Google Keeps Investing Prudently

Jeremy Glaser: For Morningstar I'm Jeremy Glaser. Google earnings missed consensus estimates as expenses rose slightly faster than many had expected. I am here today with Rick Summer. He's our equity strategist for the technology sector. And we are going to get his take on the quarter.

Rick, thanks for joining me today.

Rick Summer: Yeah, sure thing.

Glaser: Let's first get your take on the top line. What does revenue growth look like for Google?

Summer: Revenues grew pretty strongly. We had 19% top-line growth, but actually n even a more interesting level, it's very hard to parse out with a lot of the new businesses that are growing. We are looking at the interesting advertising segment growing about 21%.

Glaser: Then how about profitability, when you look at free cash flow growth in terms of operating margin, is Google spending a lot more to get this growth?

Summer: They absolutely are spending more. Now we have some things that mixed up into the quarter. One is the Nest acquisition and some M&A activity. But more importantly, we are actually seeing free cash flow decline. We saw heavy investment and capital expenditures for data centers; growth in data center activity. That's something that really will depress cash flow margins going forward.

Glaser: Do you see these investments as being a positive for the long term, or are they just spending on projects like self-driving cars or Google Glass that may not turn into real businesses later.

Summer: This is a very important nuance which we think that those are very prudent in investments. But we do believe that returns on capital going forward are certainly lower than we’ve seen in the part of the last decade when they only had to invest in search. So looking at data centers and new products, these are really probably return-on-capital investments more in the 20% range, rather than more in the 40% to 50% range.

Glaser: If you expect those returns to decline over time, what does that mean you’re your valuation? What does that mean for where the shares are trading today?

Summer: We've been a little bit south of where consensus has been in terms of recommending the stock. But we really think it is fairly valued. [Our fair value estimate is] $520 today; the stock's trading a little bit north of that. It's a great core holding. The firm has really strong positioning and very prudent investments. It's just we are very sensitive to valuation around this name.

Glaser: And what does it look like compared with some of the other Internet names in terms of valuation.

Summer: I think that’s the best point. One point is it's a wide-moat, very much more of a low-risk, limited-downside name. Two, when you look at companies like Facebook and Twitter which we think are very well-extended past their fair values, Google looks extremely attractive in comparison to those names.

Glaser: Rick, thanks for your take on the quarter this morning.

Summer: Sure thing. Thanks Jeremy.

Glaser: For Morningstar I'm Jeremy Glaser.