QUALIPORT
When Google Was Cheap

By Maynard Paton (TMFMayn)
February 8, 2005

"We try to buy companies that trade at large discounts to intrinsic value. What's different is we will look for value anywhere we can. We don't rule out technology as an area to look for value." -- Bill Miller.

Bill Miller is a US investment legend. Last year, his Legg Mason Value Trust mutual fund beat the S&P 500 index for the fourteenth year running. Anybody owning the fund for the past ten years would have seen their money grow by around 18% per annum.

Miller's investing style is what you'd expect from a market-beating investor: a long-term horizon, low portfolio turnover, relatively large holdings, a focus on valuation, an indifference to economic predictions and a penchant for business 'moats'. Read more.

However, what's catapulted Miller into the mutual fund spotlight has been his success with technology shares. Miller once wrote: "We believe and continue to believe that technology can be analysed on a business basis, that intrinsic value can be estimated, and that using a value approach in the tech sector is a competitive advantage in an area dominated by investors who focus exclusively, or mainly on growth, and often ignored by those who focus on value".

The approach has prompted Miller to sometimes overlook traditional 'value' stocks and buy into some of America's leading Nasdaq constituents. Past big winners include Dell Computer (Nasdaq: DELL) and AOL (now part of Time Warner (NYSE: TWX)). Current portfolio holdings include Amazon (Nasdaq: AMZN), eBay (Nasdaq: EBAY), Nextel Communications (Nasdaq: NXTL)…

And Google (Nasdaq: GOOG).

Auction

Miller's September 2004 update to shareholders included a note on why he bought Google the previous month. Miller explained:

"Google chose to come to market using an auction mechanism, instead of the more usual way of having investment bankers set the price…  Our sense of this was that many would choose not to bid, since the determination of what to bid would require considerable work to be done in order to value the company.

We believed this created an opportunity. Our large ownership positions in Amazon, eBay, and IAC/Interactive gave us, we thought, a competitive advantage in understanding, analyzing, and valuing companies such as Google. We created a team of analysts who studied every aspect of the company's business, focusing especially on the competitive dynamics that might ensue from Microsoft and Yahoo, as well as more targeted search providers such as Amazon's A9.

The result was a comprehensive assessment of Google's strategic position, competitive advantages and potential value. We ended up putting in three bids for the shares… Our highest bid, valuing the company at over $30 billion dollars, still provided us with a reasonable margin of safety had we received shares at that price. We were delighted when the so-called FUD factor (fear, uncertainty, doubt) dominated the process, resulting in the shares coming at the bargain price of $85, valuing the company at $23 billion roughly."

Miller has since done well with Google. The search engine's shares currently trade at $196 -- up 131% on the auction price six months ago. Even at $85 though, Google was far from obviously undervalued. Investors buying the shares in the auction ended up paying seven times 2004 sales and 57 times underlying 2004 earnings.

Variety of scenarios

Recent results showed Google firing on all cylinders. Sales and profits in 2004 jumped 118% and 278% respectively. During the fourth quarter, Google's reported operating margin was 29% -- indicating a very strong competitive advantage.

But how does Miller value such fast-expanding companies? This quote sums up his approach well: "We project cash flows out anywhere from five to ten years under a variety of scenarios... For new companies, we will use multiple scenarios with different end points, varying growth rates and a range of discount rates to get a sense of the risk/reward under different outcomes".

Here's one quick and dirty attempt at a 'valuation scenario' on Google:

* Annual sales growth: 100% during 2005, 75% during 2006; 50% during 2007; 35% during 2008; 25% during 2009; 20% during 2010; 15% during 2011; 10% during 2012; 5% during 2013 and 2014;
* Operating margin: remains at 30% by 2014
* Tax charge: 34% in 2014

These projections indicate Google's sales and earnings could leap seven-fold (to $47b and $9.4b respectively) between 2006 and 2014. Slap a price to earnings (P/E) ratio of 15 on the 2014 net income figure and a rough $140b market valuation is constructed.

At Google's $23b auction value then, anybody believing in the above forecasts would be anticipating making six times their money over ten years -- approximately 20% per annum and the size of return that may well have attracted Miller to bid.

(Note that these calculations do not account for Google's cash pile (which by 2014 could be very substantial) and any additional share issues (which by 2014 could also be very substantial). It also assumes Google's reported earnings are a genuine proxy for free cash, which may not be the case now or in the future.)

Microsoft

So, are the above growth assumptions realistic? As a comparison, the last ten years has seen sales at Microsoft (Nasdaq: MSFT) improve eight times (from $4.7b to $37b) and net income increase seven times (from $1.1b to $8.2b). However, the software group's cash and short-term investments have surged seventeen-fold (from $3.6b to $61b) since 1994.

Whisper it, but it seems the auction for Google presented a 'value' opportunity -- if, like Miller, you believed the company would remain the Microsoft of the search engine industry and continue on its path to hypergrowth. That said, there's a fine line between judging leading techs with Miller's skill, foresight and experience, and ending up with the kind of blue-sky profit extrapolation that ruined many dotcom investors a few years ago.

More: Legg Mason Value Trust | Bill Miller Does It Again | Bill Miller: Consistently Beating The S&P | Start Your Streak Today

Portfolio value

Holding	Number of shares	Closing price 07/02/05 (p)	Value (£)
Associated British Ports	681	491	3,343.71
Emap	372	854.5	3,178.74
Halma	1,920	167.5	3,126.00
Johnston Press	1,608	559	8,988.72
London Stock Exchange	2,018	566	11,421.88
Cash			157.53
Total			30,306.58