Upside Remains for Google Shares

Jeremy Glaser: For Morningstar, I am Jeremy Glaser.

Google had another blowout quarter, and I'm here with senior analyst Rick Summer to take a look at the results and see what it could mean for investors.

Rick, thanks for joining me today.

Rick Summer: Sure thing. Thanks for having me.

Glaser: So, can you give us just your initial take on these earnings. Were they as good as the Street is saying?

Summer: One of the interesting things is we obviously had a very disappointing quarter here in the first quarter of this year, really by and large driven by high operating expenses. So, that expectation was really managed here for this second quarter. Top line: blowout, an absolute blowout. We saw a lot of strength in international, a lot of strength in core search, and really holding the line and toeing the line on those operating expenses versus where they were last quarter. So, everything that we look at, there is nothing really bad in the quarter that we can really point to here.

Glaser: They're not seen any headwinds from slowing economic growth at all?

Summer: No. I think ... this is one of the things that investors depending on the day, sometimes they have their nearsighted glasses on and sometimes they have their farsighted glasses on. After their earnings report today, it seems like they had their nearsighted glasses on, and they are forgetting about the fear, the fear of the regulatory headwinds that may face them, the fear about potential threats around social networking--those were all longer-term fears that sometimes hit this stock.

Glaser: So, social networking has been a big theme for Google recently. They launched Google Plus, their answer or their competition to Facebook or to Twitter. How do you rate the success of that rollout? Do you think it's going to be a success for them?

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Summer: It's way too early to tell. I would say that we've been very surprised really by the rapid adoption. We're looking at about north of 10 million users is what they had announced today, and that's only in two weeks--that you and I would like to start to a social network that had 10 million users. But largely it's 10 million people sitting around talking about Google Plus today. So, we'd really caution about being too excited about it.

Certainly from a functionality perspective, it is very impressive. From a product perspective, it's very impressive, but it's hard to have a social network without a network. So, we really need to see continued growth in that area to get more excited about it.

Glaser: You're not expecting any great financial performance from there anytime soon?

Summer: No. In fact, one of the things to think about--we're looking at about just south of 32% operating margins for the quarter. If we really look at them spending probably about $200 million a  year on Google Plus, that's actually artificially depressing what we think is ultimately what could be the profitability of the company. No financial return yet from Google Plus at all, and obviously heavy investing and heavy spending.

Glaser: Looking forward to the rest of the year, do you think Google will be able to keep this pace up or do you think they are going to see a slowdown?

Summer: From a financial perspective, we absolutely think they'll able to keep this pace up. Certainly we look at our own model, and we're very encouraged by what we're seeing; it is really validating a lot of what we believed and what we thought.

I think, once again, the surprise for a lot of people has been, they are still reliant on search, and they are not slowing down that much. So, you look at this huge behemoth of a company, and often when a company is a growth company, they start to deteriorate a lot more rapidly. Look at two things: lots of great short-term growth, and still heavy investment in longer-term objectives.

Glaser: You mentioned that some potential risks include regulatory changes or missing the boat on social networking. Is there anything else that worries you? Anything else that could come out of the blue that would really slow down the stock substantially?

Summer: That's a good question. Right now, particularly on the mobile front--and this is a little bit tied to the regulatory issue--but the mobile front is one of the key points to our thesis. They have been very successful in pushing out Android, particularly on a smartphone basis, but we think they will be successful from a tablet perspective as well.

That ecosystem is very key to extending their dominance beyond the desktop. So, we're obviously going to see a Windows phone launch at some point with Nokia on the smartphone, and Windows putting their tablet version forth as well. Those are going to be key to have Google actually fight that to be able to hold the ground and really keep that competition from eating into them at the same time. Relationships with developers are key. Relationships with these device manufacturers are key. So, we're really looking for anything that would cause any massive deterioration in those relationships.

Glaser: Microsoft certainly has a lot of money, they want to put behind these initiatives and try to push Google out of that space as the competitor to Apple. Looking at valuations, do you think Google shares makes sense for investors right now or is all of this good news baked in already?

Summer: You look at the aftermarket [price] today, I think the current price is about 20% to 22% below where our fair value is. We think it's worth about $720. Once again, we think it's a great core holding. We recommended it at a much larger discount, when it hit about $480 a couple of weeks ago. For holders, certainly this is something that investors should continue to look at. But, look, we've got some pretty reasonable upside here, and this is a large company that's really still investing in high ROI projects. This is a very difficult thing to find in technology.

Glaser: Rick, I appreciate you talking with me today.

Summer: Thanks for having me, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser.