10/6/10 9:26 AMGoogle: A Free Cash Flow Analysis -- Seeking Alpha

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Google: A Free Cash Flow Analysisby: Peter Psaras

October 06, 2010 | about: AAPL / BIDU / GOOG / MSFT / NWS

Google (GOOG) is a company that has had a tough go of it since it hit its all time high of $747 in 2007 and has sincebeen on quite a roller coaster ride. Recently they have been embroiled in an ethical conflict with China, which hasdropped the stock and has allowed me to buy some. The stock, in my opinion, is not a classic (Benjamin Graham type)value play but is a conservative growth play and that puts it right in my ballpark.

Google is a very unique company in that they have an ultra-unique business model that cannot be easily duplicated,due to their economies of scale. Outside of China they totally dominate their industry and are getting stronger andstronger every day. How do I know this? Well, I use a very simple metric to analyze ”Economies of Scale”. It is called“Capital Expenditures as a Percentage of Cash Flow” and basically how this ratio is defined is - what percentage ofcash flow is used for capital expenditures or what Warren Buffett calls "owners' earnings" - the result being free cashflow, which is the heart and soul of a company. If a company is growing their free cash flow and at the same timereducing their capital expenditures, they are basically reducing their cost to produce their product and thus you haveeconomies of scale.

Here are two charts that explain what I mean;

The first is the free cash flow numbers of Google since 2002:

click to enlarge

And the second is Capital Expenditures as a Percentage of Cash Flow:

10/6/10 9:26 AMGoogle: A Free Cash Flow Analysis -- Seeking Alpha

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That is only one of the many metrics that I use in analyzing a company, but as you can see it clearly shows that Googleis really controlling costs. I learned this trick by analyzing Warren Buffett’s purchase of International Dairy Queen andnoticed that many of the investments he was making then were low capital expenditure/ high free cash flow machines.Studying Buffett also introduced me to Philip A. Fisher, who is to Growth Investing what Benjamin Graham is to ValueInvesting. Here is a page from my website devoted to Mr. Fisher.

For those interested in reading his writings I would highly recommend his book “Common Stocks and UncommonProfits”, which includes the masterpiece “Conservative Investors Sleep Well”. It is the bible of Qualitative Analysis andyou can find it here.

Most people think that Google is just an advertising machine, but I would also classify it as being in the real estatebusiness. But by real estate I don’t mean the physical land and building type of real estate, but the ultra uniquebusiness of renting out words and phrases. They basically charge a fee to rent search space by word.

The English language for example has about 200,000 words in it but when added together to make phrases you havemillions and millions of mini-real estate opportunities result. Google has 150 offices (Google websites) around the worldand thus people can look up words in different languages, which now gives you billions and billions of mini-real estateword locations. Basically, Google gives away mountains of free information and in return rents out that space toadvertisers, but has those advertisers bid against each other for the best location. Baidu (BIDU) may have a monopolynow in China but Google has the rest of the world. Someday, hopefully, Google and China will come to an agreementand they will enter China again, but while researching Google I discovered their corporate Philosophy and was trulyimpressed.

Google, though an amazing company, is not perfect and they make some stupid business decisions every once in awhile, like coming out with a Nexus phone to compete directly with their own clients using their Android system. If youwant to have companies invest in your technology, the last thing you want to do is compete with them. Apple (AAPL) isdifferent, as they don’t farm out their operating system to others but are a mobile phone company. Google and theircompetition Microsoft (MSFT) tried to do both and they screwed up, but now they are on the right path and havetempered their Nexus ambitions dramatically.

Google in the end has zero debt, $30 billion in cash and an ultra-unique business model and by looking at the followingdata, the internet is growing like a rocket to the moon.

Sure they will have more competition in the future from Facebook, Baidu, My Space (NWS) and multiple othercompetitors, but they are not slowing down and neither is the internet. I for one am looking for more internetinvestments currently as I feel the Internet today is nothing like the Internet of 1999 when valuations were out ofcontrol. I bought Google at 17 times its 2010 estimated free cash flow and thank the Chinese for giving me theopportunity to do so.

Disclosure: Long GOOG, MSFT; No position in NWS, AAPL, BIDU