Behind The Idea: Google - FCF & Earnings Compounder

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About: Alphabet Inc. (GOOG), GOOGL
by: Thomas Lott
Summary

Google on a sum of the parts basis is easily worth $1500, perhaps much more. Investors often ignore the value of YouTube, cash and their Other Bets.

Regulatory concerns seem way overdone. I suspect the stock would be $100 per share higher without US government antitrust investigations.

Even with big fines and changes to their business, Google can grow for many years to come. At $75 in EPS in 2-3 years, with resolution of the government’s meddling, then $2000 is not a crazy valuation.

Last week Thomas Lott published a Top Idea on Google (NASDAQ:GOOG) (NASDAQ:GOOGL). For a look behind the idea, please see his interview with the PRO+ team. He is planning to launch a Marketplace service next week, entitled Cash Flow Compounders: The Best Stocks in the World. This service will utilize his 25 years of professional investing experience and is the result of screening of over 5000 stocks in search of the highest quality investment opportunities at the best entry points possible. These are high return on equity, high free cash flow stocks with a proven track record in compounding earnings at higher than market rates. Keep your eyes open for that and direct message him if you’re interested.

Seeking Alpha: Can you briefly summarize your bullish thesis for readers?

Thomas Lott: Absolutely. Like many of my finds that I have written up on Seeking Alpha, Google is not only a fantastic company and blue chip growth stock, but also very interesting on a sum of the parts basis. These sum of the parts stories need a catalyst for demonstrating that value. Often a spin-off, or an asset sale. Google reminds me a lot of Fox actually, which I wrote up here in October 2016, where the sum of the parts implied at least 30% upside immediately, and 60% upside in 2 years. It wasn’t obvious that the Murdochs had any interest in selling. But lo and behold, they decided to monetize certain Fox assets. Some assets there didn’t generate much cash flow by the way, like Fox’s Star India, but were worth a fortune. A bidding war ensued and FOX more than doubled since that write-up.

In this case, Google isn’t likely to monetize anything on its own, but regulatory fears of a breakup ironically have kept a lid on the stock price. My opinion is, if the government forces a breakup of Google, into say YouTube, Android and Search, or whatever they dream up, then the upside would be tremendous, perhaps as much as 50%. Like Fox’s Star India asset, YouTube doesn’t generate much in the way of profits today. But it’s worth a fortune. Indeed if YouTube traded as a separate business, then a Netflix (NASDAQ:NFLX) type valuation would put its value in the $100-150 billion range. That’s worth $200/share to Google today. Android I think is also worth a ton, although entirely ignored as an asset within Google. And did I mention that the company has over $180 per share in cash alone on the balance sheet?

In the non-breakup case, assuming some fines and monitoring costs then the upside would potentially be just as strong. Throw a fine onto Google of $15BB, and assume only 15% growth for the next couple of years, and you get a stock doing $75 in EPS in 2021-2022, with over $200 per share in cash. At just a market multiple of say 17.5x plus the cash gets you a $1500 stock. Not bad. The real upside optionality is when regulatory issues are resolved and Google trades back to its typical 20-25x earnings multiple. That to me is quite a fair multiple considering that similar big cap tech names like Microsoft (NASDAQ:MSFT) and Visa (NYSE:V)/Mastercard (NYSE:MA) trade at 25-30+ times earnings. Then we’re talking $2000/share in 2-3 years.

SA: A large part of the mispricing is due to regulatory fears. What is your base case for how this is resolved? Should investors view it as a speeding ticket, or an existential threat?

TL: I’d say closer to a speeding ticket than an existential threat. The European Commission has fined Google about $10BB US since their regulatory reviews began in 2010. It’s a big speeding ticket, but hasn’t impeded the company’s growth at all. Google did make changes to its search algorithms and is separating Android from Chrome in the EU.

As for the US, while it is pure speculation on my part, I am putting a $15BB government fine on Google, which I think is quite conservative. I mean, the only fine materially higher than $15BB was the BP (NYSE:BP) disaster, which was $21BB. That’s after their Deepwater Horizon oil rig killed almost a dozen people and dumped some huge volume of oil into the Gulf of Mexico. Is Google that bad? No, but the stock market seems to think so as the stock has arguably underperformed by $100 per share. That’s $70BB! I’d say that this is an overreaction.

Personally, I think US consumers love Google products. YouTube runs non-stop in our house with teenagers around. I can immediately tell when I use another search engine; results are subpar. Nobody is forced to use Gmail and advertisers have dozens of choices when it comes to choosing who to advertise with. Google does have huge search share. But there are plenty of search engines out there and I think punishing them for having the best product makes no sense at all. There is no law that I know of that limits market share, or even monopolies. Duke Energy (NYSE:DUK) has a legal monopoly on power in my area. That’s 100% legitimate, but with regulated rates. Google doesn’t charge for using its search, so how is regulating it going to impact it apart from fines or a breakup?

SA: GOOG received some criticism for overpaying for YouTube at the time. Are there any divisions or projects GOOG is working on now that investors are misunderstanding or undervaluing?

TL: Great question. I talked a bit about YouTube, and article readers can get a glimpse into why it’s an amazing asset. I’d probably highlight a couple of other things.

One, Android is a free product, but it won’t stay free. Google gives away Android to phone makers and bundles Google search with it. However, the EU has mandated that Google separate Android from search in Europe. So, last week GOOG announced it will auction off search engine options to other companies. Every phone sold now in the EU will have essentially a fee that Google can collect from other search providers. Again, the irony to me is that I doubt market share will change much. But the fees could be huge. At $10 per phone in incremental fees, that could be a $2BB in cash flow just in Europe. Rolled out worldwide, it’s a huge number potentially.

The second thing I would highlight at Google is that their Other Bets, which are emerging businesses and burn cash, could also have significant value. While I admittedly have no idea what say Waymo could be worth in the future, the good news is I am getting this investment virtually free. Some rumors were circling that they were trying to raise money at a $100BB valuation earlier this year for Waymo. Not too long ago, Google paid $39.75 for a slug of Lyft (NASDAQ:LYFT). Now it's $60. The company just booked $3BB in equity gains in the second quarter from their Other Bets. There are promising, and potentially large values to be gained in the future. And like I said, we are pretty much getting these for free.

SA: You’ve recently focused on compounders – what would you say to readers who say “GOOG was a compounder but it’s too large to grow now.” What are they missing?

TL: Google is quite large, but suggesting it’s too big to grow is premature I think. You’d have to believe that the digitalization of the world has matured. I just looked up global Internet usage, and today internet users are still in the minority. Wikipedia says that 48% of the world’s population is online. Five years ago that number was 40%. I suspect in a decade easily 60%+ of the world will be connected to the web and searching on Google. Looking at Google’s ad market specifically, advertising forecasts are also strong, with 15% type growth figures for the next 2-4 years. It’s way too early to call this trend over. While growth won’t be as crazy as the early days, I think double-digit-type numbers can be achieved for many many years to come.

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Thanks to Thomas for the interview. If you'd like to check out or follow his work, you can find the profile here.

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: Thomas Lott is long GOOG and V.