13.6 billion in first-half operating cash flow, buybacks or a dividend are possibilities.
"It gets into the context of, how do you prioritize and allocate cash after an appropriate reserve for working capital amongst the capital spending, [mergers and acquisitions] and then potentially that capital return?" Porat said. "The profitability of our business gives us many opportunities."
As Porat's plans come into focus, the bet looks much like the one Apple (AAPL) has made as it became more shareholder-focused. And it begins with the idea that there is now enough money coming out of the business to walk (do R&D) and chew gum (think about shareholder returns) at the same time.
For Apple, that has led to a $200 billion stock buyback announced this April and a 1.6% annual dividend -- the latter a notion that was once heresy in tech circles, where it was assumed you could get a better return on the cash by rolling it back into the business. Apple's yield used to be higher, but its dividend hikes have been outstripped by the doubling of its shares in the last two years. Nonetheless, there's enough cash left over for Apple's forays into cars, video and headphones.
The assumption that growth and shareholder-friendliness were opposite principles was fine when Apple and Google's ambitions were bigger than they were. But that's not really the case any more.
A 3% yield would cost Google about $13 billion a year at today's stock price -- roughly its operating cash flow from the last six months. That's after $5.54 billion of first-half research and development spending, so it wouldn't really be a pullback. So Larry Page and Sergey Brin could develop all of the driverless cars they want to, and if they're counting pennies they can just start with a 2% yield.
That's what happens when you are, as Mahaney points out, the only $70 billion company on the planet that is consistently growing sales 16% to 21% year over year, every quarter, for three years running. You can do these things. If you want to.
Growth will have to do most of the work if Google is to hit the $750 price target Mahaney set out today. But buybacks and dividends could make shares more stable once that happens.