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Wide-Moat Search Business Still Google's Growth Engine

Jeremy Glaser

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Google reported a 61% rise in first-quarter earnings. I'm here today with Rick Summer, our senior equity analyst who covers Google, for a closer look.

Rick, thanks for joining me.

Rick Summer: Thank you.

Glaser: Let's start with the core of Google search and the text ads the company serves with its search results. What's happening there? Is Google still just driving most of the business from this part of the company?

Summer: Yes, absolutely. This is still primarily a search company. We talk about this a lot, where we really think Google has a big wide moat around the search capability. What we saw yet again, the company has held onto market share, and we're seeing search spending continue to go very dramatically at the same time. We're looking north of 20% growth in search year over year. Google has continued to hold onto its fair share of that and more, in spite of the fact that there's more of a sensitive pricing environment around each individual ad unit at the same time.

Glaser: Even though Google is serving more units, it is actually getting less money for each of them. Is that a trend do you think is going to continue? Is that a long-term threat for the company?

Summer: This is one thing that we really think doesn't matter in isolation. So, when you really think about it, if you and I as an advertiser wanted to spend $100 million on advertising, I as a company am more concerned that you want to continue to spend $100 million. I don't care if I give you 20 ads or 40 ads because ultimately I'm getting conversions for you; I'm getting return on investment for you at the same time.

What we're not seeing is, we're not seeing an advertiser pull back, an advertiser decrease its demand for advertising. Generally speaking, the way the auction algorithm is run, Google can actually tweak what pricing ends up resulting from that and end up changing conversions for the advertiser.

Glaser: So, let's take a look at mobile. Android has also become a large part of the market. Did you get any color on where Android is going and how exactly Google is going to take the Motorola Mobility acquisition and be able to deal with that and keep the rest of its Android handset partners happy?

Summer: Sure. So, I think, there's three things to look at there. I think, one, we didn't get a lot of real significant update around Android. We know activations are just being blown out of the water. They are doing tremendously well, continuing to grow Android market share in the smartphone environment across the globe. We know that's been a real boon for the company.

I think, two, is that we're starting to see from a mobile ad-inventory perspective Google is able to start to present mobile ad inventory to advertisers as unified as a display ad inventory at the same time. So, that becomes interesting not only for Android, but anywhere where Google's AdMob unit is which includes Apple iOS devices.

I think third thing to look at, and this is the first time we've really heard a lot of allusion to this, is that CEO Larry Page started to talk about tablets and the importance of tablets. More importantly, he mentioned that Google feels that low-end tablets are going to be real beneficial for Android. So, we're going to see cheaper-priced tablets in a place where Apple as of yet has not come as a premium price device maker at the same time. Is this Google's strategy longer term? That will be interesting. In the acquisition of Motorola Mobility, that is certainly not the cheap device maker at the same time; Motorola's always come in as a premier device maker. We don't think that that's what Google means when it's talking about that.

For Motorola Mobility, there was not a lot of update there. The companies are still planning on closing in 2012. We're having a little bit of review going on in China for them to be able to prove that acquisition.

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Glaser: It seems like there is still a big question mark over that. Another question mark for Google is social media. Social was in a lot of people's mind this week after Facebook announced it is spending $1 billion for the photo sharing app Instagram. Did Google have any update on Google+? Is that gaining traction, and is it important for Google to be in that social space?

Summer: I think two things apply here. I think, one, it is important for the firm to be in the social space. We received an update again, and Google said it's reached about 170 million users. But that's not of users who are going to Google+ as a destination, and the company actually admitted that and was very upfront about that after the backlash from last quarter's earnings release.

But the interesting thing about that is we look at that in the same way we look at Facebook. It's a way of Google following you around the Web, as nefarious as that may sound. That's very important for you and I to be logged on to Google services, so the company can serve us ads and not only that understand what we're doing not only in search, but also in browsing capability at the same time. That is very interesting.

In terms of a social destination, it's still the real early days for Google. We had never been incredibly bullish on Google's ability to really create a social network from scratch. It will be interesting. To us it's interesting that Google continues to pass on acquisitions. It never came to terms with Twitter. Certainly, it absolutely looked at Instagram and didn't feel that that was the glue that would take Google's service to that next level at the same time.

Glaser: So, let's talk about the dividend. Google is going to pay a dividend of nonvoting shares, essentially a stock split. Can you talk a little bit about why the company is doing this right now and what if any impact it has on investors who are interested in Google stock?

Summer: I think generally it's a way of creating a lower share price for more of a retail investor at the same time. Obviously, the interesting component is the fact that it is a stock dividend of nonvoting shares. Although economically it looks a lot like a two-for-one stock split, it's not exactly that. Primarily, this will allow Larry Page, [co-founder] Sergey Brin, and [executive chairman] Eric Schmidt to continue to ratchet down their investment in Google. It's obviously a large percentage of their wealth.

Is this something that really changes our thesis going forward? Not tremendously, whenever the executives sell a nonvoting share, they are going to be required to sell a voting share up to a point. So, it's going to look a very similar to the way it does today. Is it unorthodox? Absolutely. Companies of strength have that ability sometimes to be able to push through things that are perhaps less traditional from a corporate governance perspective.

Glaser: Finally, on valuation, is this a good entry point for investors looking at Google?

Summer: We would like a bigger discount. The shares are still trading in a price range to warrant a Morningstar Rating for stocks of 4 stars. Our fair value estimate is at $780. This isn't something we pound the table on, but if it fell to the low $600s, we'd get really excited about it. Right here, some risk is priced in. We think too much risk is priced into the stock. For anybody who holds it, the stock is absolutely a very strong core holding, and we think it will outperform in the market over time.

Glaser: Rick, thanks so much for your thoughts.

Summer: Thanks.

Glaser: For Morningstar, I'm Jeremy Glaser.