Google: Not Worried About Antitrust Lawsuit (NASDAQ:GOOGL)

investment thesis

This week, Google (NASDAQ:GOOGL) is facing its second lawsuit this year brought by the US Department of Justice (DOJ), this time focused on the government’s attempts to label parts of Google’s advertising business. a monopoly. At the heart of this lawsuit are President Biden’s DOJ allegations that the $2 trillion company is engaged in a series of advertising business practices that violate antitrust laws. The DOJ accused the search giant of monopolizing the digital ad space through a series of acquisitions that forced advertisers to use its tools to be competitive in listing ads on the Internet.

This lawsuit follows another court case last month, in which a District of Columbia judge found the company guilty of a different set of antitrust violations, this time. centered on cases where Google paid device manufacturers such as Apple (AAPL) to make Google the default search engine.

The market clearly looks worried, with the stock down 17.25% since we last wrote about it, and despite a solid second quarter.

On the other hand, I’m less worried about the lawsuit both because I think Google has a very strong case here and because I think even if a breakup happened, Google can unlock hidden value for investors.

Basically, I’m not worried about the process. I think their stock remains a strong buy. Here’s why.

Why do I back cover

Google shares are down 17.25% since we last covered them in July (including dividends).

At the heart of this selloff that sent the tech giant’s shares from $193.31, a 52-week high, to around $150 at the time of writing, are the market’s growing concerns about the fights Google’s ongoing antitrust litigation with the US government. This has some investors questioning the company’s long-term outlook.

What’s notable is that despite these legal hurdles, the company’s core business remains extremely strong. Their dominance in search, advertising and cloud services continues to drive impressive revenue, as evidenced by Q2 ad revenue of $64.6 billion, which accounted for over 75% of their total sales.

I think the market’s concerns are probably overstated because Google’s core businesses — search and advertising — are fundamentally strong and likely to thrive even if the US government wins the case and forces structural changes.

My purpose in doing this follow-up coverage is to show that Google stock isn’t nearly as risky as it looks as a result of this attempt.

What is at stake in the trial

The DOJ, along with several states (governed by Republicans and Democrats), allege that Google monopolized the digital advertising market through a series of key acquisitions and internal anti-competitive practices. This case specifically targets Google’s ad technology business (such as DoubleClick), which has drawn criticism for its dominance in both the buying and selling of digital advertising.

At the heart of this case is the allegation that Google used its position as a dominant search leader to expand its control over the digital advertising ecosystem by playing both sides of the advertising exchange that brokers the buying and selling of ads on the Google Network. The DOJ alleges that Google’s acquisition of DoubleClick in 2008 allowed the company to control both the ad server market and the ad exchange market, creating this alleged “moat” that restricted competition.

This follows the previous search monopoly case this summer, in which the tech firm was found to have illegally maintained its dominance of the search market. Google said they are appealing the outcome of this case. For now, the DOJ can use the findings of this ruling as additional evidence in this current case.

The potential results of this study are crucial. A ruling in favor of the DOJ could lead to the breakup of Google’s advertising business, particularly a divestiture of Google Ad Manager, which would have effects on the structure of the digital advertising market. Digital ad publishers, who currently rely on Google’s tools to manage ad placements and campaigns, would now theoretically see competing tools emerge, which the DOJ says could lead to lower prices and more solutions.

Investors are concerned that a breakup would disrupt Google’s operations, and Google argues that a breakup could actually increase costs for companies that rely on its services (competitors wouldn’t have Google’s economies of scale).

If the government wins in the suit, Google could also face huge financial penalties, with some analysts projecting the company could pay up to $100 billion in lawsuits from advertisers if the DOJ’s claims be supported in the trial that began this week in Virginia.

One of Google’s main central defenses in the ongoing lawsuit is that the DOJ (via the FTC) previously approved many of the company’s key acquisitions, such as DoubleClick.

Google claims that these approvals suggest tacit approval of Google’s business practices at the time.

In other words, Google is going to argue that if these acquisitions were approved by regulators, then the company’s subsequent integration of these assets was legitimate and within legal limits.

In the US, it is not necessarily illegal to establish a monopoly through merit and efficient business practices, as long as those practices were not done in the name of trying to create a monopoly (vs. just competitive actions). In fact, specifically from the DOJ website:

…the intentional acquisition or maintenance of …(a monopoly)… as opposed to growth or development as a result of a superior product, business acumen or historical accident (is illegal)…

What is key here is the deliberate creation of one. Google claims in the lawsuit that it did not intentionally try to create a monopoly. They argue that their innovations and actions approved by regulators fall under Google’s exemption from building a superior product and/or historical accident. Note that when Google bought DoubleClick in 2008, Yahoo was much larger as a % of market share than it is today.

Ads on the Google network are integrated into their broader operations and functions somewhat independently (as CNBC points out in their analysis). DOJ is suing Google Ad Manager (GAM) to be separated from Google. That’s different from the core search business, which has seen more than $200 billion in revenue over the past 12 months.

This particular division that GAM is a part of generated revenue of around $7.4 billion in Q2 and actually saw revenue decline by 5% YoY (T2 Call).

Essentially, what I’m trying to point out in this analysis is that the DOJ lawsuit against Google targets a much smaller part of their business, which is actually declining. I think Google still has a good chance of winning this lawsuit (although I’m not a lawyer). Even if they don’t, this business will likely be a strong standalone company if Google reveals it.

With industry-leading domestic technology for ad tech, this segment could command a price-to-sales multiple of about five times annual sales (revenue is about $30 billion in the last 12 months). This would equate to approximately $150 billion in equity. Even if we offset this $150 billion equity value with the low-chance event of $100 billion in advertiser lawsuits that I mentioned earlier, it still yields an equity value of $50 billion dollars that I believe the market values ​​at zero right now, given that Google is trading at a lower valuation multiple than its historical median (see valuation section).

This makes the network business really valuable and I don’t think the market appreciates the full value of this division.

ASSESSMENT

Google’s current P/E ratio is well below their five-year average of 19.61 (vs. 25.79 average), which really shows the market’s cautious attitude in the process.

Investors appear to fear that a breakup could severely damage the network business model that integrates Google’s core advertising operations.

However, as this analysis has argued, the core process division is one of Google’s less profitable segments (Dan Ives estimated in 2020 that this division made only about $1 billion in operating profit). Given these numbers, divesting this business could benefit Google’s balance sheet, potentially unlocking $50 billion in net worth, and lead to a re-expansion of the P/E multiple as market concerns about litigation antitrust diminishes.

In total, I think Google should trade at around 30 times forward earnings. This process is a distraction from the strength the underlying business has in the cloud and its new strength in AI. Winning this lawsuit (and/or exiting this business) will allow investors to refocus. I think this revaluation of the stock at about 30 times forward earnings would provide an upside of about 50%.

risks

While I believe that Google is in a good position regardless of the outcome of this lawsuit, I am confident that the end of these US antitrust lawsuits does not signal the end of Google’s legal troubles. The company is also facing a competitive practices investigation in the UK with no official conclusion.

The UK’s Competition and Markets Authority (CMA) has provisionally found that Google is abusing their dominance in the online advertising technology market by engaging in anti-competitive practices that harm UK publishers and advertisers. This could lead to increased regulatory scrutiny in the UK and across Europe, where regulators have already expressed similar concerns.

Despite that, I’m less worried than the broader market. A major reason for my confidence is that the importance of Google is much greater in the United States than in Europe. Even if the company faces legal setbacks or a forced split in Europe, I think the impact on the stock may not be as devastating as some investors fear. A potential spin-out in Europe could even benefit Google by isolating legal liabilities and regulatory compliance requirements in a subsidiary while the US parent remains relatively untouched.

All of this informs my thesis that this could also expand Google’s P/E multiple as investors separate regulatory risk from core operations.

Conclusion

Google’s ongoing antitrust battles pose notable risks, but I believe they may continue following a US lawsuit, despite past losses or even if the lawsuit itself results in a loss.

Even if they lose, breaking up the company could unlock value for shareholders, similar to the breakup of Standard Oil in 1911.

Each spinout (a GAM spinout and/or a European spinout) could result in the sum of the portfolio companies trading at a higher multiple of earnings, reflecting more focused business models with more defined risk profiles.

While the market’s fears about regulatory risks are valid, I remain optimistic about Google’s future. Their core business remains very valuable, and a break-up scenario could ultimately lead to higher valuations for each segment. I continue to see Google as a strong buy.