Finance Banter

Google held up fairly well during the recent recession, both in terms of financial and share price performance. A key reason was that the company decided to dramatically scale back hiring and spending on excessive perks in order to preserve (and even grow) their profit margins during a period where revenue growth was slowing meaningfully. The result was growing margins and earnings and investors applauded because the company had really been spending money without much regard for their shareholders when times were good.

The strange thing is that Google reported earnings last week and signaled that they thought the worst of the recession was behind us. More importantly they stated that they intend to dramatically step up spending in areas such as on hiring, research and development, and acquisitions (both small and large deals). I have cooled on Google stock in recent months as the forward P/E multiple has moved well above 20 and the company’s market value has surpassed $170 billion (with the shares around $550 per share) but current shareholders should be concerned about the company’s new plans.

Just as investors should be contrarian and be aggressive with their capital allocation when prices are depressed and demand is low, companies should be on the prowl for deals when prices are low and enthusiasm is muted. Google is essentially saying that they waited for the cloud cover to dissipate and now they are going to go back to their old ways of spending like drunken sailors. Given that prices are going to be higher now than just a few short months ago (not only for acquisitions but also for poaching talented employees from other high tech firms), this strategy appears to be completely backwards.

It was not that long ago that Google shelled out $100 million for FeedBurner, $1 billion on a 5% stake in AOL, and $2 billion on YouTube. Google immediately scrapped FeedBurner’s ad network and replaced it with their own, lost a lot of money on the AOL deal, and YouTube continues to bleed red ink.

The moves Google has signaled should worry Google investors but also serve as a lesson for everyone. Pay close attention when companies seem to spend money at all the wrong times for all the wrong reasons. This happens a lot with commodities producers; they halt production and acquisitions when prices are low and then they expand significantly when prices soar. These moves almost always serve as losing moves to shareholders. Investors and company managements alike should be opportunistic rather than simply follow trends that ultimate will not be sustainable.

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Full Disclosure: Some clients of Peridot Capital Management have small positions in Google at the time of writing, but those positions have been reduced in recent months to reflect the concerns highlighted in this piece.

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