Google: Not Worried About The Antitrust Trial (NASDAQ:GOOGL)

Investment Thesis

This week, Google (NASDAQ:GOOGL) is facing the second trial this year brought by the US Department of Justice (DOJ), this time focused around the government’s attempts to label parts of Google’s advertising business a monopoly. At the center of this trial are accusations by President Biden’s DOJ that the $2 trillion company runs on a series of advertising business practices that violate antitrust laws. The DOJ has accused the search giant of monopolizing the digital advertising space through a series of acquisitions that forced advertisers to use their tools in order to be competitive in listing their ads on the internet​.

This trial comes on the heels of another court case last month, where a District of Columbia judge found the company guilty on a different set of antitrust law violations, this first time centered around cases where Google paid device makers like Apple (AAPL) to make Google their default search engine.

The market clearly seems concerned, with shares down 17.25% since I last wrote on them, and despite an overall solid Q2.

On the other hand, I am less concerned about the trial both because I think Google has a really strong case here, and because I think even if a breakup took place, Google can unlock hidden value for investors.

In essence, I am not worried about the trial. I think their stock remains a strong buy. Here’s why.

Why I’m Doing Follow-Up Coverage

Google’s shares are down 17.25% since I last covered them in July (including dividends).

At the core of this selloff that’s caused the tech giant’s shares to go from $193.31 at the 52-week high, to around $150 at the time of this writing are the market growing concerns surrounding Google’s ongoing antitrust battles with the US government. This is making some investors increasingly question the company’s long-term outlook.

What’s notable is despite these legal hurdles, the company’s core business remains extremely strong. Their dominance in search, advertising, and cloud services continues to deliver impressive revenue, as demonstrated by their Q2 ad revenue of $64.6 billion, which accounted for over 75% of their total sales​.

I believe the market’s concerns are likely overstated, as Google’s core businesses—search and advertising—are fundamentally strong and are likely to thrive even if the U.S. government wins the case and forces structural changes.

The purpose of me doing this followup coverage is to show that Google stock is not nearly as risky as it seems as a result of this trial.

What’s At Stake In The Trial

The DOJ, alongside several states (governed by Republicans and Democrats), are alleging that Google has monopolized the digital advertising market through a series of key acquisitions and anti-competitive internal practices. This case specifically targets Google’s ad tech business (such as DoubleClick), which has drawn criticism for its dominance in both the buying and selling of digital ads​.

At the heart of this case is the accusation that Google used its position as a dominant leader in search to extend its control over the digital advertising ecosystem by playing both sides of the advertising exchange that brokers the buying and selling of ads in the Google Network. The DOJ argues that Google’s acquisition of DoubleClick in 2008 allowed the company to control both the ad server market and the ad exchange market, creating this alleged “moat” that restricted competition​.

This follows the previous search monopoly case from over this summer, where the tech firm was found to have illegally maintained dominance in the search market​. Google said they are appealing the outcome of this case. For now, the DOJ can use the findings of this ruling as supplemental evidence in this current case.

The potential outcomes of this trial are crucial. A ruling in favor of the DOJ could result in the breakup of Google’s advertising business, specifically a divestiture of Google Ad Manager, which would have effects on the structure of the digital ad market. Digital ad publishers, who currently rely on Google’s tools to manage ad placements and campaigns, would now theoretically see competing tools emerge, which the DOJ claims could lead to lower prices and more solutions​.

Investors are concerned a breakup would disrupt Google’s operations, and Google claims a breakup may actually net raise costs for businesses that rely on their services (competitors would not have Google’s economies of scale).

If the government prevails in this trial, Google could also face hefty financial penalties, with some analysts projecting the company could pay up to $100 billion in lawsuits from advertisers if the DOJ’s claims are upheld in the trial that started this week in Virginia.

One of Google’s key central defenses in the ongoing trial is that the DOJ (through the FTC) previously approved many of the company’s key acquisitions, like DoubleClick.

Google is arguing these approvals suggest a tacit endorsement of Google’s business practices at the time.

In other words, Google is set to argue that if these acquisitions were approved by regulators, then the company’s subsequent integration of these assets was legitimate and within legal bounds​.

In the US, it is not necessarily illegal to establish a monopoly through merit and efficient business practices, so long as these practices were not done in the name of trying to create a monopoly (vs. just competitive actions). In fact, specifically from the DOJ’s website:

…the willful acquisition or maintenance of …[a monopoly]… as distinguished from growth or development as a consequence of a superior product, business acumen, or historic accident [is illegal]…

What is key here is the willful creation of one. Google is arguing in this trial that they did not intentionally try to create a monopoly. They claim their innovations, and regulator approved actions, fall under the exemption of Google building a superior product, and/or historic accident. Keep in mind, when Google bought DoubleClick in 2008, Yahoo was much bigger as a % of market share than they are today.

Google’s Network ads are integrated into their broader operations and functions somewhat independently (as CNBC points out in their analysis)​. The DOJ is suing for the Google Ad Manager (GAM) to be separated from Google. This is different from the core search business, which did over $200 billion in revenue over the last 12 months.

This specific division that GAM is a part of generated around $7.4 billion in revenue in Q2, and actually saw revenue drop by 5% YoY (Q2 Call).

In essence, what I am trying to point out in this analysis is that the DOJ’s lawsuit against Google targets a much smaller part of their business that is actually shrinking. I think Google still has a good chance to win this lawsuit (though I am not a lawyer). Even if they don’t, this business will likely be a strong standalone company if Google spun it out.

With its industry leading in-house technology for ad-tech, this segment would potentially command a price-to-sales multiple of around five times annual sales (revenue is around $30 billion over the trailing 12 months). This would equate to about $150 billion in equity value. Even if we offset this $150 billion in equity value against the low odds event of $100 billion in advertiser lawsuits I mentioned before, this still produces $50 billion in equity value that I believe the market is valuing at net-zero right now given that Google is trading at lower than historical median valuation multiples (see valuation section).

This makes the network business really valuable, and I don’t think the market is pricing this division’s full value in.

Valuation

Google’s current forward P/E ratio is well below their five-year average at 19.61 (vs the average 25.79), which really shows the market’s cautious stance going into this trial.

Investors really seem to fear a breakup could severely impact the network business model that integrates Google’s core advertising operations.

However, as this analysis has argued, the division at the center of the lawsuit is one of Google’s less profitable segments (Dan Ives estimated in 2020 that this division only did about $1 billion in operating profit). Given these figures, divesting this business could benefit Google’s balance sheet, potentially unlocking net $50 billion in value, and could lead to a re-expansion of their P/E multiple as market concerns about antitrust litigation subside​.

Altogether, I think Google should be trading at about 30 times forward earnings. This lawsuit is a distraction to the strength the underlying business has in the cloud and its newfound strength in AI. Winning this lawsuit (and/or dumping this business) will allow investors to refocus. I think this rerating of shares to about 30 times forward earnings would provide upside of about 50%.

Risks

While I think Google is in a good position regardless of this lawsuit outcome, I am confident that the end of these antitrust trials in the United States does not signal the end of Google’s legal troubles. The company is also facing a competitive practices probe in the United Kingdom, with no formal conclusion.

The UK’s Competition and Markets Authority (CMA) has provisionally found that Google is abusing their dominance in the online ad tech market by engaging in anti-competitive practices that harm UK publishers and advertisers​. This could lead to increased regulatory scrutiny in the UK and across Europe, where regulators have already expressed similar concerns.

Despite this, I am less worried than the broader market. A major reason for my confidence is that Google’s importance is far greater in the United States than it is in Europe. Even if the company faces legal setbacks or a forced spin-out in Europe, I think the impact on shares may not be as devastating as some investors fear. A potential spin-out in Europe could even benefit Google by isolating the legal liabilities & regulatory compliance requirements in a subsidiary, while the parent company in the US remains relatively untouched​.

All of this feeds into my thesis that this could also expand Google’s P/E multiple, as investors separate the regulatory risk from core operations.

Bottom Line

Google’s ongoing antitrust battles pose notable risks, but I believe they can still come ahead from a US trial, despite previous losses or even if this trial itself results in a loss.

Even if they lose, the breakup of the company could unlock shareholder value, similar to Standard Oil’s breakup in 1911.

Each spinout (a GAM spinout and or a European spinout) could make the sum of the portfolio companies trade at a higher earnings multiple, reflecting more focused business models with more defined risk profiles.

While market fears surrounding regulatory risks are valid, I remain optimistic about Google’s future. Their core business remains highly valuable, and a breakup scenario could ultimately lead to higher valuations for each segment. I continue to view Google as a strong buy.