Alphabet,
A fundamental analysis!
February 20, 2019
SHARE PRICE: $1126,51
MARKET CAP: $781,03B
1. INTRODUCTION
As many of you know, Alphabet is the parent company of Google. I’ve seen a couple of investors I admire praising the company, so I decided to take a look at it. I’m expecting to find an amazing company. I love their products and my life would be a lot harder without them. As always, the first stop is their website which is located at the very funny URL www.abc.xyz. Quite a nice reading on the first page. Go and check it out.
2. BUSINESS OVERVIEW
2.1. BUSINESS DESCRIPTION
As the founders say, Alphabet is a collection of businesses of which Google is the largest one. Some of these businesses or endeavours are as different from each other as they could be, ranging from Life Sciences, self driving cars, balloons that provide internet access to remote regions of this planet, artificial intelligence, etc.
Deep down, Alphabet, or should I say Google, is an advertising company. They sell virtual space to advertisers, but not just any space. Similarly to Facebook, the fact that they have so much information about their users allows the advertisers to laser focus ads in order to reach their target audience in a way that wouldn’t be possible through traditional channels.
2.2. LARGEST SHAREHOLDERS
Those of you who have read any of my previous analyses, know that I love companies in which the founders still have considerable skin in the game. In this case, both founders Larry and Sergey still hold significant amounts of shares.
There are 3 different classes of stocks: A, B and C. The A’s get 1 voting right per share, the B’s get 10 voting rights per share (these are all in the hands of the founders and represent 56% of voting rights) and the C’s don’t get any voting rights, and that’s why they trade at a slight discount from the A’s.
2.3. MANAGEMENT TEAM
As I was saying, the founders are still at the helm of the company. They’ve opted for a structure where they put a CEO in each company under their umbrella, like Sundar Pichai in Google or “Dinni” in Access. This way they can concentrate in capital allocation and spread their arms onto other adventures.
3. HISTORICAL CONTEXT
3.1. LONG TERM CHART
Whether we’re talking about the class A shares or the class C shares, the long term chart is almost the same. For the sake of simplification I’ll be talking about the class A shares from now on.
If you would’ve bought Google shares at the IPO price of $42.5 (split adjusted), and held on to them until today, you would’ve gotten a 24,4% CAGR.
Don’t worry, even Buffett was offered to buy them at the IPO and he declined. Years later this is what he had to say about his decision: “We blew it“.
3.2. MARKET CAP AND SHARES OUTSTANDING
The number of shares outstanding grew significantly in 2015 but has been stable throughout the subsequent years, growing at 1% yoy due to stock based compensation, which is perfectly acceptable. One thing that didn’t grow as slowly is the market cap which is now $781,03 Billion, from the original IPO level of $23B.
3.3. SALES - OPERATING INCOME - OPERATING MARGIN
Sales have been growing at an astonishing rate of 31% yoy since 2004 and in 2018 alone, they grew 23% from 2017.
Something that I don’t really like is the operating margin declining. This is due to higher overhead, higher marketing expenses and to a $5 billion fine the European Commission applied to Alphabet for breaching antitrust rules.
3.4. SALES BY GEOGRAPHY
Not surprisingly, the USA is their largest market accounting for almost half of the revenue, followed by EMEA representing 33% of total revenues.
This is more less the same situation Facebook is facing, so my opinion on this is more less the same as in my Facebook analysis. When other countries converge to similar amounts of ad spending, Google is in for a nice treat.
3.5. SALES BY SEGMENT
“Google ads” obviously refers to the revenue coming from advertising, which accounts for 85% of total revenue, while “Other Revenue” includes cloud, apps, youtube and other digital content accounting for 14,5% of total revenue. “Other bets” is the combination of many other endeavours that are too small to be reported separately. This includes businesses like Calico, Waymo, CapitalG, etc..
Clearly, Google is still highly dependant on ads to generate its revenue but there are plans put into motion to slowly change that. We’ll take a look at what they are in a minute.
3.6. NET INCOME, NET MARGIN
Net Income was $31B in 2018, going up more than 100% from the previous year, but this wasn’t due to a stellar operational 2018 or a really poor 2017.
In 2017 the company had to pay a one-time-tax under the Tax Cut and Jobs Act so it could bring home all of the cash it had overseas, effectively lowering its net income.
The more attentive readers out there might’ve noticed that for 2018 the net income was higher than the operating income. This was mostly due to the price variation of Alphabet’s marketable securities.
3.7. CASH FLOWS
I’m introducing a new kind of chart, so I hope this is not too confusing. Please let me know if it is.
Although FCF went down to $21B in 2018 (blue bars), this was not because the operations were bringing in less cash (green bars). In fact, cash from operations grew 30%. This was because Alphabet doubled its CAPEX (red bars) in order to give a strong push to its cloud operations.
This is what Alphabet’s chief financial officer, Ruth Porat said: “With respect to capex [capital expenditures], we continue to invest in both compute requirements and for office facilities, although we expect the capex growth rate in 2019 to moderate quite significantly,”
3.8. R&D
R&D expenses have increased over the years, but in relation to total revenue, they’ve been quite stable.
3.9. DIVIDENDS
To my satisfaction, Alphabet doesn’t pay a dividend.
3.10. PROFITABILITY RATIOS
ROE has been around the mid teens for the last 5 years (2017 was an exception) and it went up quite well on 2018 to 17%.
3.11. FINANCIAL RATIOS
Alphabet is another great company with current ratio of 3,9 and the debt-to-equity ratio at 0,3. Have I already told you I love companies with little to no debt?
In fact, they ended last quarter with a net cash position of $105B.
3.12. PRICE TO EARNINGS RATIO
The forward 2019 PE is 23, and if we discount net cash, the PE is 20, for a company that grew its revenue 23% last year.
Let’s take a look at the Price to FCF to see the whole picture.
The Price/FCF is rising because of the increase in capital expenditures that leads to a temporary depressed FCF. When Capex slows down and comes back to normal levels, we’re going to see the FCF go back up again and consequently the Price-to-FCF come back down.
4. GAINING PERSPECTIVE
4.1. INDUSTRY AND NEW VENTURES
The first chart clearly illustrates Google’s dominance in the ad spending market, which is dominated by Google and Facebook. And if you watch it closely you can see that Google’s share is slowly decreasing as other players come into the market (think Amazon).
And if we take a look at the second chart, we can see that there is still a huge runway for Google Ads to grow in years to come.
Even with this long runway, Google is pursuing new ways of making money:
Youtube: They are currently betting on their own content to compete with Netflix and Amazon, as well as on paid music to compete with Spotify and Apple Music. I have no doubt that Google will be able to further monetize youtube and that this will be a major source of revenue in th coming years.
Personal note: I’ve always found it so annoying that the mobile youtube app didn’t let me listen to music while using other apps. Now I understand why. I must pay for that.
Cloud: Although the cloud contributes to a small part of the total revenue, it is expected to grow a lot. As we’ve seen throughout this analysis, they are investing heavily on data centers and other facilities.
The image below shows us the three largest cloud services providers with Amazon clearly leading the way, but if you watch closely, Google is expected to more or less double its cloud revenue each year in the near future.
4.2. SEASONALITY
For the same reason as I stated on my Facebook analysis, Alphabet’s best quarter is the 4th quarter. Both are advertising companies, so their revenue is highly dependant on ad spending. And when is ad spending the greatest? You got it! In Thanksgiving and Christmas.
4.3. TYPE OF PLAY
Alphabet is a growth stock.
4.4. RISKS AND COMPETITION
As any other advertising company, Alphabet is highly dependant on global ad spending, so if something goes wrong with the economy, they’re going to feel it.
Regulation: This obviously is a major issue. Like we’ve witnessed recently, regulation has the power to slow down the bottom line growth when regulators fine these big companies.
Competition: Being an advertising company, and with other giants like Facebook and Amazon closing in, this is another major risk.
Privacy: This is still a major risk, especially when you give your credit card details and your family’s photos to Google, but from what I’ve been seeing, people don’t care for privacy matters as much as I would’ve thought.
5. OVERVIEW AND CONCLUSION
5.1. OVERVIEW
I just love Alphabet’s products (the google sheets, not so much). I don’t know how we could live without Google to tell us what time does the supermarket closes, how to get to the beach when we rent a car on a foreign country, or to save our credit card details. It is without a doubt an amazing company whith a huge moat.
I love that there is still a long runway in advertising spending around the world, and I’m eager to see where they are going with the cloud, how they are monetizing youtube and all of the smaller bets they are making. Have you ever heard of project loon? They are releasing balloons into the air in remote parts of Africa so people can have access to the internet!!!
Time has come to make some estimates. Let’s draw 2 different scenarios for the next 5 years. One of no growth, which is very unlikely and another one of moderate growth, which I think might be closer to reality:
No Growth Scenario:
With no need for growth Capex, the company will generate $35B every year. In 5 years time, there will be $280B sitting on the company’s balance sheet. At a PE of 25, its Market Cap will be $875B. Add back the $280B and we get a Market Cap of $1.155B. That represents an 8% CAGR from today’s values. For a no-growth company!
Conservative Scenario:
- “Google Ads” will grow at a 10% rate (it grew 22% last year).
- “Other Google Revenue” will grow at a 20% rate (it grew 33% last year, and youtube music and original content are coming alongside with higher revenue from the cloud, so I’m being very conservative here).
- “Other bets” will stay flat. I’m sure this segment will grow but I won’t even factor it in on my back-of-the-envelope estimate.
- Net margin will go down to 20%.
- PE of 25 (the average PE for the last 10 years is 28).
- No shares outstanding variation.
All of this leads to a 2023 Net Income of $47,5B. If we apply a 25 PE ratio we get a Market Cap of $1.187B. Meanwhile the company will be generating cash. If we add back all that cash we get to a $1.485B Market Cap, which represents a 14% CAGR from today’s valuation.
5.2. CONCLUSION
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