Google: $600 and Counting

Google is at it again. No, I’m not talking about pushing the envelope in innovative search and advertising technologies; I’m talking about increasing the wealth of lucky shareholders who have enjoyed a 33.6% gain in price per share (PPS) year to date (YTD). Yesterday the internet behemoth, stock ticker GOOG, broke $600 for the first time.

Although the stock has been pushing all time highs for the last month, this psychologically important mark provides a good point for reflection on the how and why of the amazing performance of this stock.

It all started on August 19th, 2004, when Google held its initial public offering (IPO) at $85 per share. In the remaining months of the year the stock more than doubled to close the year over $190. The PPS more than doubled again in 2005. The following year was a volatile period, most of which was spent in the red. GOOG closed 2006 only slightly higher than where it began.

Statements declaring the causes of a stock’s performance are conjectures at best, but to my recollection the common thought in 2006 was that GOOG simply could not continue grow its earnings per share (EPS) at a fast enough rate to warrant its tremendous price to earnings (PE) ratio. This is a painful phase in the life of many publicly traded tech companies as they transition from what traders refer to as a “growth stock” to a “value stock.” In GOOG’s case the PE ratio contracted from 100 to the high 50s in a year when EPS grew over 70%.

Late in 2006 Google began taking actions that have rekindled the street’s love of this company as a growth stock. It started with the October purchase of YouTube for $1.65 billion in stock. Over the following months the company began to demonstrate its ability to monetize the video-sharing website through advertising, as well as negotiate the legal risk of user posted content.

Recently speculation about a Google phone has accelerated the growth of stock price. It is believed that the company will either produce a phone enabled with Google’s mobile applications, or more likely it will release a free mobile operating system and software suit that will be advertising funded. Google has clearly demonstrated its interest in the cellular space with its release of Goog-411 and its involvement in the FCC’s auction of the 700 MHz spectrum.

Also adding fuel to the fire is the appearance that Google is gaining market share in the world’s hottest economy: China. A recent report by Analysis International indicates that Google increased its market share 4% in the last quarter to 22.8% versus the slower 1% increase by Baidu to 58.1%. Cynics have dismissed this by saying Google is not taking share from Baidu, but merely capturing more of the new market.

Whatever its plans, Google has shown the glass ceiling for its business may be higher than anyone has expected and it appears the stock is ready to run. Fundamentally the company is being valued at its historic lows, with a PE ratio in the 50s. Should the PE enter a period of expansion combined with sustained EPS growth, GOOG could easily hit the $800 target set by popular stock commentator Jim Cramer.

Wall Street analysts seem to recognize this potential as well. Of the analysts polled by Reuters, in the last month five have raised price targets compared to one lowering. TheStreet.com shows that of the 20 analysts the site covers, 16 rate GOOG a buy, 2 overweight, and 2 a hold. In other words none recommend selling the stock and the vast majority think you should be buying. All this optimism is the result of what is known as an “upgrade cycle.”

To top it off the Federal Open Market Committee (FOMC) has been dropping interest rates to avoid a recession due to the imploding home mortgage market in the U.S. This is at least a temporary boon to stocks as a whole since a lower interest rate frees up cash for investment.

Could this picture get any brighter and could the GOOG rose smell any sweeter? Sure, there is always potential with this company, but a few words of caution are in order. First off it should be understood that some of the processes driving GOOG’s performance may have reached their limits. The analyst upgrade cycle is fairly well played out. How much more positive can they get on this company? Myopically positive analyst coverage is one of Jim Cramer’s favorite warnings that a stock may be reaching its top.

Also the FOMC could decide that the economy is actually cooking along nicely and stop the interest rate cut cycle. The recent jobs report indicated that America is growing employment slightly faster than expected lending credit to this idea. The dramatic plunge in the value of the U.S. Dollar will pressure the FOMC to hike or at least maintain interest rates in the near future. The negative effect of a rate hike was demonstrated in May 2006 when it led to an 11% decline in the NASDAQ over the next three months. During this period GOOG decreased nearly 15%.

Another development to keep in mind is the accelerated insider selling by Google executives. According to Form4Oracle.com, over the past 13 weeks Google insiders have sold over $420 million in shares versus the $290 million of the previous 13 week period. Although trading on inside information is illegal, street sentiment is that heavy insider selling is a negative indicator.

Later this month Google share holders will face an important hurdle when third quarter earnings are announced. This year Google missed quarter earnings estimates for the second time in company history when their second quarter failed to meet analysts’ expectations. Over the next month the stock sank 10%, although in Google’s defense the NASDAQ sank over 7% in the same period. If on October, 18, Google should again miss earnings estimates it will add great strength the sentiment that their growth is unsustainable and a nasty period of PE contraction will most surely follow. The flip side of this coin is that if they blow away the estimates, like they traditionally do, a lot of apprehension will be relieved and you can expect to see new money from the sidelines push the stock even higher.

The last word of caution that I will offer is to keep in mind the big picture of how big this company is. A recent report by comScore indicates that Google conducted over 37 billion searches in August. The company accounts for over 50% of U.S. searches and over 60% world-wide. These numbers are expected to keep growing. Google is so dominate that investors, myself included, think Yahoo! should throw in the towel on search and focus on other services where they have fighting chance. I recently heard Leo Laporte say that if you are not listed by Google you don’t exist online. Combine Google’s asymptotic march to 100% search market share with its printed advertising and mobile phone ambitions, and you have a company that is ripe for an antitrust lawsuit. This is an endgame to the unbridled growth that many people seem to regard as inevitable for Google.

Having stated all these pros and cons for GOOG, the only thing I can say with complete confidence about this company is to summarize a quote from an investor whose name I cannot recall. The future will be volatile.

Source: Andrew Campbell