At The Motley Fool, we poke plenty of fun at Wall Street analysts and their endless cycle of upgrades, downgrades, and "initiating coverage at neutral." Today, we'll show you whether those bigwigs actually know what they're talking about. To help, we've enlisted Motley Fool CAPS to track the long-term performance of Wall Street's best and worst.
Google mauled by bear
Alas, poor Google
According to Morgan, Google+ won't be enough to save Google's market cap. In fact, it might even hurt the stock. You see, taking on Facebook, as Google is doing, costs money. StreetInsider.com quotes Morgan complaining about the money Google will spend "to innovate in social/local, retain talent, and … drive user adoption of key products." The problem, to Morgan's way of thinking, is that there's no way of knowing whether all of this spending will pay off in the form of profits -- or, even if it does, how long we might have to wait to see those profits.
Show us the money
What we do know, or what Morgan Stanley thinks it knows, is that investors won't see much benefit from Google's spending in the near term. While Google continues to own rivals Microsoft and Yahoo! in search, generally, Morgan's not enthusiastic about the potential for Google subsidiaries DoubleClick and AdMob to contribute meaningfully to revenue this year. Likewise, no matter how many Android phones Motorola
Meanwhile, the costs add up. In the short term, Morgan warns that Google's adjusted EBITDA margin will decline from the upper 60s it regularly recorded earlier this decade and down through the 60% level we saw last year, before finally plateauing near 50% mid-next year.
That's bad, right?
It's hard to say. Morgan's decision to go with EBITDA, adjusted to exclude stock-based compensation, makes it hard to verify its numbers through independent data providers that may count the numbers differently. Standard & Poor's superb Capital IQ service, for example, shows that pure EBITDA margins at Google have erformed opposite to what Morgan Stanley claims is the trend for adjusted EBITDA. After falling into the low 30s in 2007 and 2008, Google's margins bounced back to 36.3% in 2009 and then inched up even further to 36.5% in 2010.
Now, Morgan Stanley could well be right that greater spending on business development will chip away at margins in the near term. I don't think, though, that we're looking at anything like the multiyear, 68%-to-50% steady slide that Morgan depicts in its reports. Whatever else Morgan may be right about, the numbers I'm looking at do not show a vaporization of a quarter of Google's profit margins. Quite the contrary, actually.
Foolish final thought
I still have to agree with Morgan Stanley on its ultimate decision to downgrade Google to "equal weight" (translation: "hold") from the previous "overweight" rating.
I don't do this willingly, mind you. But it's what the numbers require. Consider: Right now Google is generating free cash flow at the rate of about $7 billion a year. That's less than the $8.3 billion in annual net profit it reports under GAAP accounting standards. It's so little FCF that, even if you credit the company for its $31 billion in net cash on the balance sheet, it still prices Google at an enterprise value-to-free cash flow ratio of 20. With consensus growth expectations for the company now hovering below 18% (annually, over the next five years), this makes the stock look only "fairly priced" to me today. And if Morgan Stanley should turn out to be right about earnings coming in 4% to 5% below the consensus … well, obviously, that wouldn't be good for the stock.
Fools, I truly hope Morgan Stanley is wrong about this. I own Google stock myself, after all. But the numbers I see are telling me that things could get worse before they get better.
The Motley Fool owns shares of Microsoft, Yahoo!, Google, and Apple. Motley Fool newsletter services have recommended buying shares of Google, Yahoo!, Apple, and Microsoft, creating a bull call spread position in Apple, and creating a diagonal call position in Microsoft.