Issue #14, Volume #2
A Question Most Tech Investors Don’t Think To Ask
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| Google earns $100 billion a year, seemingly a 30% profit margin… It also invests – spends – heavily on tech upgrades, employees, and buybacks… Compare it to this “boring” company… Trump and China fight over tariffs… Jobs report looks soft – again… |
If you’re going to buy a tech stock, Google (GOOG) is hard to beat.
It’s not terribly expensive, at around 25x earnings. It has incredible prospects: its cars are driving themselves around San Francisco. It dominates the high-margin business of online advertising with its famous Google search engine. It has an enormous user base with its ubiquitous Gmail platform. And then there’s YouTube, which seems to be quietly winning the streaming wars.
Google is one of the most powerful tech companies in the world, and probably the biggest winner of the internet revolution that began in the late 1990s. But… is it a good business?
Its earnings just came out, so we have lots of timely and relevant data to consider.
When I judge the quality of any business, I’m primarily looking for return on equity (“ROE”): I want to see how much money the businesses managers can produce with their assets, because – assuming share count remains the same – that’s the rate at which the business is likely to compound over time. There are different ways to generate ROE (profit margin, asset-turns, and leverage). So, my next question is, how profitable is the business… and, then, finally, how much growth is there.
(These questions all assume that the company’s balance sheet is stable, that its products or services are widely embraced, etc.)
Last year, Google produced an enormous amount of revenue – up 14% over last year to $350 billion! That makes it one of the largest businesses in the history of capitalism. And, the company’s accountants claim (more about this below) that the firm ended the year with after-tax profits of $100 billion. Again, that makes it one of the most profitable businesses in the history of capitalism.
A few other figures we need to know. Google has total assets of $450 billion and total debts of $125 billion, giving it a net asset value of $325 billion.
Thus, we can see this is a pretty darn good business: $100 billion in after-tax profit on $325 billion in equity shows the firm is compounding its equity at more than 30% a year. That would make it one of the greatest businesses in America.
So… then why would the stock have fallen so much today – down 7% as of 2 pm ET? Seems like this is a great business, that’s growing pretty fast…
Well, the trouble with technology is that it’s always changing. Among Google’s listed expenses are $49 billion (!) on research and development (R&D). The company also has to pay a lot of really smart people to keep creating great software and services. Selling, general & administrative costs are also close to $50 billion a year. And that’s not including the $22 billion that Google spent giving employees shares last year.
When you add up all of this overhead, you discover that Google’s net income margin is only 28% a year.
While that’s not bad… that’s not the kind of profit margin you’d expect at a software company. And that’s because provisioning web services is pretty expensive: cost of revenue at Google last year was $146 billion.
So… maybe Google is only a good business, not a great business.
And there are a few other problems too.
The biggest problem is that the depreciation rate on tech investments keeps accelerating. Moore’s Law (which says that the speed of computer chips doubles every two years) used to make new computers obsolete every four to five years. But, Nvidia’s parallel-processing revolution has blown those growth rates to pieces.
As a result, Google (and all of the other big tech firms) are having to spend a lot more, year after year, just to keep up. That’s because most people using the internet don’t really care if they’re using Google search… or Gmail… or YouTube. There’s no moat around web properties, because all of these things are free. You’ll use whichever web service offers you the best technology. And that means that in order to keep its audience – and to keep selling advertising – Google must continue to spend heavily to make sure its web services are the best.
Last year, it spent $52 billion on these major capital investments. As you can see, that’s a major portion of the money it made.
Simple question for you: If a business has to spend billions and billions every year on major equipment upgrades, then shouldn’t those expenses be included as a line item on the income statement?
Google doesn’t count these as expenses because its accountants view these costs as investments. The only trouble is, as I mentioned, tech investments have been depreciating faster and faster every year.
If these tech upgrades were treated as expenses (and I’d argue they should be) then Google’s business would look a lot different. It would have made less than half as much money last year – only $48 billion on sales of $350 billion (rather than $100 billion), for a net income margin of only 13%.
That’s not a good business at all. Judging the business on an after-capital investments basis would leave you with a paltry 14% ROE, which is barely better than average.
And then there’s this troubling fact: While Google expenses the stock options it gives to employees ($22 billion is charged against income), it actually spends way more than it expenses to prevent its share count from rising year after year.
Last year, Google spent $62 billion buying back shares.
And, again, most of these costs didn’t count against its earnings. That seems odd, doesn’t it? Google must continue to invest in both building out new data centers and it must continue to buy back the shares it gives to employees. (Over the last decade, Google has lowered share count by 11%.)
These are real costs of Google’s business… but they don’t count against its earnings.
If they did, Google wouldn’t have made $100 billion last year… it would have lost $14 billion.
And now Google says it will have to spend $75 billion on still more capital investments this year. That, combined with ongoing big stock-options expenses could make it impossible, once again, to actually make any money at all this year.
I’d be willing to bet that there are not many investors who realize any of these facts.
To give you some further perspective on how important it is for investors to understand all of the financial statements (not only the income statement – which, as you can see, leaves out many of the actual costs of running the company), let’s take a look at a different business that I’d wager most of you don’t think will outperform Google in the years ahead: AutoZone (AZO).
AutoZone is the very definition of a boring business that shouldn’t be worth very much. It’s not growing fast (annual revenue growth is around 5%). It doesn’t have high margins – it’s a physical retailer. On annual revenue of $18.5 billion, it earns a paltry 14% ($2.6 billion) in after-tax net income.
This is, I’m sure many would argue, a pretty lousy business. Or is it?
As I mentioned earlier, the real test of a company’s quality is how fast it can compound its equity. You can think of ROE as being like the annual return of a mutual fund. If a company is compounding its equity at high rates (over 20%), then it will almost certainly outperform the stock market over time.
There are three ways that companies can increase ROE. 1) They can increase their profit margins – that’s the most obvious way. 2) They can use debt to add leverage to their business model, which is also a pretty obvious way of increasing returns on equity (because adding debt reduces net assets). Or 3), the hardest way: by increasing the inventory turnover ratio. Selling multiples of your company’s assets each year can dramatically increase the amount of earnings being generated from the asset base, increasing total ROE.
And while AutoZone can’t do much about its profit margins (retailing auto parts is extremely price competitive), it has become a master at using its balance sheet and turning its inventory.
AutoZone keeps only a sliver of equity on its balance sheet – in fact, its net equity is less than zero. Beyond the stores it owns ($14 billion worth), AutoZone funds virtually all of its operations with vendor financing ($7.5 billion) and leases ($3 billion). It is as asset-light as possible, so to calculate ROE (we can’t divide into a negative number), we have to approximate a net asset value by subtracting long-term debt ($9 billion) from total assets, which leaves us with $8 billion.
As you can see, with $18.5 billion each year in sales, it’s “turning” a multiple of its net assets every year, driving ROE higher. Likewise, by financing so much of its operations with vendor financing and debt, it uses a lot of leverage. The combination leads to a return on net assets of approximately 25% a year.
That’s a great business.
Plus, unlike Google, AutoZone doesn’t have to hire the world’s smartest (and most expensive) employees. And it doesn’t have to give them a bunch of stock. So, year after year, because AutoZone spends virtually all of its earnings buying back its own shares, the share count rapidly falls. Since 1998, Autozone has retired 89% of its shares. Over the last decade, the share count has fallen from 30 million to 16.6 million, a decline of 44%.
Will Google maintain its supremacy in the world of high-tech web services? I bet it will. But I also believe that’s going to cost a lot more than most investors expect. I doubt that Google will work out very well for investors over the next five years as the AI bubble booms and busts.
In the meantime, I’m virtually certain that AutoZone will continue to compound at over 20% a year in a simple business.
So… which stock should you own?
As Porter wrote above… Nvidia has wrecked Moore’s Law and set off the parallel-processing revolution. And what (besides tech companies having to spend more to stay in the game) does it all mean? (Porter recently put together a presentation about what this is all about, what it means for the future of technology, and how to best invest in it… you can view it here.)
Three Things You Need to Know Before We Go…
1. China retaliates. Following Tuesday’s imposition by President Donald Trump of a 10% tariff on imports from China, Beijing responded with protectionist measures of its own. These include a 15% tariff on U.S. energy imports (which came to around $20 billion last year), a 10% tariff on American oil and agricultural equipment, export controls on tungsten and other metals, and the blacklisting of a handful of U.S. companies. It also said it will investigate Google for alleged antitrust operations (although the search engine has been unavailable in China for nearly 15 years). A tariff war with America’s third-largest trade partner is not a great idea, and China’s measured response suggests that it’s looking to avoid escalation. Perhaps a deal will be discussed when Trump and Chinese leader Xi Jinping meet in coming days.
2. Cracks in the labor market. The latest Job Openings and Labor Turnover Survey (“JOLTS”) revealed a drop of 560,000 job openings in December compared to November, the largest decrease in 14 months. In the construction sector, job openings fell to just 217,000 – the lowest level since April 2020, when the economy ground to a halt during the COVID-19 outbreak. While the recent employment data looks robust on the surface, job openings are a key leading indicator that point toward potential weakness in the U.S. labor market.
3. Rents plummet, signaling (more) economic weakness. New rents are falling faster than overall rents, indicating that consumers are struggling to keep up with higher housing costs. The Cleveland Fed’s New Tenant Repeat Rent Index saw its sharpest monthly drop in December 2024 since the Great Financial Crisis, reinforcing concerns about weakening consumer demand and a slowing economy… not to mention the stress added to landlords and the banks that finance them.
Poll Results… How Long Will Tariffs On Canada Last?
Over the weekend, the Trump administration slapped various levels of tariffs on China, Mexico, and Canada. So on Monday, we asked readers: How long do you think the tariffs on Canada, at the current levels, will be in place? The vast majority of survey takers didn’t think tariffs against our neighbor to the north would be long lasting, with 37% selecting “One to four weeks,” 27% selecting “Less than one week,” and 26% tapping on “One month to six months.” Just 11% felt tariffs would stick for “6+ months.”
And not long after we released Monday’s issue, U.S. tariffs against Canada were paused for a month – potentially making 27% of survey takers correct. But the battle might probably isn’t over.
Mailbag
Tell us what you think: [email protected].
In Monday’s Daily Journal we let readers know about a new presentation, called The Prophecy, released by longtime market prognosticator Mason Sexton. We received a number of letters from readers who shared their views on Mason. Below are portions of a few of them – including responses from Porter.
Thanks for allowing me to be a part of the MarketWise Fellowship at Canyon Ranch last week. I had a great time and learned so much. You are very impressive, Porter. So it is funny to me that you are plugging Mason Sexton.
I like Mason Sexton. I subscribed to his services for a couple years. I got hooked back up with Mason and find that he is on the mark quite often. He does make mistakes, as with all advisors, but often quickly moves his stop loss into a profit zone when shorting or going long, which is always a relief.
Chris C.
Porter’s comment: Best strategy?
Measure twice, cut once. (Be careful what you do.)
And, when facing losses, take the lesson and move on.
Like the old sheriff said at the end of the movie No Place For Old Men: You spend all your time trying to chase down what’s already gone out the door, pretty soon you’ll have nothin’ left.
I hope we meet again —
Porter
Signed up a week ago and have paid for most of the $3k fee. Yay!
Donald R.
Yes, I already subscribe to Mason Sexton’s “The Map.” It’s worth every penny of what I paid just for the timing of his projections.
Glenn R.
I am gobsmacked to find that you have recommended Mason Sexton’s “The Map” as a legitimate investment advisory service.
I succumbed to signing on to “The Map” in 2023, following the seductive push promos that featured his son Buck that touted all the success Mason has had over the years. Worst $3,500 I ever spent. It wasn’t easily recognized from those presentations, but he has turned out to be (IMO) a snake-oil day-trader salesman that purports to use astrological phenomena to predict stock movements… Based on my observations, his recommendations have resulted in more failures than successes, and those successes are for little to no gain.
Mason Sexton is the grossly total opposite of the work you put into your investment advice and insight, and I simply can’t believe you have proffered him off as a legitimate alternative to what you do.
I am immensely disappointed… Or perhaps you can explain what I am missing.
John N.
Porter’s comment: Jeez… very sorry to “immensely” disappoint you.
In my defense:
- I don’t publish Mason Sexton. We advertised his product. We do things like that, from time to time, so that we can afford to offer world-class investment research for pennies. (In full disclosure: I did help Mason arrange a publishing deal with Legacy Research. And I did encourage Agora Publishing to publish his work more recently.)
- I know Mason Sexton personally. I like him very much. He is honest and sincere in his beliefs. And he is one of the kindest people I have ever met in my life. He cares deeply about the success of his subscribers.
- Mason is a legend on Wall Street. He has advised some of the biggest pools of capital in the world for more than 40 years.
- I have dozens of letters from his subscribers telling me how much they enjoy his work and how well they do with his trading advice. At my Fellowship retreat last week (at Canyon Ranch in Arizona) Mason’s work was the most discussed amongst a group of attendees where the average net worth was in excess of $100 million.
Where do I come down on all of this?
- I don’t believe in astrology. Nor do I believe most short-term trading is effective – I’ll have to save a more complete answer about trading for another time.
- I don’t know everything. There are things beneath the stars that I can’t explain. For example, there’s no real explanation for gravity. We know it exists. We can measure it. But we don’t know how it works. Is it possible that gravity fields alter human behaviors? How could I possibly know for certain? I certainly can’t rule it out.
- If people are honest (and keep an honest track record), if they provide the value they promised to their subscribers, and if they have a proven record of satisfying their customers, I have no problem advertising their work. In Mason’s case, I’m even willing to endorse him because I think he’s a genuinely fascinating person who has had a legendary career. His market experience alone is worth more than he’s charging.
Perhaps if you knew him, you’d feel differently.
Mason is an old-fashioned gentleman. He goes through life cheerfully. He supports the things he likes, like several elite clubs in New York, Harvard, his sons…. and simply avoids the things he doesn’t like. He doesn’t waste time making enemies – especially not of people who have treated him kindly and well.
In any case, I sincerely wish you the best.
I hope you’ll continue to find value in my work – whether we see the world in exactly the same ways or not.
Porter
(In case you haven’t seen the presentation that has generated so much interest, you can view it here.)
Good investing,
Porter Stansberry
Stevenson, MD
P.S. On Friday, we released the newest episode of our Black Label Podcast. This month Porter and co-host Aaron Brabham welcomed special guest Edward Dowd – founding member of economic consultancy Phinance Technologies – a data-driven consulting business.
In this latest episode, the three shed light on the newest COVID data, heat up some of the latest conspiracy theories, dig deep into Warren Buffett’s holdings, expose certain aspects of the life-insurance industry, and share thoughts on Porter’s latest charity idea.
Jump into this episode of Porter & Co.’s Black Label Podcast right here.
