By Chris Bulkey, principal analyst at Technology Research Group
reported revenue of $6.78 billion and pro forma earnings of $6.76 a per share for the first quarter, but when stock-based compensation is included net income gets pulled down to $6.06 a share in GAAP terms. Elevated interest income, a lenient tax rate, and decelerating cash flow were primary points of contention.
Sustainable Operating Earnings
Recall that Google records gains from marketable securities with interest income. This gives management flexibility to boost income by timing investment sales. Normalizing this line item with the year-ago period shaves 3 cents a share from the bottom line. The effective tax rate came in below the prior year with essentially no change in revenue from international customers (53% vs. 52% in the first quarter of 2009). It is therefore likely that deliberate utilization of deferred tax assets was responsible for the easy comparison. Attempts to ascertain specific amounts deferred were unsuccessful; we'll have to wait for the 10-Q.
Applying the tax rate from the first quarter of 2009 drags earnings down by another 21 cents a share and this may be a conservative estimate. Bottom line: GAAP earnings on a sustainable operating basis would be closer to $5.82 a share vs. the as-reported $6.06 a share; return on equity falls to 19.6% in this scenario vs. the as-reported 20.4%.
Cash Flow a Growing Concern
Cash flow decelerated to $2.58 billion from $2.73 billion sequentially. On a year-over-year basis, cash generated from operations increased 15% -- respectable in absolute terms, but loosely correlated with net income, up 38% from last year. In the previous first quarter, cash flow, up 26%, was well ahead of profit growth, up 9% year over year. This is far from a disastrous progression, but a reversal of past tendencies is worth noting. Cash flow was a minor concern in the preceding quarter. In our fourth quarter 2009 report, we noted that the irregularity would be no cause for concern as long as there was no recurrence.
The following table summarizes profit and loss indicators from the most recent quarter, the previous fourth quarter, as well as the year-earlier first quarter. Metrics are GAAP, unless stated otherwise.
Google provides guidance in pro forma terms. Restructuring charges, assetimpairments, and deferred compensation are excluded from consensus estimates.Projections that are not fully expensed overstate growth potential and understatecorresponding valuation multiples. For 2010 and 2011, the consensus GAAP earningsestimate is roughly 12% below pro forma.
Valuation and Recommendation
Shares are down 5% year to date and valued at just under 30 times trailing GAAP earnings. Comparable search engine provider
trades at 45 times.
Yahoo!'s pricey valuation is a function of erratic profitability. Financials may be nearing distressed levels, but the company deserves credit for providing guidance on a fully costed basis.
Sustainable growth -- ROE multiplied by retention rate -- is respectable in absolute terms (20.4% as-reported and 19.6% in sustainable operating terms), but potentially inadequate against a premium earnings multiple. Risk/reward is far less attractive than it used to be.
We reiterate a "sell" rating and $544 price objective; Our target multiple moves to 21 times revised 2010 EPS estimate from 23 times.