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2 Stellar Tech Stocks Outpacing Google

March 29, 2012 | About:
On the surface Google (GOOG) might seem like a fantastic triple-play. Shareholders benefit from its traditional web business, and its reach into smartphones and social media. The company recently launched its Web 2.0 platform called Google+. It also expects to acquire Motorola Mobility Holdings (MMI), though the deal is not final yet. This deal would allow Google to complement its Android smartphone operating system. Unfortunately, Google really isn't like Apple (AAPL), Yahoo (YHOO) and Facebook rolled into one.

Despite countless new projects, Google remains a Web 1.0 search company. Its new projects may prove damaging because they are a "license to spend," and they might actually make Google more complicated and bureaucratic. Investors should not buy Google based on their hopes for Google+ or its merits as a smartphone contender. Investors would do well to look elsewhere for investment ideas, since many other Web 1.0 and Web 2.0 companies seem richly valued.

Inside Google

Large companies can be incredibly complex and become subject to issues that are not captured in the balance sheet, income statement and cash flow statement. As such, investors will have to read company filings to truly understand issues facing the firm. The Google 10-K for fiscal 2011 was released in late January. Though only 86 pages in length, it contains key information.

Google has canceled some of its internally developed products while sourcing some of its new products through acquisitions. Google Buzz, Google Desktop, and Google Labs were shut down in 2011. At the same time, Google made several acquisitions. In 2011, it acquired 79 other firms.

The company's research and development expense is growing wildly. R&D expense was 13.6% of revenues in 2011, up $1.6 billion ($1.4 billion cash and $0.2 billion stock incentives) from last year. These increases are the result of a 10% increase in R&D salaries and a 23% increase in headcount. The 10-K clearly states an expectation to continue raising R&D expenditures:

"We expect that research and development expenses will increase in dollar amount and may increase as a percentage of revenues in 2012 and future periods because we expect to continue to invest in building the necessary employee and systems infrastructures required to support the development of new, and improve existing, products and services."(p. 34)

Investors should be scared of this statement. Investing is about paying the smallest cash outflows as possible to receive the largest and most certain cash inflows. Spending on an R&D arms race is a reason not to invest in Google.

Additionally, boosting headcount costs more than money. Stock based compensation was $1.97 billion or 5.2% of revenues. Google dilutes its shares between 1% and 2% each year through stock options.

Regardless of the amount of money thrown at research and development, Adwords accounted for 97% of revenues in 2009, and 96% of revenues in 2010 and 2011. About 71.5% of this revenue came from Google websites, and only 28.5% comes from Google Network Member websites. Google does not profit directly from its Android operating system. Until the deal with Motorola Mobility Holdings is completed, Google is not really in the smartphone race.

Insiders control the company. Larry Page, Sergey Brin, and Eric Schmidt control 66% of existing voting rights based on their ownership of Class B shares with enhanced voting rights. Larry Page assumed control in April of 2011. Outside investors have no means to challenge the direction of Larry, Sergey, and Eric.

Bear in mind that Larry, Sergey, and Eric are not likely to milk the firm. Since Google is incorporated in Delaware, Class A shareholders would have to approve any preferential dividend to Class B shareholders. Moreover, these men are each paid $1 in salary and are compensated primarily by the appreciation of their existing stock holdings.

How should these qualitative observations influence investor sentiment? Taken as a whole, some of these observations should quench investor enthusiasm for Google stock.

First of all, Google's appetite for R&D spending is troubling. Enthusiasm for high R&D payments, when virtually all firm revenues are derived from Web 1.0 advertising, is contradictory. R&D should be kept lean and mean, at least until new products create revenue streams that would justify such spending.

In addition, investors should also ponder the wisdom of acquiring 79 other firm in one year. Investors see higher returns from organic growth through internally developed products than they do from mergers and acquisitions.

Alternative Stocks Are Less Rich

At roughly $600 per share, Google shares are richly valued, even after enduring a -7.1% change in share price over the past year. At this price level, it trades at a price-to-book ratio of 3.4, a price-to-earnings multiple of 20.2, and a price-to-sales multiple of 5.2 (trailing twelve months).

Fortunately, there are other ways to invest in the tech space, including plays in the internet, social media, and smartphone realms.

A cheaper internet investment can be found in Yahoo, which recently traded around $14.50 per share. After having endured a -10.2% change in share price over the past year, shares now trade at a price-to-book ratio of 1.4, a price-to-earnings multiple of 17.7, and a price-to-sales multiple of 3.5 (trailing twelve months). Though not as sexy as Google, Yahoo has alleged that Facebook has infringed on 10 of its patents. Yahoo might be more hip than investors realize, since some of its intellectual property could be relevant to social media. Based on these factors, Yahoo looks more attractive than Google, and, in my view, is a more deserving investment.

As far as the smartphone market is concerned, Apple is more cheaply valued at $552 per share, even after shares rose 36.3% over the past year. Shares of this large cap stock trade at a price-to-book ratio of 5.7, a price-to-earnings multiple of 15.7, and a price-to-sales multiple of 4.0 (trailing twelve months). Oddly enough, the main player in the smartphone space is more attractively valued than the upstart Google.

Of course, it's all relative. It should be noted that Google is trading at valuations that are more reasonable than those seen for Web 2.0 stocks. For example, LinkedIn (LNKD) recently traded around $90 per share. At this price level, the stock trades at a price-to-book ratio of 14.7, a price-to-earnings multiple of 755.6, and a price-to-sales multiple of 17.8 (trailing twelve months). These valuations are very rich, even hopeful. Google looks cheap by comparison to LinkedIn, in the same way that Yahoo looks cheap when compared to Google.

Though LinkedIn is an unattractive investment, it is a competitor of the Google+ social media platform. Google+ promises to organize your social networks to keep work and play separate. Social media users currently use LinkedIn for work and Facebook for play. Google+ will have to make gains by winning users from these two mature platforms.

Overall, I believe a combination of Apple and Yahoo shares is more attractive than Google shares. A portfolio containing these two companies would have exposure to new web and technology platforms at lower valuations than could be obtained by buying Google.

About the author:

StockCroc
I'm mostly interested in income investing using dividends, preferred stocks and other debt instruments, and pair trading.

I fundamentally analyze every business from the top down.

In my personal life, I have a strong Jewish faith and enjoy playing Scrabble and entrepreneurship.

Visit StockCroc's Website


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