Google Brings Good Earnings But Uncertainty Prevails. For Now.

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Despite another strong earnings report, Wall Street is worried about the implications of Google’s management change. Is it a sign that things are not as good as earnings make them appear?
It has been an interesting several trading days in Google (GGOG) shares. After the close on Thursday, January 20th, GOOG reported very good 4Q10 earnings. EPS easily exceeded expectations on much better than expected revenue growth. The top line benefited from rising searches, rising revenue per search, and continued growth in new growth initiatives in display advertising, mobile advertising, and YouTube. While coming in way ahead of street expectations, EPS growth would have been even higher if not for another quarter of heavy investment as GOOG seeks to sustain its lead in search and build display, mobile, and YouTube into material, new growth drivers.
When the results were first reported, GOOG shares soared about 4%. Investors have finally become comfortable rewarding GOOG for top line growth even if it comes with a price of higher operating expenses. The gains did not last long, however, as GOOG simultaneously announced a major shuffle of its top management. Eric Schmidt, long time CEO, was moved out of his operating responsibilities and replaced by Google co-founder, Larry Page. Schmidt, Page, and Sergey Brin, Google’s other co-founder, came on the quarterly earnings conference call to reassure investors, but GOOG shares quickly reversed, giving up most of their gains.
Several things seemed to worry the street about the management change. First, Schmidt is well thought of and despite being at Google for 15 years is still viewed as a bit of an outsider, offering mentoring and positive influence to a company still dominated by its founders. Wall Street has liked Schmidt being a check on the founders. Second, Larry Paige, while acknowledged as a visionary, is not thought of us an operating manager. Furthermore, his strengths do not align with a CEO’s typical role as the face of the company, particularly to Wall Street investors. Finally, the need to shuffle top management was interpreted as a sign that Google’s competitive positioning and growth outlook might not be as strong a recent string of positive earnings reports suggest. Facebook and social media and Google’s lack of success in its own social media initiatives are a worry that had been put on the back burner as search growth reaccelerated and new initiatives kicked in. Now Wall Street is asking whether the management change is sign of weakness?
Friday morning saw most Wall Street analysts defend GOOG and reiterate their buys while raising their target prices. This did little good as the shares were being sold and down from prices immediately before the earnings report. The stock really plunged in final half hour of Friday trading when it was announced that Schmidt would be selling 6% of his GOOG shares over the course of 2011. Selling continued into Monday morning with a low of about $600, a full 4% or $25 below the pre-earnings/management change announcements. The stock had sold off about 8% from its high immediately after the earnings were reported. Over the past 24 hours, the stock has begun to find its footing and regained about 3% but it still sits below its pre-earnings level.
I provide this recap mainly to educate Media Talk readers about the crazy ways of Wall Street, particularly in regard to short-term trading. Perception often drives trading and earnings are often discounted ahead of the actual report. In this case, we have a company that based on its most recent quarterly results is stronger than expected but uncertainty has been introduced via the management change.
I continue to have great confidence in Google’s earnings and growth outlook and feel the stock offers a lot of bang for the buck. A P-E of 15 adjusted for massive and growing cash balance seems like a good deal for a leading growth stock that has the potential to sustain EPS growth of 15-20% for the foreseeable future. I concur with analyst targets of $700 plus and will continue to hold Google shares in Northlake client accounts, the Entermedia hedge funds, and my personal accounts.
Disclosure: Google is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts. Steve is sole proprietor of Northlake, an SEC registered investment advisor. Google is a net long position in the Entermedia Funds. Steve is co-portfolio manager of Entermedia, owns a stake in Entermedia’s investment management company, and has personal monies invested in the Funds.

Apple Reports “Beat and Raise” in an Unusual Occurence

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Following the disclosure that Steve Jobs would take a medical leave of absence, Apple reported another in a string of incredibly strong quarterly earnings reports. The reported numbers easily beat expectations. Revenue upside came mostly from higher than expected selling prices with unit volumes in line with the high end of expectations. iPad volumes were a bit stronger than expected, while iPhones missed some whisper numbers.
iPad expectations had come in a bit on supply constraint concerns and worries that the new MacBook Air would cannibalize. Those issues did not appear. iPads look set to accelerate further as U.S. demand is robust and many new countries are being added. iPad 2 is also due and will have a few missing features likely to stoke demand further (camera, Facetime, bigger viewing area, even better display).
iPhone unit shipments would have been higher had the company been able to produce enough phones. Management admitted it is struggling to meet massive global demand for iPhones. The iPhone supply constraint was the only real negative in the quarter or the conference call. The issue would be that consumers would opt for an Android phone instead, losing a potential sale for several years at least and improving the Android ecosystem via more users. I do not consider this a big problem but when dealing with a high flying stock like Apple any minor issue deserves examination.
The bigger story for the stock coming out of the quarter was guidance for the March quarter. Management guided revenues and EPS above street estimates. This is a very rare occurrence for Apple, which usually guides conservatively and below analyst estimates (although ends up easily beating both). I only remember one other recent quarter when Apple produced what Wall Street likes to call a “beat and raise” quarter. The stock acted very well in response.
This time, however, Apple shares have retreated since reporting, something that seems to generally be the case. Apple shares often rally into the quarterly number, already building in the upside. That seems to be what happened this quarter, exacerbated by general selling pressure in the stock market, led by technology stocks. I also think the rally in the shares off the lows on Tuesday following the Jobs health news set up a second chance for investors who wanted to lighten positions on the health concerns.
I feel extremely strongly that Apple shares will move to significant new highs, $400 or higher, later this year. Earnings in fiscal year 2011 now look like they will be at least $23. Yearend cash on the balance sheet should be around $70. A P-E of 15 times just the earnings (cash is earning minimal amounts) gives the underlying business value of $345. Add in $70 in projected cash and $425 is a good target.
Disclosure: Apple is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts. Steve is sole proprietor of Northlake, an SEC registered investment advisor. Apple is a net long position in the Entermedia Funds. Steve is co-portfolio manager of the Entermedia, owns a stake in the Funds’ investment management company, and ahs personal monies invested in the Funds.

Good Thoughts on Jobs and Apple

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Walter Piecyk, an analyst I know at BTIG, wrote the following brief comment on Apple and published it this morning. The volume of Wall Street commentary on Apple this morning is enormous as expected. Walter’s note best captures my thinking so I reproduce it here with the hope that Walter and BTIG don’t mind.
“The knee-jerk reaction for a stock like Apple would be to buy on dips and that would certainly be following the advice of most analysts this morning. The chorus of buy on weakness calls could certainly temper the sell off today in front of a quarter when, as usual, the consensus is well above guidance. That sets up for a pretty risky 24 hours given how the stock has reacted in the past from slight deviations in items like gross margins and units not to mention the risk of any commentary on the call that provides more details about Jobs’ health or the coming quarter. We continue to believe that Apple is the best way to play the explosion of smart phone and tablet growth, but we don’t think investors need to be more aggressive than normal when the sell side is pounding the table the day of an EPS report.
Valuation multiples are driven by growth and risk and when you introduce increased risk, the multiple of a stock should contract. Steve Jobs’ medical leave increases the risk at Apple both in terms of near term execution as well as the long term growth potential of the company so investors should not be surprised by the sell-off in Apple’s stock this morning. Investors will soon have a new data point to consider when evaluating growth and risk this afternoon when the company reports its first fiscal quarter of the new year.
We are believers that one person, particularly the CEO, can make a material difference in an organization, whether that difference is for the good or the bad. In any organization the tone is set at the top. We have seen companies like Motorola and Sprint spend years and in some cases multiple CEO’s trying to undo a losing culture. We believe Jobs has installed a winning culture and a focus on quality that will have a lasting impact at Apple whether he returns or not. More specifically, product roadmaps are not developed overnight. Jobs product decisions and direction will be felt for at least six quarters before investors have to worry about the decisions made by any replacements but a stock like Apple might look out at growth estimates beyond six quarters.”
Disclosure: Apple is widely held by clients of Northlake Capital Management, LLC, inlcuding in Steve Birenberg’s personal accounts. Steve is sole proprietor of Northlake, an SEC registered investment advisor.

Shifting to Mid Cap and Sticking with Value to Start the New Year

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Northlake’s Style model shifted back to Mid Cap for January after a three month run at small cap. As a result, client assets dedicated to the Core and Explore strategy shifted their investment from the Russell 2000 (IWM) into the S&P 400 Mid Cap (MDY). The Style model was unchanged for January, sticking with the value signal. Client positions in the Russell 1000 Value (IWD) will be maintained.
The Market Cap model has been vacillating between small cap and mid cap over the past six months. There is no real message there. Rather the favoring of small or mid cap over large cap is a sign that the economic recovery is proceeding and interest rates are low. These conditions favor the more volatile asset class with a higher risk-reward tradeoff. For January, there were actually no shifts in the underlying factors making up the Market Cap model. The model uses a two month average and last month the slight uptick in interest rates, which accelerated in December, had moved the one month reading to mid cap. The January update confirmed the prior month reading and shifted the two month average to mid cap.
The Style model has moved back pretty firmly into Value territory after a one month stay at growth in November. I would expect February to once again signal value based on the current readings of the model’s underlying factors. The Style model is also signaling a firming economic expansion with conditions that favor continued strengthening. These include low interest rates, a steeper yield curve, and investor appetite for risk. Value is also sensitive to the performance of financial stocks. Banks led the rally in December, pushing the technical and trend indicators that contribute to the Style model deeply in favor of value.
Last month, both model signals proved accurate, capping off a great year for Northlake’s models. IWM gained over 7.5%, about 1% more than the S&P 500 and S&P Mid Cap 400. For the year, the Market Cap model returned just over 28% vs. a little under 13% for the S&P 500 on a price only basis.
In December, IWD was also up about 7.5%, beating the S&P 500 by 1% and the Russell 1000 Growth (IWF) by almost 2.5%. For 2010, the Style Model earned over 1%, also about 2.5% more than the S&P 500 on a price only basis.
Both of Northlake’s models did their job well in 2010. Here is a New Year’s wish for more of the same in 2011!
Disclosure: MDY and IWD are widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts. IWM is a core holding for select clients of Northlake. Steve is sole proprietor of Northlake, an SEC registered investment advisor. IWM is currently a short position as a hedge against much greater longs in the Entermedia Funds. Steve Birenberg is co-portfolio manager of Entermedia, owns a stake in the Funds’ investment management company, and has personal monies invested in the Funds.