Description

Summary

Alphabet Inc. (GOOGL, GOOG) is a collection of businesses which in aggregate, place GOOG amongst the highest quality franchises in the world. The company operates three primary segments, Alphabet services (core business), Alphabet Cloud, and Other bets.

In the near term (24 months), GOOG shareholders stand to benefit from continued operating leverage at scale, Google Cloud (which is nearing profitability), a strong free cash flow driven share buyback program, continued investment in growth, potential strategic acquisitions, and—according to a February 2022 announcement—a 20-for-1 stock split. In the long term, Alphabet continues to invest heavily in the future, funding revolutionary changes in technology.

Alphabet is a user-focused company. By developing products that improve the lives of the company’s users, Alphabet unlocks massive, two-sided networks. Google Services leverages these network effects, earning money by selling performance and brand advertising. The segment continues to invest heavily in non-advertising revenue streams from Google Play, Hardware, and YouTube subscriptions.

The Google Cloud segment generates revenue from the infrastructure, platform, and related services of both the Google Cloud Platform and Google Workspace.

Other Bets encompasses emerging companies—in stages that range from R&D to early commercialization. Primary themes for Other Bets  are in health, life sciences, transportation, and internet services including Google Health, Verily, Calico, Waymo, and Google Fiber.

Growth & Operating Expenditures

Since 2017, Alphabet’s total revenue has grown at a 23% CAGR while the company’s operating expenditures, including R&D and Sales and Marketing, have grown by only 17% compounded annually. General and Administrative costs have decreased at a 4% CAGR in the same period. 

Source: Alphabet SEC documents

Alphabet’s traffic acquisition costs (TAC) have grown at a 20% CAGR since 2017. Alphabet’s other cost of revenues have grown at 29% compounded annually in the same period presenting minor concern.

Source: Alphabet SEC documents

Operating Income

Operating income from Alphabet’s segments is as impressive as the company’s revenue growth. Driven by Google Services, total income from operations grew at a whopping 42% compounded annually.

Source: Alphabet SEC documents

Incremental Margins

As Google Services continues to grow, the segment’s incremental margins have started to increase. The segment is clearly experiencing a great deal of fundamental momentum.

Source: Alphabet SEC documents

As Google Cloud nears profitability, the segment is beginning to show very strong incremental margins. While Amazon AWS and Microsoft Azure have a clear head start on Google Cloud, the company is making up lost ground quickly. In a few years, I expect Cloud to materially contribute to Alphabet’s free cash flow generation.

Source: Alphabet SEC documents

As the company continues to grow and scale, capital expenditures remain a significant priority.

Growth & Capital Expenditures

On the 2021 4th quarter conference call, CFO Ruth Porat stated, “the results in the fourth quarter primarily reflect ongoing investment in our technical infrastructure, most notably in servers, to support ongoing growth in both Alphabet Services and Alphabet Cloud. We also increased the pace of investment in fit-outs and ground-up construction of office facilities.”

Looking forward, Porat mentioned that, “In 2022, we expect a meaningful increase in CapEx. In technical infrastructure, servers will again be the largest driver of spend. With respect to office facilities, after fairly muted CapEx over the past 2 years, we are reaccelerating investment in fit-outs and ground-up construction.” This investment could create some free cash flow headwinds, however with Alphabet’s growth and scale, it should have no significant negative impact on the company.

As illustrated in the table below, Alphabet spends a considerable amount [mb1] [mb2] on capital expenditures above depreciation on PP&E (growth CapEx). Any meaningful increases in capital expenditures going forward indicate that the company has growth opportunities likely supporting future fundamental momentum.

  Source: Alphabet SEC documents

Aggressive Share Buybacks

Since 2018, Alphabet has aggressively repurchased shares. In 2021 alone, the company repurchased nearly $50 billion worth of shares for an average price of $2,321. Since 2018, the company has repurchased $118.4 billion in shares at an average price of $1,812. As of February 2022, the company is authorized to purchase another $17.4 billion of shares. Given Alphabet’s track record of repurchasing shares, the company will likely continue this trend.

 Source: Alphabet SEC documents

Smart Acquisitions

Alphabet also has a rich track record of making strategic acquisitions to stimulate growth and strengthen competitive positioning. One of Alphabet’s most notable growth acquisitions was YouTube, which it acquired for $1.65 billion. Today, YouTube generates $28.85 billion of revenue. Alphabet has also made notable strategic acquisitions of DoubleClick, MotorolaMobility, and Waze. Doubleclick has ensured that Alphabet dominates the online ad space. Though Alphabet acquired the advertising company in 2008, it remains the target of antitrust complaints. Meanwhile, MotorolaMobility’s IP catalogue protected Alphabet in multiple disputes, Waze was an excellent fit for Google Maps, and Fitbit has recently given Alphabet a top seat within the competitive wearable technology industry.

Alphabet most recently announced an acquisition of cybersecurity firm Mandiant for $5.4 billion.

Source: Alphabet SEC documents

Stock Split

In February 2022, Alphabet announced a 20-for-1 stock split. This split will reduce the price per share, making both Alphabet stock and options more approachable to the general investing public.

Valuation

Alphabet’s valuation today is extremely attractive. Estimated 2022 EV/EBIT is 17.04 x compared to a 3-year median of 21.7x and an industry average (median) 2022 EV/EBIT of 21.4x. Estimated 2022 EV/FCF is 18.79 x compared to a 3-year median of 27.95x and an industry average (median) 2022 EV/FCF of 26.6x.

Source: Alphabet SEC documents, Factset, RBC Capital Markets

Economic Earnings

In addition to Alphabet’s many positive qualities, the company is a powerhouse generator of economic earnings. In 2019, 2020, and 2021, Alphabet generated $19.75 billion, $25.04 billion, and $60.99 billion of economic earnings respectively (using an 8% cost of capital). This figure grew by 75.7% over this period.

Source: Alphabet SEC documents

Expectations

Alphabet perpetually under promises and over delivers. In the most recent year, analysts  have continually revised their revenue, EBITDA, and EPS estimates upwards, and I expect that this trend will continue. Alphabet’s average price target for the company also continues to rise and sits at $3,452, a 31% premium above the current price.

Risks

Alphabet’s most significant risk is likely regulatory. If regulatory bodies determine that Alphabet is an antitrust risk, the company could potentially be split. While this split could hurt Alphabet in the short term, the division would also probably unlock additional value currently hidden in Alphabet’s individual segments.

Alphabet also faces intense competition in many areas. The company spends a great deal of resources to maintain its competitive positioning and I have every confidence that the company will successfully continue to do so.

Alphabet is an ideal asset-light business to own through periods of inflationary pressure.

In the case of a recession, the company’s enterprise value multiples could contract and the stock price should remain roughly flat through 2024. Given Alphabet’s strong cash position and healthy cash flow, the company could actually benefit from any widespread economic downturn either through market share capture, strategic acquisitions, or additional share buybacks.  

Conclusion

Alphabet is a business that constitutes a rare convergence of value, quality, and momentum. The company does not have to experience a multiple re-rate or major sentiment change to deliver over a 20% IRR for investors. The company’s strong competitive position, growing moat, and lengthening runway make it one of the most attractive risk vs. reward investments available in markets today.

Catalyst

Operating leverage, Cloud profitability, Buybacks, Growth CapEx, Acquisitions, 20:1 split