Software is Eating the World

In the good old days you bought a computer and it had hardware. You bought IBM, or Honeywell or DEC and that became your world: hard or soft it was all from one company. Now software is flexing its muscles and Google’s Android software packages are a key element. They have become what UNIX hoped to become.

Apple is swimming strongly against the tide. They feel that if you like their software you will have to buy their hardware. And to a very large extent that is true. Let’s call this model A.

Elsewhere, cheap chips mean cheaper tools. Wholesale prices of bottom of the line Android phones are under $50. Google sells the operating level of the software and thousands of hackers and small firms and rapidly growing firms make the software gadgets that some of these users want. If the potential market for your $8.95 software gadget is a billion plus [as of September 3, 2013, 1 billion Android devices have been activated] then you need a tiny percentage of that to be profitable.

The Android software is based on Unix principles and Open Source philosophy. Android was unveiled in 2007 along with the founding of the Open Handset Alliance: a consortium of hardware, software, and telecommunication companies. So although it’s not a huge cash generator for Google, it shows them building a different customer-ecology than Apple and demonstrates their software expertise.

At the moment then, Google is sitting on a mound of cash from its main source of revenue: on line ads and clicks. Here’s a summary from Rizzi Capital.

Nov 20 2013, 08:59                              by: Rizzi Capital  |              about: GOOG

Google (GOOG), the third largest company by market cap in the world has been on a tear lately. It’s shares are trading just shy of an all time high, and investors are rejoicing. And soon, shareholders will have another reason to cheer – Google may be just a few months away from announcing its first dividend. The blogosphere and analysts have been buzzing with speculation on this subject for the last year, and now the writing may be on the wall.

Google fights every day to win over consumers, and the Google investor relations team works diligently from morning to night working to please investors. With major tech competitors such as Apple (AAPL), Microsoft (MSFT) and Cisco (CSCO) all returning huge shareholder value via buybacks and dividends, Google will have little choice but to join the tech stock dividend bonanza. Considering Google’s massive cash hoard and abundant free cash flow, it seems like a very small price to pay.

Cash Is Flowing

Google has always been a cash flow generating machine. Its basic core business model of selling advertising space on the back of its search engine results required low capital expenditures and provided fat profit margins. As Google expanded its offerings and made some expensive acquisitions, such as YouTube, DoubleClick and Motorola, as part of its growth strategy, its cash flow generation slowed marginally. However, now, under the leadership of CEO Larry Page, it has integrated most of its businesses and is focusing on strategic, organic growth opportunities. Cash flow is once again powering higher at an accelerating rate and capital expenditures are remaining rather tame.

The chart below shows Google’s net operating cash flow as well as its capital expenditures.

(click to enlarge)google cash flow

It’s always a beautiful thing to see. As net operating cash flow has increased dramatically since 2009, capital expenditures seem to have reached a plateau. In 2013, a year which is not shown in the chart, the numbers only get better.

A cash flow of this size is something which few companies can brag about, and it’s an enviable problem to have. Google has been storing away a large portion of the cash on its balance sheet, and has accumulated more than $50 billion so far. This is more than enough cash for the company to have on hand for any foreseeable capital expenditures. Furthermore, given their debt level, stock price, and the current rock-bottom financing costs, Google would have ample resources available if it wanted to make a major acquisition in the future. There is just no good reason for the company to continue stockpiling cash.


The company fundamentally has two main options. Google can either use their cash to buy back shares on a massive scale, or they can institute a quarterly cash dividend. Either one of these options would be applauded by shareholders, but one option is more likely than the other.

In terms of a share buyback, we should note that Google shares are currently trading near an all time high at over $1000 per share. I know Google. I love Google. But can the company really justify a massive share buyback? Even though Google operates in a virtual monopoly and it is growing rapidly, investors would be hard pressed to say that the shares are cheap based upon any commonly accepted valuation methods. Apple recently announced a massive share buyback worth $60 billion. But Apple has a P/E ratio of 13.12. By comparison, Google’s P/E ratio is 29.5. That’s not exactly discount territory.

In addition, it should be noted that Google “only” has a cash hoard of about $50 billion, of which only 20% is held onshore. Considering that Google’s present market cap is over $300 billion, a small share buyback valued at under $10 billion, would not be particularly meaningful.

For this reason, the most likely course of action will be for Google to institute a dividend program similar to that of its rival, Apple. The program will likely start small, with quarterly payments, and then rise as cash flow continues to increase. For comparison, when Apple initiated its dividend program, the initial payout ratio was about 12% in the first year but was boosted to almost 30% in the second year. Google would likely follow a similar path. At a 12% payout ration, Google would have an initial dividend of about $5 per year, based on analysts 2014 earnings per share estimates of $43.50. Although a dividend of this amount would not compute to a very high yield, it would send a clear message to investors that Google is committed to return value to investors, and not only through price appreciation of its shares.

At the same time Google would be retaining a large enough portion of its cashflow to fund any foreseeable acquisition or to implement a share buyback if market conditions would warrant it. Analysts are predicting that by 2016 Google will have free cash flow of over $20 billion per year. Google would clearly be able to adjust the dividend higher as the cash flows increase.

Counter Arguments

Some analysts have been vocal that Google will not implement a dividend policy for at least 2 more years. These analysts state that Google will want to hold on to as much cash as possible in order to finance a possibly huge acquisition. They claim that until Google reaches the goal of having $100 billion in the bank, it will not return value to shareholders via a dividend. To be honest, I dismiss these claims.

Google is now the largest company in the world not paying a dividend. It has made large acquisitions in the past, such as Motorola and Youtube, but when we really compare these purchases to the massive size of Google’s cash balance, they are minor. Google is a tech company headed by a CEO who is focused on changing the world. Larry Page pumps Billions of dollars into R&D and projects like Google Glass and Google X. From time to time there may be a complementary acquisition which might help further his endeavors, but ultimately Google does not have the culture or history of making massive acquisitions which would radically affect the company. Larry Page has his eyes set on using Google’s cash reserve on research and development to create revolutionary products from scratch. These so call “moonshot” projects require large development costs, but given Google’s size, they do not make a significant impact on cash flow.

“While they’re-in absolute dollars-probably significant amounts, they’re not significant for Google, and I think you should actually be asking me to make more significant investments. I wish I knew how to do that,” – CEO Larry Page, when asked about Google R&D expenditures.

Furthermore, stating that the company would choose to only start paying a dividend once it had $100 billion in cash on the balance sheet is arbitrary. Google is already facing scrutiny from the government because of it’s low tax rate and high offshore cash reserve. Would it really want to make global headlines by declaring it had achieved the dubious honor of joining the $100 billion club?

Bottom Line

Google is a company which is growing rapidly and generating more cash than it knows what to do with. It has a war chest worth over $50 billion, and will likely not want to keep adding to that number for very much longer. As all other large technology companies have started paying dividends, shareholder pressure for a return of value is intense and will only increase. In a situation like this, shareholders will inevitably be rewarded. All the elements are in place for Google to implement a dividend policy next year. While it will likely start with a low payout ratio as compared to competitors, as cash generation accelerates, shareholders will be rewarded with a rapid dividend increase. Look for an initial quarterly dividend of $1.25, or $5.00 annually, and expect it soon.

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