Barrons’ Jacqueline Doherty provides a refreshing macro view of the Google (GOOG) story, arguing that the stock will likely plunge below $350 in short order. That’s only about a 15% drop from where we are now, so it’s not an earth-shattering prediction. But it’s always helpful to step back from the day-to-day noise and look at the big picture (mostly ours, not Barrons):
Google is still trading at 30+ times run-rate-free cash flow, a high multiple for a company that’s only expected to grow earnings 20% or so the next couple of years. Given the factors below, it is easy to see how this multiple could compress further.
Revenue growth is decelerating. Thanks to the weak economy, the slowdown is likely to get even more pronounced. This, combined with margin declines, is leading to multiple compression.
The “search” product cycle is past middle age. Google has been so spectacularly successful so fast that there isn’t that much more new territory in the world for it to invade. And in its existing territories, Google’s market share is so high that there’s not that much more share to claim. Google can continue to increase prices, but as far as revenue units go, the low-hanging fruit is gone.
Display, video, mobile, and enterprise–the next big potential product cycles–are still in their infancy. This will likely leave a big gap between the end of the search cycle and the start of the next product cycle.
Google has built a huge cost base and is still growing expenses faster than revenue (thus the operating margin decline over the past year). It will likely take the company a while to shift gears and radically slow its expense growth, much less start cutting costs.
All this will likely lead to continued multiple compression, as we argued last week.
Barrons bases its $350 argument mostly on the assumption that analysts’ estimates for revenue and earnings growth have to come down. This seems reasonable. Estimates have come down modestly for Q1, but the consensus for full-year 2008 still calls for 40% revenue growth. Given that the expected growth rate for Q1 is only 44%, this seems a stretch.
Google’s annualized free cash flow is about $4.1 billion. At $433, the stock trades at about 31X enterprise value to free cash flow. This isn’t an outrageous multiple, but it’s easy to see how it could compress further (and it’s certainly possible that free cash flow could decline). $350 would be about a 24X EV/FCF multiple.
The good news: We’re approaching hair-splitting territory. Google’s 40X-50X FCF multiple of five months ago was extreme, but unless Google really falls apart, 25X-30X is a reasonable multiple range. A 20X-25X multiple, meanwhile, should provide some real valuation support. Google’s long-term future is just too promising for investors to completely throw in the towel.
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