Sequoia Fund Comments on Google

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Aug 28, 2015

Chase Sheridan:

Great question. When people ask me about risks to Google (NASDAQ:GOOGL), hubris is one of the primary risks that it faces because the core business is so good. Management is investing really, really heavily in being the aggressor in a lot of areas — the opposite of a milker. Some people milk their businesses. Google is putting the milk back in the cow. With its capital allocation strategy, I will start by looking backwards and saying I thought that Google overpaid for YouTube at the time. I thought that Google overpaid for DoubleClick at the time. Looking back, those were both great acquisitions. I would certainly advise Google to do them again.

Android was a very insightful acquisition. The acquisition and development of Android were spearheaded by Larry Page, who was very involved in the project. Android has become an enormous asset for the company. I will say that second guessing Larry Page has proven to be a humbling experience. Management is extremely farsighted when it comes to the direction that technology is moving. That said, I think the reason we did not put on a bigger position in Google at the time we bought it was that we perceived — I think a lot of investors perceived correctly — that shareholders are not first in line when it comes to the buffet of cash flow that Google produces. Larry Page has very large ambitions and the joke around here is Google generates more cash than its managers know what to do with, and the fear is that Larry Page is going to use it to colonize Mars. I think Google will start paying a dividend ten years after Larry Page’s death. I do not want to second-guess management, but I really cannot handicap very well what the company’s investments now are going to look like in ten years.

I will say this: A lot of the products that get a lot of press are really not material to Google’s overall results. If you look at Google Fiber, if you look at Google’s recent moves in the wireless industry, these are points of leverage that Google is finding to pressure the rest of the ecosystem to invest, to improve access to the Internet for all users, which ultimately benefits Google. It does not require very much money and Google is actually getting responses from folks like AT&T speeding up fiber access. So I do not think that these projects that we are reading about like driverless cars — they are interesting, but I do not think that the resources that they consume are significant in the context of Google’s overall earnings power. When I look over the next five years, I think that Google could create $100 billion of profits. So I am going to give management the benefit of the doubt for now. But it is a good question and I do not have a great answer for it.

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Question:

Could you please share your point of view about margins at Google and stock options?

Chase Sheridan:

Net margins at Google have been declining rather rapidly as the company has expanded into non-search businesses. Search is such a high margin business that nothing is going to compare. But in addition to the display business and other businesses that Google is currently monetizing, management is planting a lot of seeds elsewhere. So the margins have come down over time. If you are looking solely at the growth of net income or EPS — let’s go to the EPS line — if you are looking solely at EPS growth, it does not look that compelling. That is because Google is being penalized for an enormous amount of growth investing.

However, Google trades at a very modest premium to the S&P. If you look at its enterprise value to net operating profit after taxes, which is a way that you would look at it to give the company credit for the $60 billion of cash on the balance sheet and some intangible amortization, it is about 19 times forward looking, 2015, ballpark. The S&P is in the 17 − 18 range for its forward P/E. Meanwhile Google grew at 18.9% last year and the S&P in aggregate grew about 4.2%. So if you are taking a long view, you do have to have some faith that some of Google’s investments that are not currently benefiting the EPS line are going to work out. It does not have to be a lot of them but Google is planting a lot of seeds in a lot of places.

With regard to stock options, Google has a policy of compensating its employees very well. I think the intention is to try to create a place for the very best talent in the world to congregate and to avoid becoming a big stale company. I would say Google is on its way. The goal seems to be to create in the twenty-first century what Bell Labs and Xerox PARC were in the twentieth. Stock options are a part of that. They are expensed so it is already included in the math. The grants are very generous, but Google does get outstanding talent.

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Question:

Two questions, one on Google. Maybe some more commentary on how you think the transition to mobile is going. I know that is a tricky question, but some thoughts on that. Then on Perrigo, any comment on the current Mylan offer/bid, and whether or not that company ultimately will remain independent now that it is technically in play.

Chase Sheridan:Â I took a peek at Google’s market shares and how they have changed over the last twelve months. Google’s market share in mobile browsers, Chrome and Android combined, went from 37% to 48%. The company’s market share in mobile search went from 91% to 92% globally. And the market share of the mobile operating system, which is the Android OS in all of its forms, from 37% to 52%. It is worth pointing out that Google’s share in mobile search is actually quite a bit higher than its market share in desktop search. The transition to mobile is fraught with all kinds of potential pitfalls, but Google was very early in emphasizing mobile with Android.

The worry for a lot of Google followers is that people tend to spend a lot of their time in apps on mobile devices; so the worry is that as apps predominate in terms of taking users eyeballs away, mobile search use may decline. As it turns out, people still do a lot of searching on their mobile phones through the browser, which is how Google makes the bulk of its mobile money. But it also has a pretty robust display business, and the company is doing what it can to maximize its presence there. I am going to pull a number from memory, but I believe that Google has something like 37% of all mobile advertising. It has a tremendously strong position. In terms of just the advertising technology stack that Google owns, there is nobody who comes close. That is sort of an unholy mess, but it is consolidating and it is consolidating into a couple of large platforms. Google will own one of them. Facebook will own one of them, and then we will see what else shakes out. But Google has a tremendously strong position in mobile. The company has navigated that transition better than I would have expected. Google saw it coming before most of us did.

From Ruane, Cunniff & Goldfarb Investor Day 2015 Transcript Part II - Sequoia Fund.