Tuesday, June 28, 2011

Are Cloud Apps A Catalyst to Add Google to Your Portfolio?

Google (NASDAQ: GOOG) is saving large organizations millions by persuading them to swap Microsoft (NASDAQ: MSFT) Office applications for Google's so-called cloud-based software as a service. Should you add Google to your portfolio?

At least one 25,000-person organization, InterContinental Hotels, has taken its employees off Microsoft email and Office applications and on to Google's Cloud Apps, according to the New York Times. For a typical business, Google charges $50 per user per year to use its email and office applications that are delivered from Google's computing systems. InterContinental estimates that Google Cloud Apps will save it millions.

And InterContinental is not the only one to stick a knife in the heart of Microsoft's $20 billion a year, 60% operating margin Office business. Here are others that switched to Google Cloud Apps, according to the Times:
  • The National Oceanic and Atmospheric Administration, (25,000 employees)
  • State of Wyoming, (10,000); and
  • McClatchy Group (8,500).
Microsoft is fighting back by introducing its Office 365 for $72 a year. While the idea of competing with Microsoft Office has been around for a while, Google appears to be the first to gain significant traction -- it has improved its offerings considerably since they were first introduced.

Google's revenues from these four alone could total $3.4 million (assuming they are paying full price) and almost 100% of Google Cloud App customers renew the service. Most likely, these employees are likely to be drawn in to other Google revenue generators so the relatively tiny Cloud App revenues could benefit Google in other ways.

Nevertheless, an investor in Google shares at this price, must consider the rest of its business and whether Google has the potential to deliver compelling upside surprises beyond Cloud Apps. Google stock had a great run between its 2004 IPO at $80 a share and its September 2007 peak of $567 -- rising at a compound annual growth rate of 92%. But the stock has since bounced around and is now trading 15% below that peak.

Nevertheless, Google's financial performance has been spectacular. In the last year, its revenues were $31 billion, up 36.7% a year over the last five years. And its net income of $8.4 billion rose at a 5-year average annual rate of 42.2%. Meanwhile Google's cash balance grew at an annual rate of 33% to $35 billion at the end of 2010 since 2006 while holding barely any debt.

Google's most recent quarterly performance was worse than expected due to its massive hiring campaign. In the first quarter of 2011, Google's net income of $2.3 billion up 18% from the year before, or $7.04 per share, compared favorably to 2010's $6.06 per share. Its adjusted EPS of $8.08 per share was three cents below analysts surveyed by FactSet.

While Google revenue was about $8.6 billion, up 27% and 37% better than analysts expected, Google's expenses grew faster than revenue -- with Google adding 1,916 employees to end March 2011 with over 26,300 workers.

Is Google investing too much in its human capital to generate a positive return to its capital providers? No way -- it is earning huge returns on capital. After all, it’s producing positive EVA Momentum, which measures the change in “economic value added” (essentially, profit after deducting capital costs) divided by sales.

In 2010, Google’s EVA momentum was 3%, based on 2009 revenue of $23.7 billion, and EVA that grew from $3.1 billion in 2009 to $3.9 billion in 2010.

And Google's stock valuation is reasonable — trading at a price-to-earnings-to-growth (PEG) ratio of 0.94 (where 1.0 is considered fairly valued). Google’s P/E is 18.7 on earnings expected to climb 20% to $35.43 a share in 2012.

While I don't expect Google Cloud Apps to make a big difference in its overall revenues, Google stock is likely to pop if all those new employees can invent services that actually generate new sources of revenue growth.

At its current price, there could be more risk by not investing and missing Google's upside over the longer-term.


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