Is Google (NSDQ: GOOG) finally falling out of favor with Wall Street? While many analysts remain bullish on the web search giant, Morgan Stanley’s Scott Devitt downgraded the company on Friday, saying the company’s investment in areas outside its core search and text ad business may not pay off any time soon. Google shares fell nearly three percent in early trading.
Devitt downgraded the stock to “equal weight” and lowered his profit forecasts for the company. He reduced his price target to $600 from $645. Google is currently trading at $530.47. The company reports earnings next Thursday, July 14.
“Given Google’s aggressive hiring plans, rising compensation expense, and significant advertising spend on Chrome and other Google products, we expect EBITDA margin to decline in 2011 and 2012,” Devitt wrote in a research note.
Google, which generates over 90 percent of its revenue from search and text advertising, is trying to diversify its business, pushing into the fast-growing mobile market, as well as the social and local spaces. Devitt doesn’t see those initiatives substantially adding the company’s bottom line, at least not in the short term.
“We are encouraged by the early progress of Google Plus and Google Offers, but Google faces stiff competition from incumbents who have a first mover advantage. The pay-off of such endeavors may be longer-term in nature,” Devitt wrote. “We see lots of promise from Google’s display/mobile/apps businesses, but we believe the consensus incorrectly attributes upside to those businesses and therefore may be overestimating their contribution in future periods.”
Devitt said the Google’s aggressive hiring and increased spending on advertising, (which it eschewed for years), will reduce the company’s profit margins. He said the Google shares “may respond positively” if the company decides to “exercise financial discipline by: 1) slowing hiring, 2) reducing advertising spend, 3) initiating a share buyback, or 4) tempering compensation packages.”
In his report, Devitt highlighted three debates surrounding Google:
Will margins decline from here? Yes. Given Google’s aggressive hiring plans, rising compensation expense, and significant advertising spend on Chrome & other Google products, we expect EBITDA margin to decline in C2011 / C2012.
Will “newer” businesses drive near-term revenue outperformance? No. We believe the consensus is too optimistic on the net revenue contribution of newer businesses, such as DoubleClick, YouTube, AdMob, Android Market, and mobile search. In 2011, we expect search & contextual ads to contribute ~90% of Google’s net revenue.
Will investments in local eCommerce and / or social pay-off? Too early to tell. We are encouraged by early progress of Google Plus and Google Offers, but Google faces stiff competition from incumbents who have first mover advantage. The pay-offs of such endeavors may be longer-term.