Following a positive earnings report, Google’s stock took a beating for two days running after having risen close to an all-time high in the days before the earnings announcement, dropping from about $650 to nearly $600 before rebounding today. What caused the selloff?
Four factors seem to be relevant to the selloff in the midst of what seemed like massively positive financial news:
(1) A simple “sell on news” response to anticipated good news, based on a valuation that had already run up in anticipation of a positive outcome.
(2) After taking awhile to digest, the news that average search CPC’s declined significantly year over year began to sink in more with Wall Street, and this dark cloud outweighed the great news about the actual current cash flow.
(3) Regulatory and legal headwinds: major government privacy and antitrust investigations are ongoing and being renewed from various angles, and Oracle is suing Google for $6 billion.
(4) What sounded like it might be a positive use of cash from an investor standpoint — the announcement of a “dividend,” morphed into a “dick move” whose purpose was to issue more nonvoting shares to further solidify the founders’ share class and iron grip of control over the company by Page and Brin (and to some extent Eric Schmidt). Outside advice and input from shareholders, this signals, will be treated with increasing levels of indifference. Wall Street can think as one mind on issues like this and at least temporarily, seek to punish companies for transparency problems and governance structures the Street doesn’t like.
All of these factors probably had something to do with the selloff, but which really matters? #4 is probably the least likely to stick over the long haul. Markets and Wall Street cannot really “think as one mind” on corporate governance issues — opportunistic money is always going to jump in and scoop up shares if the price is right, defecting from any unspoken pact to uphold broader shareholder or Wall Street interests in a showdown with some relcalcitrant geek execs.
The issue is #2, but it’s unclear whether it should be an issue. Naturally, stock analysts want to look to the future to understand growth potential. What’s the mix among Google’s core and new businesses? How mature is the core business? Will the new businesses be high margin? A lot of number-crunching needs to go into finding an appropriate valuation.
Wall Street has known that Google would be an amazing financial juggernaut for many years, though it still had to play catchup after the IPO, where it underestimated the potential. The markets, over the long haul, have told the Google tale pretty well. If you were smart enough to understand the company at IPO time, you had a great return. The return in the first five years of the company’s status as a public company were phenomenal.
But Google’s stock has offered anemic returns in the past five years, during the time that it actually enjoyed its most eye-popping financial success. The stock has appreciated just 32% over the past five years. Since the beginning of 2012, it’s down 4.6%.
What do those dropping average CPC’s on search mean, anyway? Google won’t share full details, but at the end of the day it’s definitely fair to say that the search ads market is becoming mature, and future price increases in clicks will be gradual at best.
The Street may have made a slight mistake in diagnosis, however. For the year over year click price average to drop so much, it’s probably not coming from competitive keyword auctions across the board. Sure, some times are tough economically, but many advertisers are still growing and optimizing and are willing to pay premiums for good keywords — more so with each passing holiday season, especially. What has likely helped to drive those prices down is a relaxing of the stringency of Quality Scores at the low end of the auction. So that former white space in the “informational” query stream is now showing more ads selling in the range of a few pennies up to 30-40 cents. Why did Google loosen that up a bit? Probably to earn more total revenue (with no harm to margins). Wall Street may have assumed that a ton of advertisers are willing to pay less for “core” clicks. Not true.
Even with that error in judgment, though, Wall Street may be correct in its assessment of Google’s P/E ratio as fair in a modest range of 18-20. Google’s new lines of business have massive potential. Some are high margin, others are huge question marks. But the maturing of the very high margin core search ads business was inevitable, and eventually growth slows to a crawl. When the markets see evidence that Google’s mobile ads, display ads, social network, and other huge pushes are actually working from a financial standpoint enough to outweigh the risks and costs, it’s at that point the valuation might start to be a bit more forward-looking again. For now, everyone recognizes that Google is an amazing financial machine today, but the majority of analysts aren’t placing any huge bets on the Google of the future. That’s probably not a lack of recognition of the potential of Android, display networks, and all the rest; just a cautious balancing of those trends against the headwinds of regulators, lawsuits, competition from Facebook, possible blunders and distractions, etc.
In the meantime, the “mature” (ho hum) search ads business is incredibly robust, and on quality keywords, click prices aren’t really dropping across the board. Some industries have seen slight pullbacks, and some reckless advertiser behavior has been scaled back. Sounds like the kind of caution by advertisers you might expect in the second deepest and longest U.S. economic downturn in history. Just don’t get too comfortable with the idea of rock-bottom click prices on quality keywords. In this regard, Google’s financial reports are vague at best.