Google's Earnings Power As The Opportunity Cost Of Tech Investments

Summary

• We share the details of our valuation of Alphabet on an Earnings Power Value basis, apply the IW Box framework, and reiterate our view that the investment opportunity is compelling.
• We estimate Alphabet's earnings power yield (5.5% without Other Bets) and advance it as "the Google hurdle", or the opportunity cost for tech investments with similar growth prospects.
• We recommend investors to avoid investments in tech businesses with similar or inferior growth prospects (mid- to high-growth rates, 20%+ ROC) that fail to clear the "Google hurdle".

As advanced in our initial take on Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL), we believe that at about $1000/share, the investment opportunity is compelling.

Specifically, we wrote:

At $1000/share, we estimate that Alphabet is trading at about 1.25x Earnings Power Value (ex-cash and without "Other Bets"), that is, at a 25% premium of the net present value of the cash flows to shareholders, had management decided to stop investments in growth and distribute all FCF.

And argued that such modest premium over Earnings Power Value (EPV) was justified in view of "exceptional avenues of value-accretive growth".

In this piece, we share the thought process behind our estimation of EPV. Based on that estimation, we reiterate our view that at $1000/share, Alphabet offers a compelling investment opportunity.

We go on to claim that on an earnings power basis, Alphabet is significantly undervalued relative to most smaller tech companies with similar or inferior growth prospects. We thus advance Alphabet's earnings power yield, or the ratio of earnings power to enterprise value, as the opportunity cost for tech investments with similar growth prospects (mid- to high-teens CAGR, with returns on capital - ROC - in excess of 20%). We dub it the Google hurdle, since the yield is calculated neglecting the value of Alphabet's Other Bets.

We close with a recommendations for investors to reduce exposure, and avoid deploying new funds, to tech companies that do not clear the Google hurdle.

Sundar Pichai, CEO of Google (photo: Pradeep Gaur/Mint)

Google's earnings power

EPV is the hypothetical value of a business if it decided to stop investing in growth and maintained those zero-growth earnings in perpetuity.

It is a hypothetical estimation of value in that the business in question may well be investing in growth, which opens a gap between EPV and actual intrinsic value. In particular, a business investing in growth is worth more than EPV if the investment produces returns over cost of capital, and it is worth less otherwise

For a company like Alphabet, whose earnings power rest on an expanding intangible asset base, EPV provides a lower bound of intrinsic value. And unlike more widespread valuation techniques such as discounted cash flows, EPV does not rely on long term predictions of very uncertain metrics such as growth rates, capex and changes in working capital.

On what follows, we estimate the EPV of Alphabet without the Other Bets division. We do that not because we believe that the Other Bets division is worthless, but to put a lower bound on intrinsic value without relying on unduly uncertain estimations. In this particular case, the uncertainty is in the value of early stage businesses such as Calico, Verily or Waymo.

Since we have a strong conviction that the value of Waymo alone will more than offset the future capital requirements of all the other bets, we believe that we are being conservative in assigning zero EPV to the Other Bets.

For full year 2017, Alphabet reported $26.1 billion of operating income. That figure is already net of stock-based compensation, which Alphabet correctly views as a real cost of running the business (although only since early last year).

We adjust that figure as follows:

• We add back the $2.7 billion European Commission fine. We expect the company to remain on the target of anti-trust agencies and tax authorities in the US, Europe and elsewhere, but we will account for the economic impact of increased regulatory pressure through a higher tax rate, rather than through recurring fines.
• We add back the $3.4 billion operating income loss from the Other Bets division.
• We look at reported R&D and S&M expenditures as investments to maintain and expand the intangible asset base, rather than expenses incurred in the reported period.
• R&D expenditures: software projects have a typical development cycle of one or two years, but when viewed as maintenance, enhancement or expansions to the Google ecosystem, their benefits accrue over many more years. Moreover, R&D expenditures are increasingly weighed towards second-wave of growth initiatives such as Cloud and Hardware which do not yet contribute proportionately to reported revenues.
  Hence, we capitalize reported R&D expenditures and amortize them linearly over 3 years. This reduces 2017 R&D expenses by $2.3 billion, from the $16.6 billion reported to $14.3 billion, which is our estimation of annual R&D expenses to support ongoing operations.
• S&M expenditures: major Google services such as Search, YouTube and Maps have very low churn rate, both in terms of end users and advertisers. Moreover, a significant part of S&M expenditures relate to Hardware, YouTube content and Cloud initiatives still in their early innings.
  Thus we capitalize S&M expenditures and amortize them linearly over 3 years. This reduces 2017 S&M expenses by $2.1 billion, from the $12.9 billion reported to $10.8 billion, which is our estimation of annual S&M expenses to support ongoing operations.
  Overall, we are reducing opex by $4.4 billion over a total of $36.4 billion to adjust for the effect of growth initiatives on reported opex. That is a 12% adjustment, which quite frankly passes the "reasonability test" for a company with 20%+ growth.

The adjustments increase 2017 zero-growth operating income by $10.5 billion ($2.7 + $3.4 + $2.3 + $2.1), to a total of $36.6 billion.

Those are adjusted 2017 figures. In Q1 2018, Alphabet reported 23% YoY FX-neutral revenue growth, and we showed in our previous research piece (linked at the top), that operating income grew even faster, after adjustment for growth.

Assuming 18% operating income growth for full year 2018 puts forward adjusted operating income at $43.2 billion.

This is our conservative estimation of the hypothetical operating income that Google, or Alphabet ex-Other Bets, could sustain into the foreseeable future by limiting future investments to maintenance of the current asset base.

Next, we apply a tax rate of 21% on that income. This is higher than historical high-teens tax rates, even though Alphabet is expected to greatly benefit from the US tax reform. But we choose a 21% rate to leave some 500 basis points of margin to account for future anti-trust fines, burdensome regulations and targeted tax initiatives.

A 500 basis point margin hit reduces after-tax income by $2.2 billion (5% of $43.2), which we believe will exceed the effect of future fiscal and regulatory burdens. We note in particular that a digital tax on 3% of revenues originated in the European Union would reduce after-tax profits by less than $1 billion (2017 EMEA revenues were $36 billion), well below our $2.2 billion "tax" margin of safety.

The conservative 21% "tax rate" puts 2018 zero-growth NOPAT (net operating profit after tax) at $34.1 billion, or $48.4/share using 705 million diluted shares.

We estimate distributable cash and marketable securities as of end Q1 2018 of $82.5 billion, or $117/share. This is net of tax payables partially related to cash repatriation. Hence, at $1000/share, the market is pricing future discounted cash flows at $883/share, for a 2018 earnings power yield of 5.5% (48.4/883).

This 5.5% forward earnings power yield is "the Google hurdle" rate that we advance as opportunity cost to assess the desirability of investments in tech businesses with similar expected growth rates (mid- to high-teens) at similar ROC (20%+).

We note once again that after adjustment for growth investments, Alphabet is in fact growing operating income at 20%+. Moreover, 2018 earnings power return on operating book value (reported book value net of distributable cash) is north of 40%, but several growth initiatives such as Cloud, Hardware and YouTube Content are significantly more capital intensive than the traditional Search business, hence we assume future ROC of about 20%.

Google as a value investment

The earnings power yield figure of 5.5% is useful to assess the relative attractiveness of investment opportunities with similar prospects of value-accretive growth.

But at $1000/share, is Alphabet attractive in the first place? And does that entry price offer a sufficient margin of safety for preservation of capital under potential adverse developments?

To answer that question, we calculate the ratio of price to EPV.

Using a discount rate of 7% (320 bps above 10 year corporate bond yields), we estimate that the stock is trading at a 27% premium of EPV (7/5.5 = 1.27). Recall that the EPV estimation is net of distributable cash and assigns zero value to future growth.

It assumes that ongoing secular tailwinds for mobile and online video monetization, "second growth wave" initiatives centered around YouTube, Cloud and Hardware, and well as the Other bets division, in particular Waymo and commercial healthcare applications of AI (through Verily, Calico and other projects in incubation) are worthless to shareholders.

The shareholder value created by growth is a function of the extent to which the benefits from that growth (increased earnings) exceed the costs to sustain it (reduced cash distributions, reduced cash/increased debt in the balance sheet, and/or increased share count).

While we will refrain from assigning a precise value to that growth, we estimate that it brings the intrinsic value of Alphabet equity to 2x EPV at the very least (for reference, a company with perpetual growth rate of 7.5% and ROC of 20% is worth 2x EPV using a 10% discount rate). If our assessment is correct, that means that you can pay 1.27x EPV and get 2x EPV+ worth of value, for a 70%+ margin of safety.

Within the IW Margin of Safety Box framework, at $1000/share, that places Alphabet in the top-left cell (see figure below). That is, at around $1000/share, the stock can be bought today at a large (70%) although uncertain margin of safety (MoS).

It is uncertain because it is substantiated on the hard-to-quantify value of growth, instead of hard assets and current earnings power alone. But in our view, the size of the margin more than offsets its uncertainty. We'll rather take a 50%-confidence 70%-size MoS than a 90%-confidence 20%-size MoS. Especially when the 70% somewhat uncertain margin is in is a wonderful business (Alphabet) and the 20% more certain margin, in an ordinary run-of-the-mill concern with subnormal returns on capital, as are most investment opportunities along the rightmost column in the IW Box.

Alphabet placement in the IW Margin of Safety Box, as of May 2018 (Source: IW Academy)

The Google hurdle, closing thoughts and future work

In today's market, most tech businesses with prospects for mid to high teens annual revenue growth and 20%+ returns on capital fail to clear the Google hurdle, that is, are selling at earnings yields below 5.5% (even after accounting for investments in growth).

We hypothesize that the market is exhibiting an irrational bias against digital advertising businesses. This includes well established businesses with enduring competitive advantages such as Google and Facebook (FB), even though advertising budgets are certain to increase and to keep shifting to digital for the foreseeable future.

It is thus no coincidence that the only two positions we have initiated in 2018, The Trade Desk (TTD) and Alphabet, derive all or most of their income from advertising. And although we have not yet performed deep research on the name, Facebook also seems to be trading at a more than reasonable valuation.

To confirm the difficulty for non-advertising tech businesses to clear the Google hurdle, we need look no further than some of the tech holdings in our portfolio, that after a significant run-up, are trading at earnings power yields well below 5.5% in spite of growth prospects comparable or inferior to Alphabet's. PayPal (PYPL), Palo Alto Networks (PANW) and Activision Blizzard (ATVI) are pertinent examples. Interested readers can learn more about our views on PayPal and The Trade Desk here and here.

While you glance over this lines, we are in the process of rationalizing the tech components of the IW Portfolio. We will reduce exposure to tech holdings that compare negatively to the Google hurdle, and may in fact completely divest one or more tech holdings to position our portfolio for continuous outperformance.

We close with an invitation to investors to proceed likewise. We hope that the Google hurdle helps you avoid overpaying for tech businesses and rebalance your portfolio after an extended bull market.

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We will update on our views of Alphabet after the Q2 conference call in July. In the meantime, we will keep publishing research on potential stock picks and other positions in our portfolio.

Analyst’s Disclosure: I am/we are long GOOGL, PANW, PYPL, ATVI, TTD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.