Jeffrey B.

Mann, CFA Independent Research Report Ticker: GOOG Current Price: $604
Forecast Summary
(in $ millions) Sales EBITDA Net Income EPS 2011A $37,905 13,937 9,737 29.76 2012E $44,349 16,135 11,498 44.57 2013E $51,888 18,878 13,743 53.27 2014E $60,709 22,087 16,374 63.46

Google Inc. Recommendation: BUY Price Target: $800.76

2015E $71,030 25,842 19,466 75.45 2016E $83,105 30,235 23,077 89.45

Highlights: Market Dominance at a Discount

Global Market Share Leader and Brand Name Are Key Competitive Advantages: With an 87.6% Market Share in search this powerhouse is poised for consistent revenue growth through increases in search traffic and rate increases per click. In a market with low switching costs, Google has been gaining market share by focusing on targeted search and providing services that users want. This gives Google a competitive advantage as users increasingly flock to the market share leader with the most traffic and content. Consistently High Employee Productivity and Technological Innovation: Revenue per employee rose from approximately $1,000,000 to $1,200,000 over the last 4 years far outpacing its peers.1 Googles resource in superior human capital is expected to continue to yield financial results as talented individuals are attracted to the culture and standards at Google. Google invests over 13% in R&D - way above industry peers. They also continue to invest in disruptive technologies and innovations that are expected to yield long term returns. 2 Rising Margins, Earnings, and Valuation Models Signal a BUY: GOOG is holding 22% of its value in cash with increasing profit margins and earnings, amidst a global recession. Valuation models demonstrate 33% upside potential. All signals point toward favorable future growth.

52-week Price Range $473.02 - $670.25 Average Volume (3m) 2,419,360 Beta 1.18 Market Cap (thousands) 196.91B Shares Outstanding 258 million
Debt/Total Cap ROE Free Cash Flow/EV 12.50% 19.59% 7.07%

Insider Holdings Institutional Holdings FMR LLC Vanguard Group T. Rowe Price
EV/Sales EV/EBITDA P/E

82.00% 7.07% 3.93% 3.75%

3.94 10.64 18.31

1 2

Source: Appendix I: Employee Productivity Source: Appendix II: Technological Innovation

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Company Overview:
History Googles birth dates back to the mid-90s when Stanford University graduate students, Sergey Brin and Larry Page, developed a technology for a search engine. The initial search engine was named BackRub, for its unique ability to analyze the back links pointing to a given website. In 1998, Brin and Page raised $1 million in funding from private investors and venture firms to start Google. By 1999, Google was answering 500,000 search queries per day. That same year, it received $25 million in equity funding from Sequoia Capital and Kleiner Perkins Caufield & Byers and AOL/Netscape incorporated Googles search technology into its Netcenter portal. By late 2000, the company answered more than 60 million searches per day and its index compromised more than 1.3 billion web pages. In that same year, in order to capitalize on its growing search business, Google launched AdWords, a self-service advertising program that could be launched online with a credit card. By 2004, Googles presence could not be denied. Ever opportunistic, Google launched the Gmail email service and went public with an IPO on the NASDAQ. Today, Googles business is focused around online search, advertising, operating systems and platforms, and enterprise. Search Google maintains an index of websites and other online content that it makes available through the Google search engine. The search technology sorts through information to deliver relevant search results to user queries. Google Search is currently the #1 search engine in the United States with an 84.2% Market Share. 3 Advertising AdWords generates revenues by charging businesses to create ads based on keywords (words or phrases related to the business). When people search on Google using one of the keywords, the ad will appear next to the search results. People may then click on the ad to make a purchase or learn about the company. Businesses pay up to a maximum of ten cents for each ad and they are only charged if the customer actually clicks on the ad, referred to as click-through. The AdSense program enables websites that are part of the Google Network to deliver ads from the AdWords advertisers that are relevant to the search results or content on their websites. Google shares the majority of the revenues generated from these ads with the Google Network Members that display the ads. AdSense enables advertisers to extend the reach of their ad campaigns to other websites. Google Display compromises videos, text, images, and other interactive ads that run across the web on computers and mobile devices, including smart phones and handheld computers such as netbooks and
3

IBISWorld Search Engines in the US February 2012

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tablets. The Google Display Network provides advertisers the ability to deliver display advertising across publishers participating in the AdSense program, the DoubleClick Ad Exchange, and Google-owned sites such as YouTube and Google Finance. The Google owned DoubleClick Ad Exchange is an auction marketplace for the trading of display ad space. YouTubes video advertising solutions provide advertisers a way to promote their content to the YouTube community, as well as to associate with content being watched by their target audience. Google Mobile extends all products and services offered by Google by providing mobile-specific features to mobile device users. These include, search by voice, search by sight, and search by location. In addition, Google offers advertisers the ability to run search ad campaigns on mobile devices with popular mobile-specific ad formats, such as click-to-call ads in which advertisers can include a phone number within ad text. Google Local provides users with relevant local information from over 50 million places globally. Users can find addresses, phone numbers, hours of operation, and directions for local queries such as shops, restaurants, parks and landmarks on google.com, google maps, and google maps for mobile. Users rate places theyve been and get customized recommendations based on their tastes within google maps. Google Places allows local businesses the opportunity to manage their online presence by allowing them to post their business listing for free and to add additional details such as photos and products/services offered. In addition, Google Offers brings people daily deals from local and national businesses. Operating Systems and Platforms Android is a free, fully open source mobile software platform that any developer can use to create applications for mobile devices and any handset manufacturer can install on a device. Currently, Android has captured 61% Market Share in the US smartphone market. 4 Google Chrome OS is an open source operating system with the Google Chrome web browser as its foundation. They are both designed for people who spend most of their time on the web, and are built around speed, simplicity, and security. Google is currently working with OEMs to bring computers running Google Chrome OS to users and businesses. The Chrome browser runs on Windows, Mac, and Linux computers. The Google Chrome web browser currently has 18.85% of the web browser market. Google+ was launched in June of 2011 as an online community to compete with Facebook. As of January 2012, over 90 million people have joined. Google TV is a platform that gives customers access to television, with the ability to search and find the content they want to watch. The Google TV platform is based on the Android operating system and runs the Google Chrome browser.

Source: https://www.npd.com/wps/portal/npd/us/news/pressreleases/pr_120502

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Google Books is a platform designed to help people search and consume content from printed books online. Through the eBookstore, Google provides a large collection of free public domain books in addition to selling popular books in electronic book format. Enterprise Enterprise products provide technology for business settings in direct competition with Microsoft Office applications. Google Apps include Gmail, Google Docs, Google Calendar, and Google Sites, in addition to web-based applications. In addition, Google provides search technology for use within businesses through the Google Search Appliance (real-time search of business applications, intranet applications, and public websites), on their public-facing sites with Google Site Search (custom search engine), and Google Commerce Search (for online retail enterprises). They also provide versions of Google Maps for businesses (public and internal websites), and Google Earth Enterprise (for imagery and data visualization). These products have been adopted by businesses, governments, schools, and non-profit organizations. Of note, Google Apps is the first cloud computing suite of message and collaboration tools to receive U.S. government security certification. Revenue Mix Google currently generates the majority of revenues from advertising and a significant amount is generated by Google owned websites. Google has indicated that margins on revenues generated from Google Network Members websites are significantly less than margins on revenues generated from Google owned websites. As you can see from Figure 2, Google owned websites are gaining a larger percentage of advertising revenue which is evidence that Google is attracting users with their content and offerings, and experiencing greater returns.
Figure 1: Segment Revenue Figure 2: Advertising Revenue

Source: Google 10-K

Source: Google 10-K

Industry Analysis:
The internet search engine industry is characterized by firms that operate search engines, internet portals and other types of search-based websites that display advertisements. Websites earn income when a user clicks on an advertising link. Websites attract users by offering a range of mostly free services, such as internet search, e-mail, news, social networking, entertainment and other information.

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The U.S. search engine industry is a $17.1 billion market with annual growth of 11.5% through2012. 5 Google currently dominates the industry with an 84.2% market share.
Figure 3: Market Share

Market Share: US Search Engine Industry

Microsoft, 6.6% Yahoo, 7.2%

Google, 84.2%

Source: IBISWorld Reports Figure 4: Global Market Share

Market Share: Global Search Engine Industry

Baidu, 4.7% Microsoft, 4.2% Yahoo, 2.4%

Google, 87.6%

Source: Karma Snack traffic analytics

Our analysis of Porters Five Forces reveals an industry with high bargaining power for customers as well as advertisers. 6 Customers can choose any search engine available at no cost. In addition, advertisers
5 6

IBISWorld Reports Search Engines in the US Industry Report February 2012 See Appendix III: Porters Five Forces Industry Analysis

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run multiple advertising campaigns through various search engines at little cost. For instance, an advertiser may rather place an ad with Microsoft Bing where they may be the number one search result as opposed to placing an ad with Google where they may end up as number ten on page two of search results. It is for this reason that we do not see this industry converging to one dominant player. With Microsofts recent agreement with Yahoo, they will be powering the yahoo search engine through Microsoft Bing in exchange for 12% of revenues. Competition for market share will remain fierce with advertisers choosing as many venues as possible. Next, we performed a SWOT analysis on Google to assess how they are addressing the industry dynamics. 7 What we found was that Google is addressing the customer side of the equation, driving clicks and thereby revenues. Even though advertisers will seek any search engine that is relevant, Google will continue to innovate and drive the customer experience in order to generate clicks. In addition, by allocating resources to drive mobile growth through Android Market, Google is setting itself up to become the Google of mobile search and advertising. Competition Microsoft is a global software company with $70 billion in sales in 2011. They generate revenue by developing, licensing, and supporting a wide range of software products and services, by designing and selling hardware, and by delivering online advertising. Through the Online Services Division Microsoft competes directly with Google. The Online Services Division offerings include Bing Search, MSN, adCenter, and advertising tools. Search and display advertising account for all of the divisions revenue. As of 2011, revenues amounted to $2,528 billion with operating losses of $2,557 billion. Microsoft has been operating at a loss in this division with losses increasing relative to revenues. Even though we have included Microsoft in our peer group analysis, attention should be paid to the overwhelming fact that Microsoft is operating at a loss in the division that competes directly with Google. Yahoo is a digital media company with $5 billion in revenue in 2011. They generate revenue from display advertising, text-based search, and other sources. Display Revenue was $2.1 in 2011 and came mainly from banner ads on yahoo websites and affiliated websites. Text-based search advertising was $1.8 billion, a $1.4 billion decline from 2010 due to the ten year Microsoft agreement. Search page views have declined 1% year over year for the last two years. Yahoo will be increasingly relying on Microsoft to drive advertiser acquisitions while being responsible for customer clicks for the text-based search business. With poor operating results over the last few years we see less and less resources available at Yahoo to effectively compete with Google and drive customer growth. Baidu is a Chinese language internet search provider which operates in China through Baidu Netcom Science Technology, which holds the licenses and approvals to operate the companys websites and provide online advertising services. The company operates in China, Hong Kong and Japan. Revenues for 2011 were $2.2 billion. Baidu currently has an 83.6% market share in China compared to Googles 11.1% 8. It appears that Googles decision to redirect users in China to a Hong Kong site in response to
7 8

See Appendix IV: Google SWOT Analysis Source - http://www.resonancechina.com/2011/03/14/baidu-83-6-search-query-market-share/

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the Chinese Governments censorship of content has backfired. With China being the worlds largest market we see Baidu with considerable room to grow. Of note, Baidu recently formed a partnership with Microsofts Bing, which will enhance Baidus English-language searches.

Financial Statement Analysis:

Figure 5: Gross Margin

Gross Margin: Peer Group Trend

90.00% 80.00% 70.00% 60.00% 50.00% 40.00% 30.00% 20.00% 10.00% 0.00% 2007 2008 2009 2010 2011 Google Yahoo Microsoft Baidu

Firms in the search and advertising industry enjoy high gross margins relative to other more capital intensive industries. We found that Microsoft was at the high-end, however the majority of its business mix is in software business which benefits from economies of scale and thus higher gross margins. That being said, Google is at the bottom of its peer group and trending upward. We see opportunity for improvement going forward which could give a boost to share price.

Independent Research Report Figure 6: Operating Margin

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Operating Margin: Peer Group Trend

60.00% 50.00% 40.00% 30.00% 20.00% 10.00% 0.00% 2007 2008 2009 2010 2011 Google Yahoo Microsoft Baidu

Operating Margins have been in line with peers but have experienced a decline within the last year. This reduction in operating margin is mainly attributable to a 0.80 basis point increase in R&D from 12.8 to 13.6% of revenues. In addition, sales and marketing expenses rose 2.60 basis points to 12.1% of revenues and Google recognized a charge related to the resolution of the Department of Justice investigation representing 1.3% of revenues. Google is currently spending the most on R&D as a percentage of sales across the peer group. In addition, sales and marketing expenses are at the bottom of the peer group. We feel this augurs well for future product development. This also demonstrates Googles ability to create awareness of products without the need for high sales and marketing expenses.

Independent Research Report Figure 7: Net Profit Margin

May 15, 2012

Net Profit Margin: Peer Group Trend

50.00% 45.00% 40.00% 35.00% 30.00% 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% 2007 2008 2009 2010 2011 Google Yahoo Microsoft Baidu

Net Profit Margins have been increasing across the peer group over the last five years. This has been due to increasing sales with a bit of help from reduced effective tax rates.
Figure 8: Effective Tax Rate

Effective Tax Rate: Peer Group Trend

45 40 35 30 25 20 15 10 5 0 Google Yahoo Microsoft Baidu 2009 2010 2011

In 2011, Google generated 53.7% of Revenues outside of the United States with the majority in the UK and Japan where corporate tax rates are 28% and 38%. In addition with US corporate tax rates at 35%, Google still enjoys a 21% effective tax rate. Through our research we were able to determine that Google benefits from tax loopholes by using a technique that shifts most of its foreign profits through Ireland and the Netherlands to Bermuda, thereby decreasing taxes on foreign profits to 2.4% 9. We have
9

Bloomberg Inside Googles $1 Billion-a-Year Tax Cutting Strategy October 21, 2010

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seen Microsoft tax advantage of this as well and expect it to continue across the peer group. We are cautious as to the results of the coming US Presidential Election and the effect on corporate tax laws.
Figure 9: Current Ratio

Current Ratio: Peer Group Trend

12 10 8 6 4 2 0 2007 2008 2009 2010 2011 Google Yahoo Microsoft Baidu

The trend in Current Ratio for the peer group has been solid, consistently averaging a ratio over two. However, we found that Google has been accumulating cash at an accelerated rate. With over $44 billion in cash and cash equivalents we see significant opportunity to return cash to shareholders through, strategic acquisitions, share buy-backs, and or dividends. In addition, we see no threat of Google having excess cash trapped overseas. Currently, Google has $35 billion in marketable securities which are all U.S. based cash equivalent securities. That leaves $10 billion in cash, a $3.6 billion decrease from a year earlier. Some of this cash may be sitting overseas, however we feel Googles use of tax loopholes will allow it to bring cash back to the U.S. at lower rates. In turn, this cash will eventually be used for strategic purposes overseas where growth is still in its infancy.

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Figure 10: Debt to Equity

Debt to Equity: Peer Group Trend

25.00% 20.00% 15.00% 10.00% 5.00% 0.00% 2007 2008 2009 2010 2011 Google Yahoo Microsoft Baidu

Debt to Equity ratios have been trending upward for the peer group. With borrowing rates at rock bottom we believe that this will continue. Googles strong stable cash flows will allow it the ability to borrow at lower rates, something they were not able to do in the early stages of the companys development. We think this is a positive for the stock in rationalizing the capital structure.
Figure 11: Receivables Turnover

Receivables Turnover: Peer Group Trend

45 40 35 30 25 20 15 10 5 0 2007 2008 2009 2010 2011 Google Yahoo Microsoft Baidu

Receivables turnover has been strong for the industry as a whole yet declining. For Google, accounts receivable are typically unsecured and are derived from revenues earned from Google Network Members who are typically in the internet industry. Accounts Receivable has grown from 13% of sales

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in 2007 to 15% in 2011 and uncollectable accounts has increased from 1.5% to 2.4%. While significant increases, we do not feel this to be a significant concern in light of current economic conditions.
Figure 12: Accounts Payable Turnover

Account Payable Turnover: Peer Group Trend

140 120 100 80 60 40 20 0 2007 2008 2009 2010 2011 Google Yahoo Microsoft Baidu

Account Payable has been strong across the industry due to favorable position of key players with Google at the top. Accounts Payable has been an insignificant 2.2% of expenses. We feel that Google may have room to increase accounts payable in the future which should benefit the cash cycle.
Figure 13: Return on Equity

ROE: Peer Group Trend

60 50 40 30 20 10 0 2007 2008 2009 2010 2011 Google Yahoo Microsoft Baidu

Return on Equity has been strong across the peer group with the exception of Yahoo. Baidu is currently in the early stages of growth exhibiting profit margins near 45% which are reflected in ROE. Microsoft is

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in the mature phase highlighted by strong cash flows and share buy-backs which result in their high ROE. We feel that Google is somewhere in the middle showing strong growth and stable cash flows but has yet to utilize excess cash for shareholder friendly activities. Any action by Google on this front will provide a huge boost to Google shares.
Figure 14: Price to Earnings

Price to Earnings Multiple: Peer Group Trend

90.0 80.0 70.0 60.0 50.0 40.0 30.0 20.0 10.0 0.0 2007 2008 2009 2010 2011 Google Yahoo Microsoft Baidu

Price Multiples have been falling across the peer group over the last five years. We feel the industry as a whole is being undervalued relative to growth forecasted for the future. We next looked at the Price to Earnings Growth Multiple.
Figure 15: Price to Earnings Growth

Price to Earnings Growth Ratio: Peer Group Trend

1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0 2007 2008 2009 2010 2011 Google Microsoft Baidu

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We removed Yahoo from our analysis due to negative and/or flat earnings growth over the last five years. You will notice Google trading at a premium to Microsoft and Baidu, however we feel the market dominating position of Google affords it the ability to command this price premium. We are seeing PEG ratios at the low end for these growth companies and see this as a signal that the peer group is undervalued.

Valuation:
To arrive at our price target, we utilized a discounted cash flow model in conjunction with a price to earnings multiple and a comparable multiple analysis. We weighted each factor by 33.33%. To arrive at our earnings per share forecast we estimated revenue growth of 17% in line with analyst expectations. Our P/E multiple price was calculated by multiplying next years forecasted earnings of $44.57 by the lowest P/E multiple over the last five years which is 18.3, to arrive at a price of $815.63. 10 We feel that this is conservative in light of current conditions and expect price multiple expansion with any positive increase in consumer sentiment. Our comparable analysis utilized an EBITDA multiple given the wide applicability of this multiple across the industry. This analysis yielded a price of $787.99 based on an industry multiple of 12.6x and a 2012 EBITDA forecast of $16,135 billion. We used competitors that are in many respects similar to Google in terms of profitability and business segments.
Figure 16: Comparisons Across Peer Group

Company Name Market Cap Yahoo 19.0 Microsoft 258.3 Baidu 43.0 Google Mean Median 200.0

Selected Comparables EV/ EV/ Gross Revenues EBITDA Margin 3.3x 12.6x 70% 3.0x 7.1x 78% 15.7x 27.0x 73% 3.9x 7.3x 3.3x 10.6x 15.6x 12.6x 65% 74% 73%

EBITDA Margin ROE % 29% 9% 42% 38% 58% 53% 35% 43% 42% 20% 33% 38%

Our discounted cash flow model forecasted a price of $798.90. Our assumptions include a WACC of 12.2% and a 3% terminal value growth rate. 11

10 11

See Appendix V: Income Statement Forecast See Appendix VI: Discounted Cash Flow Forecast

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Independent Research Report Figure 17: Price Target

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Price Target P/E Multiple Value $815.63 Comparables Value $787.99 DCF Value $798.90 Price Target

33% $271.85 33% $262.64 33% $266.27 $800.76

Risks:
Ownership structure limits stockholders ability to influence corporate matters: Google has Class A and Class B common stock. Class A common stock is what trades on the Nasdaq Stock Exchange and is referred to throughout this report. Class B stock has 10 votes per share while Class A has one vote per share. As of December 31, 2011, CEO Larry Page, Co-Founder and Director Sergey Brin, and Executive Chairman Eric Schmidt beneficially own 92% of outstanding Class B common stock, representing approximately 66% of the voting power of the outstanding capital stock. This may adversely affect shareholders in the future if management does not make decisions for the benefit of all shareholders. See Appendix II for excerpt from company 10-K. Significant Reliance on advertising spending: With over 96% of revenues coming from advertising, Google has a significant reliance on the advertising market and industry. Advertisers can terminate contracts at any time if investment is not resulting in sales leads or if advertisements are not delivered in an effective manner. In addition, advertising spending tends to be cyclical, reflecting overall economic conditions and budgeting and buying patterns. Adverse economic conditions can have a material negative impact on the demand for advertising and cause advertisers to reduce spending. If the economy goes into a double dip recession earnings will be affected negatively. May be subject to legal liability associated with providing online services: Google recently accrued $500 million related to the Department of Justice investigation regarding the use of Google advertising by certain advertisers. The law relating to the liability of providers of these online services and products for activities of their users is still somewhat unsettled both within the U.S. and internationally. Claims have been threatened and have been brought against them for defamation, negligence, breaches of contract, copyright or trademark infringement, unfair competition, unlawful activity, tort, or theories based on the nature and content of information which they publish or to which they provide links or that may be posted online or generated by Google or third parties, including users. In addition, they have been subject to domestic and international actions alleging that certain content they generated or third-party content they have made available within their services violates laws in domestic and international jurisdictions. We expect these allegations to continue and any adverse ruling could have a material impact on the stock price.

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Appendix:
Appendix I: Employee Productivity

Highest Employee Productivity

1400000 1200000 Revenue Per Employee 1000000 800000 600000 400000 200000 0 2004 2005 2006 2007 2008 2009 2010 2011 Appendix II: Technological Innovation Google YHOO MSFT BIDU

Our ongoing investment in new business strategies and new products, services, and technologies is inherently risky, and could disrupt our ongoing businesses. We have invested and expect to continue to invest in new business strategies, products, services, and technologies. Such endeavors may involve significant risks and uncertainties, including distraction of management from current operations, insufficient revenues to offset liabilities assumed and expenses associated with these new investments, inadequate return of capital on our investments, and unidentified issues not discovered in our due diligence of such strategies and offerings. Because these new ventures are inherently risky, no assurance can be given that such strategies and offerings will be successful and will not materially adversely affect our reputation, financial condition, and operating results.

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Independent Research Report Appendix III: Porters Five Forces Industry Analysis

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Porter's Five Forces

Bargaining Power Rivalry Among of Suppliers (High) Existing Players (High) Customers are able to use Due to high Remaining any search engine industry players are available at no cost other concentration, increasingly than the cost to connect to advertisers are battling for the internet forced to place ads market share. through the three Microsoft now top players. powers the However, due to yahoo search inexpensive click engine and through rates, shares revenues advertisers use with yahoo in multiple ad order to campaigns. compete with google. Bargaining Power of Customers (High)
Appendix IV: Google SWOT Analysis

Threat of Threat of New Entrants (Low) Substitutes (Low) High Barriers to entry indicated by high market concentration, brand recognition of existing search engines, and technological expertise required to handle indexing and algorithms. Search engines are engrained in popular culture even though technology advances rapidly. We do not anticipate any game changing advances within the forceable future.

SWOT Analysis
Strengths Strong Brand Image provides distinct competitive advantage. Wide portfolio of offerings attracts customers which drives revenues Opportunities Strategic acquisitions. Rising Android market share. Robust outlook for mobile advertising. Entry into mobile payments market. Weaknesses Patent infringements lawsuits may affect financial results.

Threats Intense competition. Exchange rate fluctuations

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Independent Research Report Appendix V: Income Statement Forecast

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Independent Research Report Appendix VI: Discounted Cash Flow Forecast

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