12 November 2013
By Nick Griffin and James Tsinidis
On 13 February 2013 we published a note entitled, ‘Blackberry, Apple … is Google the next low hanging fruit’, explaining why we had rotated the portfolio out of our longstanding holding in Apple into our new largest position Google. Since that note Google is up 29% to US$1,011, while Apple has risen just 11% to US$519, with the S&P500 index up 17% over the same time frame. While this switch has worked well, we still think that Google has a long way to go. Below we highlight a couple of basic assumptions regarding the secular shift to online advertising that could see Google become the world’s first company to have a market capitalization of over US$1 trillion by 2020.
Getting Google to US$1 trillion…Roadmap
Google is currently the world’s dominant internet company. Via its core search business Google controls 60% of the world’s internet searches and 95% of all mobile internet searches. Google also owns the world’s largest online video platform in YouTube and the world’s largest mobile phone operating system in Android. Adding to these three prime assets is an entire network of free online services including Gmail, Chrome, Google Maps, Google Plus, Google Hangouts and Google Drive that are all designed to lead you, the consumer, towards Google’s search products, and those that advertise on them. Finally Google is also present in hardware via the Nexus and Motorola products and continues to experiment with new products in Google Glass and Self Driving Cars.
Google Search: Revenue CAGR of 14% per annum 2013-2020 as the shift to online media is still not reflected in advertising budgets.
Total advertising spend globally is expected to grow from around US$511 billion in 2013 to around US$720 billion by 2020 (in line with World GDP growth), a CAGR of 5%. In the online space this growth is likely to be even faster as advertisers continue to align advertising dollars with consumer habits. The chart below shows that in spite of the explosive growth in the time spent by consumers online and increasingly also on mobile platforms, advertising dollars have been relatively slow to follow. We would expect digital advertising spend to catch up fast with these changes, especially in the mobile area, and Google will be amongst the biggest beneficiaries of this shift.
Chart 1 - Ad Spend vs. Proportion of Time Spent on Media (US).
Online advertising, including mobile, currently makes up 22% of all advertising with a total spend of $115 billion per annum in 2013. Google’s core search business currently dominates the online advertising market with a 45% market share. If we assume that growth in digital advertising (desktop and mobile) continues to grow in line with media consumption habits to 36% of all advertising spend by 2020 from 22% today, then this would represent a 13% CAGR in Google’s core market to $260bn by 2020. Assuming Google can grow its market share of this market to 50% from 45% today in line with recent trends, then core Google search could command a $130bn run rate in gross revenue (pre-traffic acquisition costs) from its core market by being the primary beneficiary of the secular shift to digital advertising.
Chart 2 - Online as a proportion of total advertising, Google share of online advertising
You Tube: Also set to take a larger share of TV advertising budgets.
Via its YouTube business Google is now also aggressively going after TV advertising budgets, which still remain the dominant category for advertising spend globally. YouTube is the largest online video site globally and as such is uniquely positioned to drag advertising dollars away from traditional TV formats as consumers increasingly move toward online video consumption. YouTube has already progressed on this front, launching advertising before and during most videos watched online, as well as launching its own online TV channels and exclusive content. We currently estimate that YouTube has captured just 1.8% of the current $230bn plus global TV advertising budget. If this were to increase to 6% by 2020, a conservative estimate given YouTube’s dominant online market share and the dramatic shift towards online consumption, this would represent a further $20bn revenue opportunity for Google.
Chart 3 – YouTube as a percentage of total TV/Video advertising
Google’s Android business: Over 1 billion activations and still growing strongly
Adding to the above success in online and video advertising is Android. Android is a mobile phone operating system which Google gives away for free to mobile phone vendors who would like to build so-called “smart phones”. The system is currently used by 30 manufacturers including HTC, Samsung and Sony, amongst others. Google benefits from users being directed to Google Search and Google Maps, but also via users being directed to the Google Play store which sells apps and media downloads similar to the Apple iTunes store, where Google earns a commission.
The Android operating system has grown from essentially zero users 4 years ago to over 1 billion now, and it is currently growing at a run rate of 187 million activations per quarter. We see no reason why this growth can’t continue, which suggests that Android activations could reach 2.5 billion users by 2020. Assuming $5 in revenue per device via downloads from the Google Play store, this represents another US$12.5bn revenue opportunity for Google by 2020. While this number seems high today it is worth highlighting that all media consumption, online storage as well as apps for Android devices, will eventually go through the Google Play store.
Chart 4 – Android number of activations in millions (LHS) and revenue per activation in US$s (RHS)
Google: The multi-headed revenue monster
Adding these three core revenue drivers together, along with moderate growth in other non-core Google websites as well as Motorola, and subtracting traffic acquisition costs, we estimate that Google can achieve a US$130bn revenue run rate by 2020 (a 15% CAGR from around $50bn of net revenue today). As discussed, this growth will mostly come from Google capturing the secular shift of advertising dollars and media spend away from traditional sources towards online, and is not overly dependent on any significant economic acceleration over this period.
Valuation: So how do we get to $1 trillion?
The waterfall chart below shows our expectations for the key drivers of Google’s revenue growth between 2013 and 2020, by business unit / driver of business unit.
Chart 5 - Google Revenue Growth Forecast by Segment 2003 – 2020
Taking our basic revenue model above, and assuming Google can grow EBITDA margins from 45% today to 50% by 2020 via minimal operating leverage, then total EBITDA could reach $65bn in 2020. Rolling that forward one year and applying the same 12x EV/EBITDA multiple that Google trades on today, achieves an enterprise value of $895 billion by 2020. Add back the estimated $120 billion in net cash that we expect the group to have accumulated by 2020, we arrive at a market capitalization of over $1 trillion. Google’s current market capitalization is US$343bn with US$60bn in net cash. Assuming Google uses none of its cash generation for share repurchases then our EV estimate would equal a 290% rise in the share price over the next 7 years.
Even this may prove conservative as it fails to take account of any shareholder friendly capital management, any improvement from the hardware business in Motorola or any material upside from hobby projects such as Google Glass or the Self Driving Car. Risks to our analysis include any competition / disintermediation from key verticals, significant regulation of Google’s dominant position in the online world, higher taxation expenses (Google paid just 19% tax rate in 2012), or continued weak management of costs via hobby projects which would undermine our assumed margin expansion.
While clearly the actual outcome is likely to be different from our assumptions above, the exercise is nevertheless useful in highlighting that companies with a dominant position in an area of strong secular growth will benefit from improved earnings largely independent of economic conditions. The bulk of Google’s growth will come from consumers shifting to online media, a world which Google dominates now and where we expect the company will extend its dominance in the future (via Google search, YouTube and Android). Consequently, in an uncertain world, Google, trading at just 16.5x forward earnings ex cash, seems to us an obvious place to invest for absolute returns over the long term.
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