Thursday after the market close, Google (GOOG) will report June quarterly earnings with consensus expectations calling for EPS of $6.78. This is down from the $7.05 consensus of 90 days ago.
Remember GOOG's last report in April? They missed the consensus number by 10 cents (1.4%) and the stock fell $50 (8.6%) from $580 to $530 the day after.
Given that the "king of the web" had now fooled the Street more than once in the past year, and expectations about earnings momentum for this high grower were declining, I thought the stock had already entered a liquidation phase by institutional fund holders. In my opinion, the gap below $550 confirmed it was a broken stock, at least in the short term.
Commence Liquidation
Based on that view, on April 15, I recommended two different bearish put trades for TheStreet.com subscribers, one aggressive spread which targeted the stock to fall below $525 and one conservative play which only needed it to stay below $550 to make a 40% return on risk.
Most of May and June saw a constant sea of selling for GOOG shares, taking the stock down to $475 as the broad market threw a lot of good names overboard during the spring swoon. That was slow liquidation by lots of intuitional investors who own the stock at good levels in the $300's and of course, those who may have bought more recently near $500, or even $600.
The put spreads I did targeting profits below $525 worked out well in both May and June expirations as fear prevailed. And obviously, the in-the-money 600/550 put spread realized its full potential profit as GOOG stayed below $550.
Gosh GOOG Got Cheap Again
This selling of a company with over $30 billion in revenues and expected profits of $9.5 billion this year — and a forward P/E multiple of under 18 times — would eventually reach a climax. And big investors who liked that valuation and those numbers, representing 12% growth from 2010 net income of $8.5 billion, came in and bought the stock below $500 and took it all the way up to $550 last week.
So the question now is: "Is GOOG fairly valued around $535?" And another good question would be: "What if they surprise and beat the number, or up their forward guidance?"
As I wrote last week when I pitted Google against Chinese upstart Baidu (BIDU), the heady growth days for the leader have been leveling off, so while we are close to fair value, there are other alternatives for fund managers. Here's what I wrote: BIDU vs. GOOG…
Searching for Growth
Speaking of growth, which is the better web search giant to buy? When Google was still a solid growth stock, I always tried to buy the dips. For instance, last September when GOOG pulled back to $450, I recommended for TheStreet.com readers a January 2011 450/500 bull call spread for about $25. That spread earned a nearly 100% profit as the stock soared quickly back above $500.
Now this was actually a time where growth was leveling-off for GOOG since its last trip to $600. I didn't know it at the time, but GOOG was starting to earn some sell ratings from the Zacks Rank since its fall from grace in the spring of 2010 on the heels of the exit from China.
In other words, analyst EPS estimates were starting to level-off, if not come down, from projections which always seemed to guarantee a forward P/E multiple below 20. And this was reflected even more in earnings misses in the June quarter of last year and the March quarter of this year, after which the stock took a dive both times.
GOOG Takes a Dive
The writing was on the wall after the last quarterly report that institutions were in "distribution" mode. In mid-April, I recommended several put trades to subscribers of the options letter I wrote for based on the logic that the stock was "broken" and would not recover the $550 level any time soon.
There will always be opportunities to trade GOOG from the chart and valuation, and combining these entry points with the Zacks Rank which currently sits at #4 (sell). But the one to watch now is Baidu, whose chart is a thing of beauty and whose current Zacks Rank is #1 (strong buy).
But if Google is projected to earn over $35 next year, that gives it a compelling mid-teens forward P/E multiple. Why should we buy BIDU currently trading at over 35 times? Because it's the trend in analyst estimates that makes the difference.
While GOOG estimates continue to come down and the growth rate slows, BIDU is seeing steady upward revisions to earnings estimates and that growth rate makes analysts and investors lick their chops.
Google's Scale Incompatible With Innovation?
It's one thing to talk about Google's monopoly of all things web and search related. It's another to look at where the analysts believe growth will come from. Currently, the EPS consensus estimate for the June quarter is $7.15. But that is down from $7.49 90 days ago. And that dropped the full year 2011 from $30.47 to $29.50. Estimates for 2012 also fell considerably and thus the Zacks Rank of 4 (sell).
So it appears that GOOG is fairly valued somewhere between $450 and $550. Why? Because 20% growth for 2012 EPS may be well priced-in near $550 and this growth is no longer as compelling for portfolio managers compared to a company like BIDU. A positive earnings surprise of any significant meaning is also unlikely.
What else might they see in their earnings crystal ball? Maybe that Google's size won't support much more attractive growth. I recently wrote about the "scale vs. innovation" theme after I heard the CEO of Motorola Mobility (MMI), Sanjay Jha, comment on the potential internal threats to the Apple (AAPL) empire:
Sanjay spoke broadly about the challenges of any giant tech success, saying that "scale and innovation very often don't mix." He explained this decline-and-fall thesis by focusing on what tends to happen when a company is faced with defending its large market share and its competitive advantages.
"Defensive actions very often set in and middle management begins to drive the culture and strategy of a company. Not speaking about Apple in particular, but with the scale that comes with that level of success, very often is in itself the beginning of a decline sometimes."
I think both Google and Apple will remain at the top of their games as innovators. But it's the earnings estimates of much smarter analysts than I that drive the buy and sell decisions of portfolio managers. Apple, by the way, is currently a Zacks #3 Rank (hold) and its earnings story appears to be intact. Given that, I would put money into Apple, and of course Baidu, before putting money back into Google.
Disclosure: I have no positions at this time in any issues mentioned. Kevin Cook is a Senior Stock Strategist for Zacks.com.
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