Invest In Alphabet And Keep It Until You Retire

| About: Alphabet Inc. (GOOGL)

Summary

Alphabet continues to deliver tremendous growth.

Alphabet has fantastic returns on investment.

Alphabet has a debt-free balance sheet with 10% of its market cap made up of cash.

Investment Thesis

Sometimes the best investments are laying in place sight. For a long time I have followed Alphabet (NASDAQ:GOOG)(NASDAQ:GOOGL) from the side without articulating my thoughts. But today this changes. I first became enthralled with a potential Alphabet investment after Mohnish Pabrai first initiated a position in the company sometime ago. In the article that follows I detail why I think that an investment in Alphabet is still not too late.

Business Overview

I trust that most readers have an idea how Alphabet derives its revenue but as a concise reminder one could say that Alphabet's main reporting segment is Google which includes products such as Search, Ads, Commerce, Maps, YouTube, Google Cloud, Android, and virtual reality. Google generates revenues primarily from advertising, sales of apps, in-app purchases, and digital content, services fees for cloud offerings, and sales of hardware products.

Alphabet also has its other segment whic is grouped under Other Bets, which are largely insignificant and a distraction to the main thesis of this article.

Mobile Advertising

Alphabet continues to grow at a very aggressive pace. In 2017 Q1 it was up 22%. This was driven through growth in advertising by mobile search. The company focus on enhancing features and functionality on mobile played a strong role as well as the secular tailwinds from the number of users with smartphones with enhanced capabilities.

This positive momentum is expected to continue. Management believes that many businesses are finding its advertisement platform offers a good value proposition. Furthermore, management believes that many more businesses are still joining its ad platform, specifically for mobile. Management singled out India and Brazil but stated that there are many more countries also.

Investment in Cloud

In light of the company's strong revenue from advertising, management felt able to increase its focus on different strategy opportunities such as its Cloud business.

The number of new hires since 2016 Q4 increased by nearly 2,000 with a sizable chunk of that for Google Cloud.

This has translated to its Cloud business becoming one the fastest growing areas within the company. Management believes that this is a strategic opportunity here as it has many strengths and that it could ultimately be an avenue for significant long-term growth in a rapidly evolving sector.

Other Successful Investments Which Are Paying Off

Further areas that drove Alphabet's growth in the quarter included Google Play. The company's previous investment to shift to direct billing with carriers assisted the way that users could access and purchase their preferred apps and games.

Other areas that contribute to the exceptionally strong quarter included YouTube revenue, particularly video advertising.

Financials

Alphabet has a very strong balance sheet with a net cash position of approximately $80B which is just over 10% of its market cap. It derives a large portion of its cash overseas and so is unable to repatriate this cash without hefty repatriation taxes. As of March 31, 2017, it had $56B of cash and cash equivalent is held overseas.

Source: morningstar.com; author's calculation

As the table above demonstrates, not only has Alphabet had very strong growth with a CAGR of 18.9%, it also has strong returns on invested capital.

Personally, I opt to measure returns on invested capital via a FCF margin (FCF/Revenue) threshold. I prefer this metric as it's unencumbered by its cash/debt balance as it is a cleaner metric than ROE.

Additionally, I prefer to use a FCF margin metric as its not skewed by having earnings in the numerator. Not that Alphabet has any problems with its GAAP recognition accounting procedures, but it's a habit of mine.

I have found that a company with a FCF margin at 5% to roughly translate to a ROE of 12%-15%, what most investors would class as a good company. In Alphabet's case it has a FCF margin of 22%, which certainly reinforces the fact that it's a stupendous company.

As a brief side bar, for readers who are interested in further studying, it was Henry Singleton the investor who inspired my zealous focus of searching for company's high margins.

Relative Valuation

Source: morningstar.com

The table above shows that relative to its five-year average Alphabet is roughly at fair value. However, this type of analysis masks the tremendous opportunity of investing in Alphabet for the long term. A more appropriate analysis for Alphabet is a Discounted Cash Flow analysis.

DCF Analysis

As a deep value investor I put a lot of emphasis on a company's track record. Traditional value investors tend to seek companies with bad news where the market has overreacted and attempt to buy those companies cheaply with the hope that once the bad news has settled its not as bad as the share price would imply and that with time the company's underlying economics would "mean revert" allowing the investor to sell at a higher price. However, in Alphabet's case I believe that a DCF analysis provides a more accurate reflection of the investment case for Alphabet. As Bill Miller said in an interview for The Investors Podcast,

Buffett has said that growth and value are not opposed to each other. Rather, growth is an input into calculating the intrinsic value. A lot of value investors tend to rule out companies that trade at high multiples without calculating their true value.

A back of the envelop DCF analysis with a normalized $17.8B of FCF, with 10% growth over the next five years (which is very conservative when compared with its five-year CAGR of 18.9%), before leveling off at 5% (which is marginally above inflation, but, crucially materially lower than Alphabet is likely perform at). I discounted this FCF back at 6%. I used 6% because Alphabet has shown that it is still aggressively growing, with no sign of slowing down while keeping a rock-solid balance sheet. This brings the DCF to at least a $1.5T market cap. Therefore, paying only $670B currently has a huge margin of safety.

Investment Risks

The biggest investment risk facing the company is that it faces consistent competition from other well-known public companies, such as Microsoft (NASDAQ:MSFT), Yahoo (NASDAQ:YHOO) and Facebook (NASDAQ:FB).

The company derives 88% of its total revenue from advertising. If any one of these companies (or other companies) creates a more effective algorithm it could significantly slow down Alphabet's advertising revenue growth.

Recently, Facebook's advertising revenue has been growing very successfully and since Facebook is able to also offer very target advertising businesses may chose Facebook over Alphabet, which would again hamper Alphabet's growth and with it, its ultimate valuation.

Conclusion

I feel that in spite of the superficial illusion of trading at high multiples, there is still plenty of growth ahead and that patient investors that are willing to invest now and stay invested for long periods of time over the next 3-5 years might be satisfactorily rewarded.

Please do your own due diligence to reach your own conclusions. If you have enjoyed reading this article, please click "Follow" to get more articles of mine in real time.

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.

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