Friday, April 21, 2006

Bloglines - Great Quarter, But...

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Great Quarter, But...

By Henry Blodget on Google

Grumpy I am occasionally perceived as a Google basher, so I have to be careful here.  Let me first say that the company's revenue and operating margin were, once again, tremendous.  Google surely has all (or at least most) of the opportunity that its fanatics say it does, and the team appears to be executing superbly.  So please take the following observations in that context.

And now for some nits:

  • Revenue growth continues to decelerate modestly year-over-year.  This is not a sign of a problem, but simple inevitable.  Just as inevitable, however, is that deceleration will lead to stock-multiple compression (which it already has).  The company's profit margins are also peaking (EBITDA margin was down y/y).  This means that profit and cash flow will lose a major growth driver--margin expansion.
  • The company's exclusion of stock-based compensation (specifically, GSUs) from non-GAAP earnings is ridiculous.  Yes, everyone who owns the stock wants the numbers to look as good as possible, and, yes, so many people own the stock that George probably gets nothing but hosannahs for excluding such expenses.  But they are expenses.  And, unlike options, which are also expenses, they will cost shareholders money even if the stock permanently tanks.  The end result of such exclusions is that the pro forma numbers (and multiples applied to them) aren't meaningful.  If anyone wants to offer a defense of this practice other than "The numbers look better that way," please do so.  Because I've never heard one.
  • The company's CAPEX spending is more than twice that of its closest competitor and is not to be believed.  This spending will presumably increase the company's competitive advantage, which is positive.  But it will also continue to eat cash flow.  The company says CAPEX growth will exceed revenue growth for this year.  Assuming revenue growth is in the 65% range, that could put full-year CAPEX in the $1.5 billion range (one Street estimates is now $1.7 billion).  This spending has a direct impact on Free Cash Flow.  Contrary to early predictions, moreover, it is showing no signs of declining now that the company has had a chance to catch up with its early growth. 
  • Because of the massive CAPEX, combined with a reclassification of some tax benefits for stock options, reported free cash flow was $480 million, up only modestly from Q4.  Unless everyone ignores the reclassification (which they may),  2006 Free Cash Flow will likely be in the neighborhood of $2.5 billion, not the $3 billion-plus many are looking for.   This makes the stock more expensive than meets the eye. 

Because of the exclusion of GSUs, et al, as well as the hyper-fluctuating tax rate, I don't find the company's EPS numbers (either of them) particularly meaningful as valuation measures.  Because of the massive CAPEX, I don't find EBITDA particularly meaningful either.  And that leaves Free Cash Flow.

At $450/share on $2.5 billion of FCF, we're back up to about 55 times Free Cash Flow.  Is it possible that the stock is worth this much?  Yes.  But in the face of ongoing deceleration and a march toward an eventual margin peak, it certainly doesn't leave a lot of room for error.

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