Last week, shares of Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL) took a hit as the company's first-quarter results fell well short of expectations. Cost per click declines were a big reason for the revenue miss, which the company was not able to make up for on the bottom line. As Alphabet approaches $100 billion in annual GAAP revenues, the law of large numbers is starting to impact the company's growth rates. That puts the name at a fork in the road, and an upcoming decision may determine how investors look at Alphabet's future.
The earnings report has been analyzed enough on this site and others, so I'm not going to repeat these details. What I want to focus on is the company's buyback, summarized in the earnings press release as detailed below:
In Q1 2016, we repurchased 3.2 million shares of Alphabet Class C capital stock for an aggregate amount of $2.3 billion, of which $2.1 billion was paid during the quarter. The total remaining authorization for future repurchases is approximately $1.4 billion.
This followed $1.8 billion of share repurchases in Q4 2015. It wouldn't take much for the program to be completed this quarter, given what we've seen recently. Even if things slow down a bit, it seems likely that the program is completed this year, meaning management and the board have a decision to make.
With more than $5 billion in free cash flow during Q1, the company ended the period with more than $75 billion in cash and investments on the balance sheet. Most of this cash is located outside the US, and the company does have a little more than $5 billion in debt. However, there is plenty of financial flexibility for a capital return program to continue, especially with the strong cash flows that Alphabet generates.
While the company's buyback isn't one of tremendous size or impact, it was done in an effort to help with the problem that we saw with Class C shares. When Google launched its second trading class, the non-voting C shares traded at a bigger and bigger discount to the Class A shares, which contained voting rights. While the gap has decreased over time, it still was more than $17 as of Tuesday's close. A continued buyback of Class C shares could help narrow the gap further.
The issue here is that if Alphabet comes out with a huge buyback announcement, does it signal to the market that it is losing some of its growth power? We saw the same kind of fears crop up when Apple (NASDAQ:AAPL) started returning capital in a big way. A nice dividend and buyback hike couldn't even save Apple's shares after a bad earnings report, which will increase growth fears tremendously.
With investors favoring growth names right now, Alphabet trades at more than 21 times its non-GAAP expected EPS this year. If you were to convert that to a GAAP valuation, you're talking about more than 25 times. A lot of big-cap tech names that aren't growing much anymore see their valuations currently in the low to mid teens. If that were to happen to Alphabet, there would be a tremendous amount of potential downside.
So what should Alphabet do here? Well, if it wants to preserve its growth image, it would probably be a better idea to use its cash on acquisitions rather than buybacks and/or dividends. By using just $10 billion, roughly 1/7th the company's net cash position, Alphabet could bring in a few billion in annual revenues, helping to keep the growth rate at a decent level. Right now, analysts are calling for less than 15% revenue growth in 2017, as the company looks to pass $100 billion annually. A few more bad reports like we saw in Q1, and the expected revenue growth rate could head towards the single digits.
As the current buyback of Alphabet gets closer to completion, the company will hit an interesting fork in the road. With about $70 billion in net cash and investments on the balance sheet, investors are going to start demanding the company use its cash. For the company to keep its growth image in the forefront, acquisitions would be the best way to go. However, if we see the company start to be more generous on the capital return side, investors might start thinking about what happened to Apple, and the premium valuation of Alphabet could easily start to contract.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Investors are always reminded that before making any investment, you should do your own proper due diligence on any name directly or indirectly mentioned in this article. Investors should also consider seeking advice from a broker or financial adviser before making any investment decisions. Any material in this article should be considered general information, and not relied on as a formal investment recommendation.