Why The Top Paid Hedge Fund Manager Owns Google

Jun.11.14 | About: Alphabet Inc. (GOOGL)

Summary

David Tepper is by all accounts the world's most respected hedge fund manager, he's also the highest paid.

He went bearish on the market earlier this year, but at the same time he was buying up shares of Google during 1Q.

But the key is that Tepper isn't just buying Google for the search business.

Billionaire David Tepper is one of the most respected hedge fund managers. His hedge fund, Appaloosa, manages some $15 billion and has been one of the best performing funds over the last two decades.

Tepper pulled in $3.5 billion last year. He has also been the highest paid fund manager the last two years. But he made some pretty pessimistic comments at this year's SALT Conference. The who's who among hedge fund managers gathered to talk markets and investing. Tepper noted:

"This is probably you're supposed to think about preserving some of your money...I think you can still be long, but I think you're supposed to have some cash now..I am nervous. I think it's nervous time."

What's most interesting is that Tepper's fund, Appaloosa, were still buying up shares of Google (GOOG, GOOGL) during the first quarter. Appaloosa increased its stake in the search giant by 86% last quarter. It's now his largest stock holding. Appaloosa now owns over 236,000 Google shares, the most he's owned in the last five years. His position is worth around $492 million. The last time we saw Appaloosa with such a large position in a stock, it was Citigroup.

Citi had been one of Appaloosa's top three stock holdings for several years, being his largest equity holding for all of 2013. Then, last quarter, Google overtook that spot. The rate that Appaloosa is buying Google is more aggressive than we've seen in some time from the fund, especially among his top 10 holdings. Not since he was adding a large Apple position in mid-2010 has Appaloosa nearly doubled its position in a single quarter. What's more is that the fund increased its Google position by 63% quarter-over-quarter during 4Q 2013. At the end of 3Q 2013, Google was Appaloosa's 16th largest stock holding.

In conjunction with his SALT Conference comments, Tepper also noted that his fund had reduced its equity exposure from 100% to 60% last quarter. Yet, he told CNBC that he still saw value in stocks like Google and Priceline.

That might not come as a surprise after Tepper's latest comments, however. Tepper actually backpedaled from his "nervous" comments at the SALT conference. He told Kate Kelly of CNBC that his worries were alleviated. Kelly reported that:

"I just spoke briefly to David Tepper this morning who said his view has changed somewhat since last month when he spoke at a conference and said, famously, it is nervous time in the markets for a number of global macro reasons dealing with Central Banks. Now that the ECB has made this somewhat historic decision today he indicates to me that he is feeling a little bit better."

This was great news for the market, which experienced a relief rally after Tepper's comments. Regardless, Tepper's worries had little to do with Google in the first place. The company is a search giant, owning just over 65% of the search market share in the U.S. It also has a dominant position in Canada, Asia and Latin America. The key is that search is not a mature business, there's still a global market that it can tap into.

But it has quickly become more than just a search destination. Innovation is Google's current focus. With its acquisition of Nest Labs, and Google Chromecast, Google is already making its presence known in the home. This is a big opportunity, where Google could look to place ads on TVs and thermostats.

Ads account for over 90% of Google's revenues. And there's a big opportunity to continue capturing market share here. Google's key focus will be online display ads. Don't forget it also has YouTube, which should continue to be a big revenue opportunity in the video ad space.

Then of course there's mobile. Google has been navigating the move from desktop search to mobile search quite nicely. This, in part, has been helped by its comprehensive mobile presence. Google's Android OS, Gmail, Chrome, etc. continue to make it a very sticky platform for users.

Google has shown a willingness to spend money to make money. Something Apple is just starting, judging by its Beats acquisition. Apple's Beats acquisition, valued at $3 billion, is only its second acquisition of $400 million or more. Google has made 11 acquisitions of $400 million or more (three of which have been in the last year).

The market will continue to reward Google with superior multiples (mainly compared to Apple) if it keeps up this strategy. The tech giant has $50 billion in net cash, thus, it has the balance sheet to continue its "moon-shooting" strategy of innovative product creation and acquisitions of unique tech (such as solar powered drones).

Over the last decade, the return on Google's shares has been more than 30 times that of Yahoo and 18 times that of Microsoft. But shares of Google only trade at a slight premium to Microsoft on a forward P/E basis, and a discount to Yahoo.

In the interim, Google could easily hit $700. The company has a strong recurring stream of revenues from ads, but it also has a number of products that could be incremental earnings contributors. The Google Glass and driverless cars are exciting to talk about, but Google's focus on a broader trend, the "connected home" or "smart home," is an area that Google could have a first mover advantage in. It knows how to make advertising work, and it's becoming more and more of a products company. This combo could be the next big growth story for Google. The mobile ad market is estimated to be $18 billion in 2014. But the "connected home" device market is already expected to be $10 billion by the end of this year. That doesn't include the potential to offer ads on devices in the home.

At $700 a share, that would put Google trading at a P/E of 22 based on next year's earnings estimates. That's still below Google's historical average P/E and the industry average. Over the last five years, Google has traded at an average P/E of 53, and the current industry average is 42.

$700 a share also assumes that Google can get free cash flow margins back to 20% (from the current 19%, but still below the 24% long-term average) for 2016. Generating close to $23 in free cash per share in 2016, and then assuming Google can grow free cash at a mere 8% over the next five years before dropping to 4% over the long-term (coupled with a 10% discount rate) assumes fair value is just over $700 a share.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.