SUMMARY:
- Alphabet’s H1 2022 results have been mediocre which is reflected in the stock’s performance down 36% from its highs in July 2022.
- Alphabet’s management appears to be turning cautious per recent announcements in the face of uncertainty.
- The company’s valuation is more compelling than it’s been in years.
- While we should expect more turbulence in the stock market and a near-term impact on Alphabet’s business, the company is well-positioned to emerge a more focused, more efficient company.
Thesis
Near-term headwinds are being reflected in Alphabet’s share price. Further deterioration in the stock price offers investors a compelling opportunity.
Overview of the company
Alphabet (GOOGL, GOOG) reports earnings broken into three segments, Google Services, Google Cloud and Other Bets. In Q2 2022, Alphabet’s Services business generated $62.84 billion in revenue, up 10.12% from Q2 2021 accounting for over 90% of Alphabet’s revenue. This was primarily driven by advertising revenue from businesses like Search, YouTube and Google Networks. Other Services revenue came from app purchases from Google Play, hardware sales primarily from Nest, Fitbit and Pixel phones, and subscription revenue from YouTube Premium and YouTube TV.
Google Cloud consists of two lines of business including Google Cloud Platform and Google Workspace. Google Cloud Platform generates revenue from infrastructure and platform services while Google Workspace generates revenue from cloud based collaboration tools like GSuite products primarily for enterprises. While Services remains Alphabet’s only profitable segment, Google Cloud is posting the company’s fastest revenue growth rates up 35% in Q2 2022 year over year despite operating at a loss of $858 million.
Other Bets is a combination of a portfolio of ventures across numerous growth industries including concepts related to quantum computing, autonomous vehicles, and drone services just to name a few. In Q2 2022, this segment operated at a substantial loss of about $1.7 billion and generated immaterial revenues primarily from the sale of health technology and internet services.
Stock Performance
Alphabet’s stock is down about 36% from its highs of around $150 per share ($3,000 per share pre-split) in July of 2021 which was around 32x ttm earnings.
Let’s take a look at the company’s near-term performance which may begin to justify this dramatic pullback.
Business Performance in 2022
In Q1 2022, we began to see a deceleration in Alphabet’s overall business with consolidated revenues growing 23% compared to 34% in the quarter a year earlier. This deterioration continued in Q2 2022 with revenue growing by 12% year over year and 18% for the first half of the year driven by strong revenue growth in cloud and its advertising businesses. Q2 2022 showed operating margins come under pressure falling 337 basis points to 27.92%. The current margin pressure can primarily be attributed to rising costs associated with employment both in terms of rising headcount and wage inflation as operating expenses rose 24% to $20.1 billion. The result was a 13.6% decrease in earnings per share year over year.
This was not completely unexpected, though. Alphabet is running into peak year-over-year comparisons which they acknowledged in their most recent earnings release. The business environment in 2021 was flush with an abundance of cash, an overheating economy and dovish monetary policy making Alphabet a clear beneficiary. In 2021, the company saw sales up 41%, net income up 89% and free cash flow up 56% year-over-year.
In 2022, we face a far different macroeconomic environment, one in which slower growth is expected and multiples are compressed. CEO Sundar Pichai speaking at Code Conference in Los Angeles in September acknowledged the uncertain business environment caused by the macroeconomic environment and announced the desire to improve efficiencies at Alphabet by 20%, a passive announcement of layoffs. The plan is to merge teams and consolidate the number of managers to reduce redundancies. On September 29, 2022, we began to see the repercussions of this cautious outlook when Alphabet released an update announcing the closure of their consumer gaming service, Stadia, because of failure to gain traction.
Valuation
Based on the near-term performance of the business, uncertain macro environment and expectations for deteriorating ad spending, it becomes apparent in hindsight that Alphabet’s valuation needed to adjust. Alphabet is currently trading around 18x ttm earnings, 19x 2022 estimates of $5.12 per share, and 17x 2023 estimates of $5.91 per share while its three and five year average P/E multiple is 35x and 28x, respectively. Based on this, one could argue that the near term factors mentioned may be priced in particularly if Alphabet’s ad business is as resilient as expected, or if the company’s past performance is even partially reflected going forward. Over the last five years, Alphabet’s revenue has grown at a CAGR of 18% while earnings and free cash flow have grown at a CAGR ~44% and ~23%, respectively.
Valuation Continued: Alphabet’s Price With Hefty A Margin of Safety
Let’s do a quick exercise to find a price at which there is a margin of safety using fairly conservative inputs to discount cash flow. Let’s begin by adjusting 2021 free cash flow by stripping out share based compensation of $15 billion which leaves Google with nearly $51 billion in free cash flow for the year. Let’s assume that the narratives mentioned above take years to materialize given the difficult macro environment. As a result, let’s assume free cash flow grows by around 14% in 2022 and then remains marginally flat for 3 years before re-accelerating well below its 5 year average (~23%) for 6 years. The result is free cash flow growing at a CAGR of around 8%. Let’s use a terminal rate of 3% and a 10% discount rate. This returns a price per share around $85 per share. One could argue these are fairly conservative inputs based on a relatively stagnant scenario for Alphabet. One could also argue this is an unlikely outcome, but it makes the point that Alphabet’s current stock price may be quite attractive.
So, What Might Justify A More Optimistic Outlook for Alphabet?
In thinking about the potential for Alphabet, several narratives justify a more optimistic outlook for Alphabet.
Resilient Ad Business. Alphabet’s ecosystem and scale have positioned the company’s ad business to weather the economic headwinds better than other advertising businesses. Alphabet dominates the online search market with +80% market share strengthened by the use of AI and technological innovation to improve the user experience, drive sales and improve margins. YouTube, concurrently, remains competitive in its traditional video format while expanding to markets like streaming through YouTubeTV and short videos through its Shorts offering. A fairly new offering, the company is still grappling with monetization, however, this could be an interesting opportunity. The company’s focus on the content creator may be a winner as it recently offered content creators competitive monetization incentives attracting attention from content creators like The Beast.
Google Cloud Growth. Despite the economic slowdown, Microsoft’s cloud leader, Scott Guthrie explained that the company was not seeing a slowdown in cloud spend during an interview on CNBC. News like this should bode well for Microsoft and competitors like Alphabet as a rising tide raises all ships. The cloud computing space is expected to grow at a CAGR of 15% per year through 2032. In Alphabet’s most recent earnings release, they disclosed a $51.2 billion revenue backlog primarily related to Google Cloud, half of which they expect to recognize over the next 24 months. Further, the company continues to make improvements to their cloud offerings through the utilization of AI and via acquisitions like Mandiant to remain competitive in this growing space.
Winning Other Bets. Other bets are little lottery tickets that Alphabet is in the process of building. Some of these businesses may warrant articles of their own, but the one worth mentioning that may be on the cusp of entering a new line of business for Alphabet is Waymo. While the race for level 5 autonomous vehicles is incredibly competitive, the opportunity is in the tens of billions of dollars over the next decade or two. A prospective leader in the space, Waymo operates two offerings, Waymo One and Waymo Via. Waymo One is a ride hailing service currently offering autonomous rides in Phoenix, AZ and San Francisco, CA while Waymo Via is their autonomous trucking technology.
Improved Efficiencies. Companies generally use difficult times to justify difficult decisions like layoffs. As previously mentioned, Alphabet intends to sharpen their focus and improve efficiencies by 20%. While this may not mean a reduction in headcount, it could mean a slowing of operating expenses rising as pertains to hiring. During the Q2 conference call, CFO Ruth Porat explained that the majority of increases in operating expenses can be attributed to headcount and that they expect the growth of headcount growth to moderate. Improved efficiencies could equate to improved margins going forward, positioning a leaner company for an improved operating environment.
Cash and Buybacks. Alphabet has a bullet proof balance sheet with a cash position at nearly $130 billion. Over the past 4 years, the company has begun returning this cash to shareholders in the form of share repurchase retiring nearly 1 billion shares. During the Q2 earnings release, Alphabet announced an increase to its share repurchase program of up to $70 billion. This will be important to offset dilution from share based compensation and should also prove to be a driver of EPS growth. The company has the wonderful opportunity to take advantage of its depressed stock price.
The Biggest Risk
There are always an abundance of risks to any company including a company like Alphabet involved in multiple markets like strategic execution risk, competition, black swans, and the list goes on. I would, however, be remiss if I did not at least mention an ongoing fear as an Alphabet shareholder regarding antitrust action against the company. There are no details to discuss, though. The headlines periodically reintroduce the threat of a government action against Alphabet. My greatest concern stems not from a break up of the major parts of Alphabet, but the regulation or inference with the search business (Can the search business be broken up?) based on anticompetitive behavior.
Conclusion
Warren Buffet has said on numerous occasions that he wants to buy wonderful companies at fair prices. The recent pullback in Alphabet’s shares to a more reasonable valuation appears to have given us an opportunity to buy a wonderful company at a wonderful price.
Could The Share Price Go Lower? The short answer is – Of course! The market is not always logical. If we take a look back at the financial crisis, then Google was trading with a P/E around 30x at its highs at the end of 2007 down to around 7x during the depths of the market pullback at the end of 2008. This was despite the fact that Google’s revenue and earnings continued to grow throughout that entire period. The saying, “throw the baby out with the bath water” applies here (Google being the baby) as the market indiscriminately sold all companies including Google. History could repeat itself today if we get a whiff of systemic issues in the financial markets, however, the point of this analysis demonstrates that the opportunity to buy Alphabet at 7x would prove to be another generational opportunity.
While we should expect more turbulence in the stock market, and a near-term impact on the business, Alphabet is well-positioned to emerge a more focused, more efficient company with a solid long-term outlook.
