Google: Suffering From Success

Summary:

• Google remains among the cheapest and fastest growing Magnificent 7 Stocks.
• However, it is suffering from success.
• Specifically, its decades-lasting dominance has led to increased scrutiny from regulators, who think that its $20-$26 billion payments to Apple are anti-competitive.
• I still think Google is worth the investment here, but with less conviction than before.
• In this article, I explain why I have downgraded my rating on Google stock.

Alphabet Inc (NASDAQ:GOOG), better known as Google, is a company suffering from its own success. Although the stock has many things going for it, the legal issues stemming from its competitive position have become hard to ignore. The ongoing antitrust lawsuit resulted in a loss for Google, with the company having been declared a monopoly by a court. The lawsuit will now go to appeals. If Google loses there, then the only recourse available is at the Supreme Court.

That’s not to say that everything about the antitrust lawsuit is bad for Google. To the contrary, it has some positives. The company is reportedly paying Apple (AAPL) and others $20 to $26 billion a year to maintain search dominance on iPhones and other devices; the company being forced to stop doing that would equate to an extra $20 to $26 billion in earnings (the amount would go directly to earnings because it is a simple cash transfer with no other associated costs).

It’s hard to gauge exactly how much market share Google gains from its Apple deal. The company has a 90% market share in search right now, and the iPhone has a 52% smartphone market share in the United States. The company predicted that it would lose between 60% and 80% of its volume on iOS devices if it lost the right to pay Apple for market share. If those estimates are correct then Google’s market share loss could be substantial, as the U.S. is its largest market.

When I last covered Google, I rated the stock a strong buy because of its then fresh earnings beat. I still believe in the company and the stock, and I still hold a position in it, but my enthusiasm is somewhat dimmed because of the legal issues the company is facing. In a worst case scenario, where the DoJ lawsuit holds up on appeal and Apple chooses not to make Google Search default on IOS, then Google could lose up to 80% of its U.S. market share, and 40% of its worldwide market share. To say that would come with a negative revenue impact would be an understatement. However, the company still has good prospects overall, and is the cheapest out of all the Magnificent 7 stocks. So, I am downgrading my rating to ‘buy’ rather than ‘hold’ or ‘sell.’

What’s at Stake in the Lawsuit

To understand why Google’s prospects have dimmed because of the ongoing DoJ lawsuit, we first need to look at what the lawsuit seeks to achieve, and how much success the DoJ has had with it.

The DoJ’s lawsuit against Google alleges that the company has been maintaining a monopoly by paying Apple and other hardware manufacturers to make Google Search the default on their devices. The majority of these payments–$20 billion out of $26 billion in total in 2023–go to Apple.

The penalties sought in the DoJ lawsuit are:

1. Cessation of Google’s practice of paying platforms to publicize Google Search above its competitors’ offerings.

2. Possible monetary relief.

Now, the DoJ press release does not specify any actual amount of monetary relief (i.e. cash penalties resulting in the company being forced to pay out). It seems that the lawsuit primarily seeks to get Google to stop paying Apple and other hardware manufacturers to make Google the default on their devices. Monetary damages, if any end up being awarded, would presumably be the lesser penalty compared to Google having to stop the payments to Apple and others.

As mentioned previously, Google estimates that it would lose between 60% and 80% of its Search market share in the U.S. if it lost its default placement on iOS devices. This is consistent with Apple’s share of the U.S. smartphone market.

In 2023, 47% of Google’s revenue came from North America. If we assume that the U.S. and Canada have similar levels of iPhone penetration, then a 60% traffic loss would equate to a 28.2% revenue loss for Google. In fact, the loss could be higher than that because ads in the U.S. cost more than in most countries.

So we’re looking at a potential 28.2% headwind to revenue if Google loses its default iPhone placement, possibly even more than that.

The story doesn’t end there though! While Google’s loss of default placement on iPhones would be a big setback, the end of payments to Apple would not necessarily mean the loss of default placement. Apparently, Apple doesn’t see any good alternatives to Google search. In an interview, Apple VP of Services Eddie Cue said that Bing is “pretty bad” and that Microsoft (MSFT) “couldn’t pay them enough money” to make Bing default on Safari. So, perhaps if the DoJ wins on appeal, Google will not be replaced by another search engine, but instead given to be as an option between several. The market share loss in this scenario is less than if Google is replaced by Bing outright. In fact, there’s even a possibility that Apple simply decides to keep Google the default on Safari despite the payments being struck down in court, in which case Google keeps its market share while pocketing $20 billion per year.

How The Lawsuit Impacts Google’s Valuation

One of Google’s strengths right now is its valuation. Trading at 23 times earnings and 21 times the consensus estimate of the next 12 month’s earnings, it’s cheaper than the rest of the Magnificent 7. However, the possible loss of revenue because of the ongoing lawsuit can’t be ruled out. So, we should model for possible changes in revenue in the year ahead period.

Because Google’s payments to Apple are a direct cash transfer, they immediately go back to revenue in any scenario where the lawsuit ruling holds up on appeal. That’s a $20 billion gain. However, Google has modelled for 60% to 80% market share loss on iOS devices if it loses default placement in Safari, which by my estimates translates to a 28.2% revenue impact. I will go with a -28.2% revenue impact in the scenario where Google is replaced by Bing, and a -14.1% impact in the scenario where users see a choice prompt asking them to choose between Google and Bing. I’ll also model a best-case scenario where Google is forced to stop paying the $20 billion but keeps default placement on Safari anyway. For all cases, I’ll assume that Google sees 10% organic revenue growth; that operating costs, interest income and GOGS grow at the 5-year CAGR rates; and that tax rates aren’t impacted by the various factors described above. Here are the scenarios we get:

	Worst case	Mid case	Best case	Weighted Average
Revenue	$282.9B	$330B	$381B
COGS	$163B	$163B	$163B
Operating expenses	$99.9B	$99.9B	$99.9B
Net interest expense/income	$4.68B	$4.68B	$4.68B
EBT	$31B	$79B	$133.78B
Taxes	$5.35B	$12.42B	$20.07B
Net income	$30.33B	$70.36B	$113.71B
Shares outstanding	12.58B	12.58B	12.58B
Rev per share	$22.5	$26.23	$30.3	$26.33
EPS	$2.41	$5.59	$9.04	$5.68

Click to enlarge

As you can see, my weighted average rev per share estimate is higher than the TTM actual one, but the EPS figure is lower than the TTM actual. These estimates produce the following multiples using Wednesday’s closing price:

• P/sales: 6.2.

• P/E: 28.69.

So, based on my model, if Google loses in an appeals court, it will ultimately prove to be more expensive than what current forward estimates imply.

The Bottom Line

As the table above shows, the DoJ lawsuit does have the potential to make Google considerably less valuable than it is today. The weighted average of the three scenarios I considered give it a 28.69 forward earnings multiple, as opposed to the 21 that analysts are currently estimating. That weakens the thesis somewhat.

There are some bright sides here too, though. If Google ultimately beats the lawsuit, it should grow organically; also, in the “best case” scenario modeled above, it experiences positive earnings growth. Considering all the possibilities, I still think that Google is among the cheapest of the Magnificent 7 stocks, and worth holding today–just with less enthusiasm than I had when I last covered it.

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Analyst’s Disclosure: I/we have a beneficial long position in the shares of GOOG either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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