Google Pullback Presents Opportunity

Didn’t get any shares of the Google (GOOG) IPO? You’re not alone. Like the majority of buy side firms, Peridot avoided bidding in the Google dutch auction after the company set a high price range ($108-$135) and disclosed little information about the company’s future growth strategy. Tempered demand brought the IPO price down to $85, a much more reasonable price, but if you passed on bidding in the first round you couldn’t lower your bid when the range was lowered. The stock opened up $15 to $100 per share as some investors decided a sub-$100 price was a good bet.

In the following few months, Google stock doubled from its first day close to $200 a share. Headlines popped up everywhere that 1999 was back again, that we had learned nothing from the bubble. However, the skeptics had forgotten one important thing, Google actually makes money. The reason why stocks like Ariba, Commerce One, and crashed from $100 to $1 was because their business models were flawed; they didn’t earn a dime. In 1999, analysts were justifying astronomical equity valuations by looking at revenues, not profits. Conventional wisdom back then was that with the increased use of the Internet, eventually the companies could turn sales and page hits into earnings.

For most companies, though, that never materialized and the stocks collapsed accordingly. There were, however, a select few that have survived, and not only survived, but thrived. eBay, Amazon, Yahoo, Interactive Corp, to name a few. Their market caps have risen steadily since the bubble burst for one simple reason, they are making a lot of money and still growing very quickly.

So, let’s come back to Google, which recently hit $200 before pulling back to the 160’s on concerns over its upcoming share lock-up expiration. There is one reason why those who got the Google IPO in August paid $85 and yet someone was still willing to pay $200 in November. Earnings. In the summer investors severely underestimated how much Google could earn. The initial earnings per share estimate for 2004 put out by the analysts was $1.31, giving Google a p/e of 65 at the $85 IPO price. Google’s growth rate was expected to be about 40% per year, about 10% sequentially for the foreseeable future. Understandably, many investors thought that, at best, Google’s IPO was fairly valued.

However, in October Google reported its first qaurter as a public company and it was a blowout. The analysts were wrong, and earnings estimates went through the roof. 2004 estimates now stand at $2.54, with 2005 numbers averaging $3.38 per share. If investors knew this in August, Google never would have priced at $85. Think about it. Forward EPS of $3.38, 40% growth rate, and an $85 stock price. That’s a forward p/e of 25x for 40% growth. Nobody on Wall Street would have pronounced the Google IPO overvalued if they knew it had a 2005 p/e of 25.

Recently Google has fallen from over 200 to the 160’s, mostly due to insiders who will be free to sell shares beginning in mid-November. Increased supply leads many to think Google will crash back to Earth. The question is, will a $35 or $40 decline in the stock price result in increased demand, and if so, will that demand be able to absorb the supply that will soon be hitting the market.

Nobody knows for sure, but we do know one thing. Investors so far have underestimated how much money Google can earn in the future. It wouldn’t be surprisng to me at all if after the company reports the next quarter or two, analysts once again have to raise their earnings estimates. At $165 per share, Google trades at 49x what the Street today expects them to earn next year. Given a 40+ percent growth rate and the potential for more blowout quarters to the upside, it seems that the lock-up fear has presented an opportunity to buy, not to sell.